Marching Markups

This new paper by De Locker and Eeckhout will likely be classic:

We document the evolution of markups based on firm-level data for the US economy since 1950. Initially, markups are stable, even slightly decreasing. In 1980, average markups start to rise from 18% above marginal cost to 67% now. .. Increase in average market power .. can account for .. slowdown in aggregate output. .. The rise in market power is consistent with seven secular trends in the last three decades.

Yes, US public firms have only 1/3 of US jobs, and an even smaller fraction of the world’s. Even so, this is a remarkably broad result. I’d feel a bit better if I understood why their firm-level simple aggregation of total sales divided by total variable costs (their Figure B.5a) gives only a 26% markup today, but I’ll give them the benefit of the doubt for now. (And that figure was 12% in 1980, so it has also risen a lot.) Though see Tyler’s critique.

The authors are correct that this can easily account for the apparent US productivity slowdown. Holding real productivity constant, if firms move up their demand curves to sell less at a higher prices, then total output, and measured GDP, get smaller. Their numerical estimates suggest that, correcting for this effect, there has been no decline in US productivity growth since 1965. That’s a pretty big deal.

Accepting the main result that markups have been marching upward, the obvious question to ask is: why? But first, let’s review some clues from the paper. First, while industries with smaller firms tend to have higher markups, within each small industry, bigger firms have larger markups, and firms with higher markups pay higher dividends.

There has been little change in output elasticity, i.e., the rate at which variable costs change with the quantity of units produced. (So this isn’t about new scale economies.) There has also been little change in the bottom half of the distribution of markups; the big change has been a big stretching in the upper half. Markups have increased more in larger industries, and the main change has been within industries, rather than a changing mix of industries in the economy. The fractions of income going to labor and to tangible capital have fallen, and firms respond less than they once did to wage changes. Firm accounting profits as a fraction of total income have risen four fold since 1980.

These results seem roughly consistent with a rise in superstar firms:

If .. changes advantage the most productive firms in each industry, product market concentration will rise as industries become increasingly dominated by superstar firms with high profits and a low share of labor in firm value-added and sales. .. aggregate labor share will tend to fall. .. industry sales will increasingly concentrate in a small number of firms.

Okay, now lets get back to explaining these marching markups. In theory, there might have been a change in the strategic situation. Perhaps price collusion got easier, or the game became less like price competition and more like quantity competition. But info tech should have both made it easier for law enforcement to monitor collusion, and also made the game more like price competition. Also, anti-trust just can’t have much effect on these small-firm industries. So I’m quite skeptical that strategy changes account for the main effect here. The authors see little overall change in output elasticity, and so I’m also pretty skeptical that there’s been any big overall change in the typical shape of demand or cost curves.

If, like me, you buy the standard “free entry” argument for zero expected economic profits of early entrants, then the only remaining possible explanation is an increase in fixed costs relative to variable costs. Now as the paper notes, the fall in tangible capital spending and the rise in accounting profits suggests that this isn’t so much about short-term tangible fixed costs, like the cost to buy machines. But that still leaves a lot of other possible fixed costs, including real estate, innovation, advertising, firm culture, brand loyalty and prestige, regulatory compliance, and context specific training. These all require long term investments, and most of them aren’t tracked well by standard accounting systems.

I can’t tell well which of these fixed costs have risen more, though hopefully folks will collect enough data on these to see which ones correlate strongest with the industries and firms where markups have most risen. But I will invoke a simple hypothesis that I’ve discussed many times, which predicts a general rise of fixed costs: increasing wealth leading to stronger tastes for product variety. Simple models of product differentiation say that as customers care more about getting products nearer to their ideal point, more products are created and fixed costs become a larger fraction of total costs.

Note that increasing product variety is consistent with increasing concentration in a smaller number of firms, if each firm offers many more products and services than before.

Added 25Aug: Karl Smith offers a similar, if more specific, explanation.

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  • Isn’t the obvious answer here the increased political power of the business class? Price collusion and consolidation have gotten easier because the laws and enforcement have gotten laxer.

    • No, that isn’t obvious at all.

      • How about a less strong version of that claim: the evidence is consistent with (if not proof of) that hypothetical cause. Tyler Cowen is claiming the output evidence is against that, and while you linked to him you seemed to agree with the economists he’s criticizing on output.

      • Anti-trust only has much of a chance in industries with large firms. It has little effect on the industries made up of many small firms. Rising markups are seen more in those industries.

      • Eh, I wouldn’t say it’s so obvious that no other explanation is plausible, but it seems pretty likely to me. I assume you wouldn’t argue that neoliberal era of the last few decades of economic policy has been marked by an increase in the political power of corporate interests. And the data we have available looks exactly like you’d expect if those interests were using that power to make the economy operate more in their favor. Could be just a coincidence, or just one factor, but it should at least be at the top of the list of explanations to consider.

      • Do you know of a data series that tracks “political power of corporate interests”?

      • I’d say a good place to start is the average ideological rankings of Congress, if possible specifically on economic issues. As I assume you must know there has been a significant move to the right on economic policy in recent decades. Labor’s influence is down, corporate influence is up, it’s nothing too controversial.

        All I’m really saying is that if “collusion got easier” would work as an explanation for a phenomenon you see in the real world, you should strongly consider it because collusion definitely has gotten easier as a result of a weaker and more laxly enforced regulatory regime. I suppose you’d actually expect that, since larger firms have more market power and thus both less need and more ability to collude under any regime.

  • Is this saying that the markups for a giving product have increased or is it compatible with saying a greater fraction of the products now have higher markups because of new entrants?

    I mean the obvious worry is that computer software where the variable costs are very very low (basically tech support, bandwidth and maybe update servers) could skew this figure as more software enters the market. This might not be obvious given the balance sheet driven model they are using to estimate markup.

    Its probably nothing so simple but could someone explain to my why not if not?

    • Software is too small a fraction of the economy to be a big effect here.

      • I was being dumb and interpreting “average markup” as the average of ratios rather than the ratio of averages when I suggested that software could, alone, have an effect. However, I was thinking about it as one example and if enough goods with low variable cost and high fixed cost enter the market that seems like it could have this effect.

        I mean it seems possible that the greater tech level we see across the board in buisness products (POS terminals, phones, even just email) for roughly the same price as before and the greater use by consumers of technology creates more potential for internal automation reducing the variable costs while at the same time increasing the fixed costs (the IT guy coming by to set things up or the contract to handle SEO and ensure listing on foursquare).

        Hmm, didn’t explain that very well. I guess what I’m asking is whether it can be the case that all industries are becoming a little more like software in that they are doing more upfront preparation to lower the marginal costs?

      • They are doing more upfront preparation, but I argue that isn’t because that lowers marginal costs, but instead to accommodate increasing demand for variety.

  • Daniel Culley

    Why not simply that the largest firms in these industries have benefitted from investing returns to scale? That would both raise their markups and lower their marginal costs, explaining why output hasn’t changed. It seems intuitive, as Wal-Mart has much lower incremental costs than the largest retail firms of the 60s did. Ditto Amazon and distribution.

    Or is that explanation incompatible with the output elasticity not changing?

    • This is mainly happening in industries with smaller firms. If those industries had increasing returns, firms there would be larger.

  • This may be a really dumb question but based on both your analysis and comments by Cowen do we really even have enough data from just these couple of papers to give anything better than an educated guess?

    I mean from what I saw of the paper it seems we are missing all kinds of information about what extent these changes are being driven by new products entering the market (I see that it isn’t about new markets) or how these effects break down between new entrants and old entrants. It seems like that leaves enough degrees of freedom to make all kinds of postulates (small firms correlate more with newer products or with older products or big firms are more/less capable of automation or ,maybe superstar firms spend more on tangible products than before while everyone else spends less) and one could use those to defend any number of interpretations, e.g., most posts I’ve read saying it couldn’t be X seem like they could be countered by an argument of the form ‘but maybe such and such correlation/offsetting effect is present’.

    So are we just at the point of throwing out some ideas and waiting for more detailed breakdown of the data combined with modelling efforts to tell us which is right or are workable explanations actually pretty scarce?

    • As usual, we know some things and not others, and we look to find things we can say with sufficient confidence given this situation.

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  • 3rdMoment

    I’m having a hard time understanding how “little change in output elasticity” is consistent with having their markup measure increase so much faster than Sales/COGS, since (if I’m reading correctly), the markup estimate is just output elasticity multiplied by Sales/COGS.

    Does this make sense to anyone else?

  • David Condon

    I have a theory. Mass manufacturing is often outsourced to places like the Phillipines and China. Many aspects of manufactured goods are not protected by copyright or patent, and as such manufacturing facilities in China can, and often will, produce a set of goods for the branded US firms, and a second set of identical goods with a Chinese label on them, and slight cosmetic changes. So yes many chinese knockoffs are cheap imitations, but in many other cases the Chinese knockoff is identical to the original. Even if the contract has a non-compete clause, after the contract ends, if the US firm decides to switch to another factory, the old factory can just continue to produce the same thing they were producing before with a different label on it, and minor changes. Knowledgeable and cost-conscious consumers will generally be aware of these knockoffs, and can buy from them at a much lower price. Said companies generally have much smaller marketing budgets, and rely entirely on wholesale online distribution. You won’t find them in stores, which reduces the problem of unsold inventory and it eliminates retail markups. If cost-conscious consumers are less likely to buy from US firms because they can get an identical product for less money from a Chinese firm, then the consumers that are still buying American will be on average more price inelastic. This will correspondingly increase markups among US firms because of globalization. If this theory is correct, markups in third world countries won’t have increased by as much as in the US, and the increase in markups in the US will correlate both with better access to information about foreign countries, and with increased manufacturing overseas.

  • You argue that growth has slowed because greater wealth leads to consumption of a greater variety of products. That seems akin to the notion that growth has slowed because an ever-greater share of consumption concerns products from low-productivity sectors, such as health care and education – an implication of Baumol’s cost disease. In both cases, consumers use their greater wealth to increase their consumption of products which cannot be very efficiently produced, which in turn reduces growth.

    • No, the difference is important. Not growing because we now emphasize industries where growth is hard is quite different from growing productivity as much as before but not using that ability because we are instead making more kinds of products.

  • Perhaps its not a matter of “our” getting richer (is the population really much better off than in the 80s, and why didn’t we see these effects earlier if they result from greater social wealth) as much as increasing economic inequality causing an increasingly greater orientation of consumer production to the affluent. (Not much “variety” for the poor, who shop at WalMart.)

  • mgoodfel

    Why lump all of U.S. industry together? It seems like the Health, Education and the Legal industries have been doing pretty much the same thing for years, but at steadily increasing expense. Doesn’t that negative productivity growth weigh down the overall average? Aren’t these industries big enough to have an effect?

    • The paper doesn’t lump industries together, but does separate analyses for different industries, and even varies the detail with which it does that.

  • Slartibartfarst

    I have not read the paper, and am reluctant to pay $5 merely to read it, so any comment I might maker would be based on an ignorance of what might be in the paper.
    However, speaking as an accountant who has been involved in output costing analysis for both services and manufacturing industries – and their associated strategic marketing exercises – I would tend to take a skeptical view of papers that studied the history of product “markup” in an economy and which then attempted to draw conclusions from that.

    The reason for my skepticism would be that “markup” – which is defined as “the amount added to the cost price of goods to cover overheads and profit” is not, per se, necessarily likely to be a statistically useful indicator of anything much – e.g., for estimating/”predicting” by an accountant or an econometrician.

    Similarly, an examination of the historical ratio of fixed versus variable costs in total output costs is not necessarily likely to be of much use as a statistically significant predictor.

    I could be wrong, of course, but one thing that does seem to be known is that, in western economies, whereas direct and indirect costs of manufacturing production in the ’60s typically could be of the ratio of 80:20 (the typical Pareto ratio), they are nowadays more likely to be reversed and of the order 20:80. One explanation for this is that some main direct costs (e.g., typically labour) can be significantly reduced by labour-rate arbitrage through the use of manufacturing resources in second or third-world economies where labour-rates are extremely low relative to western economies.

    • The fraction of US firms which are relying on substantial fractions of foreign workers is pretty small.

      • Slartibartfarst

        @RobinHanson: Sorry, I had assumed (perhaps incorrectly) that the US economy would have used a lot of that overseas labour pool in manufacturing outsourcing – for example, the manufacture of various products, such as say, general manufactured goods, cars or car components or clothing, or computer manufacture. And then the service side too – for example, the outsourcing of Helpdesks and IT outsourcing, etc.. Would that only affect a small fraction of US GDP? (I don’t know.)

    • > I have not read the paper, and am reluctant to pay $5 merely to read it

      Use Libgen.

      • Slartibartfarst

        [b]@gwern:[/b] Thanks for that tip! I shall try it.

  • Gunnar Zarncke

    “Premium Mediocre” seems like a suitable term to describe this increased taste for variety at low cost:

  • Robert Rounthwaite

    I don’t understand why we would expect markup percentages to be stable when more and more goods are produced offshore at lower costs. Say the wholesale cost of a t-shirt over time moves from $10 or $5, but the markup in $ remains almost constant — this will look like an increase in markup (or, perhaps, as RobinHanson suggests, in fixed costs) while it is really a failure to decline.

    I’m not saying this is the full effect, but it doesn’t seem to be accounted for.

  • David R Henderson

    Robin, What is “quantity competition?”

    • Cournot competition: Max_q1 q1*(P(q1,q2, ..)-c(q1)).

  • Greg van Paassen

    The only market that matters is the labor market. Firms’ market power was obtained by traditional political rent-seeking, not network effects.

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