A new paper argues that the decline of the labor and capital shares, as well as the decline in low-skilled wages and other economic trends, have been aided by a significant increase in markups and market power.
Of the various ills that currently plague the American economy, one that has economists particularly worried is the decline in the labor share—that is, the part of national income that’s allocated to wages.
The two standard explanations for why labor’s share of output has fallen by 10 percent over the past 30 years are globalization (American workers are losing out to their counterparts in places like China and India) and automation (American workers are losing out to robots). Last year, however, a highly-cited Stigler Center paper by Simcha Barkai offered another explanation: an increase in markups. The capital share of GDP, which includes what companies spend on equipment like robots, is also declining, he found. What has gone up, significantly, is the profit share, with profits rising more than sixfold: from 2.2 percent of GDP in 1984 to 15.7 percent in 2014. This, Barkai argued, is the result of higher markups, with the trend being more pronounced in industries that experienced large increases in concentration.
A new paper by Jan De Loecker (of KU Leuven and Princeton University) and Jan Eeckhout (of the Barcelona Graduate School of Economics UPF and University College London) echoes these results, arguing that the decline of both the labor and capital shares, as well as the decline in low-skilled wages and other economic trends, have been aided by a significant increase in markups and market power.
In order to document the rise of market power across the U.S. economy throughout six decades, the authors rely on Compustat data from 1950 to 2014. Since privately-held firms are not required to disclose financial information, they note, their dataset includes only publicly-traded firms (which still account for a third of total U.S. employment and 41 percent of sales). Furthermore, since Compustat data represent only a sample, they then compare their results with aggregate data from the IRS.
Measuring markups, De Loecker explained in a conversation with ProMarket, is notoriously difficult due to the scarcity of data. In attempting to track markups across a wide set of firms and industries, De Loecker and Eeckhout diverged from the standard way in which Industrial Organization economists look at markups, the so-called “demand approach,” which requires a lot of data on consumer demand (prices, quantities, characteristics of products) and models of how firms compete. The standard approach, explains De Loecker, works when it is tailor-made for particular markets, but is “not feasible” when studying markups across many markets and over a long period of time.
To do that, De Loecker and Eeckhout use another approach, the “production approach,” which relies on standard, publicly-available balance sheet data and an assumption that firms will try to minimize costs, and does not require other assumptions regarding demand and market competition.
Using this approach, De Loecker and Eeckhout find that between 1950 and 1980, markups were more or less stable at around 20 percent above marginal cost, and even slightly decreased from 1960 onward. Since 1980, however, markups have increased significantly: on average, firms charged 67 percent over marginal cost in 2014, compared with 18 percent in 1980.
Markups, De Loecker and Eeckhout note, do not necessarily imply market power—but profits do. The enormous increase in profits over the past 35 years, they argue, is consistent with an increase in market power. “In perfect competition, your costs and total sales are identical, because there’s no difference between price and marginal costs. The extent to which these two numbers—the sales-to-wage bill and total-costs-to-wage bill—start differing is going to be immediately indicative of the market power,” says De Loecker.
Markup increases, De Loecker and Eeckhout find, became more pronounced following the 2000 and 2008 recessions. Curiously, they find that economy-wide it is mainly smaller firms that have the higher markups, which according to De Loecker is indicative of widely different characteristics between various industries. Within narrowly defined industries, however, the standard prediction holds: firms with larger market shares have higher markups as well. “Most of the action happens within industries, where we see the big guys getting bigger and their markups increase,” De Loecker explains.
The economic implications of market power
In recent years, a growing body of literature has linked the rise of market power to several adverse economic trends, such as the decline in new business start-ups, diminishing competition, and rising income inequality.
Likewise, De Loecker and Eeckhout argue that the increase in market power is consistent with a number of economic trends, among them the decline in the labor and capital shares, declining wages for low-skilled workers, decreases in labor force participation, flows, and interstate migration rates, as well as slowing GDP growth.
While some economists argue that the decline in the labor share is largely due to the transition of the U.S. economy from manufacturing to service industries, De Loecker and Eeckhout dispute this approach: most of the transition from manufacturing to services, they contend, happened before the late 1980s and has since slowed down. The decline in the labor share, they find, is closely linked to the rise in markups, especially since 1980. And while growth has been high during the 1980s and 1990s, they argue, the slowdown in GDP in the past decade, since the financial crisis, coincided with the sharper increase in market power.
“If you get a productivity shock in perfect competition, you’re just going to pass on that productivity gain to your consumers. Your costs go down and mechanically price goes down for everybody,” says De Loecker. “But if you have a bit of market power, you’re going to hold some of those cost savings in your own pocket, and the wedge between price and cost is going to increase. If you don’t produce as much as you would in a perfect competitive outcome, you’re not going to need as much labor, you’re not going to need as much capital, and there’s not going to be that much entry. That kind of insight almost naturally gives rise to all those implications.”
Market power, De Loecker and Eeckhout note, is far from the only force contributing to these trends, and the paper does not attempt to establish any causal link. “We are providing a very simple Econ 101 explanation,” says De Loecker. “If firms’ costs minimize and markups go up, it’s almost a direct implication that their expenditure for labor over sales will go down. If I’m a monopolist, I’m going to reduce quantity, so I need fewer workers, then my prices go up, and my profits go up. It’s almost a direct consequence of the optimal behavior of the firm. Essentially, nominal and real wages will go down, which is something that we see in the data, flows will go down across sectors, and you will see participation going down. Those are the logical implications for market power.”
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