The sharp increase in inflation in 2021–22 came on the heels of a decade-long rise in corporate power, as reflected by the steady and broad increase in firm-level markups (De Loecker et al. 2020). This ignited a debate on whether firms were using their pricing power to pass more of the increased costs to consumers (Arce et al. 2023, Gerinovics and Metelli 2023, Glover et al. 2023). Some policymakers also expressed concern that high-markup companies could hamper the disinflation process, by retaining the benefits from declining input costs instead of passing them through in their prices. For example, Isabel Schnabel, a member of the Executive Board of the ECB, in a speech delivered in August 2023 at the conference on “Inflation: Drivers and Dynamics” co-hosted by the Federal Reserve Bank of Cleveland and the ECB, noted:
“[T]here is often an asymmetry between positive and negative cost-push shocks. While firms are quick to pass large cost increases onto consumers, they may be more reluctant to pass on declines in marginal costs.”
In Kharroubi et al. (2023), we shed light on these questions, through an analysis of the pass-through of cost-push shocks – in the form of global oil supply shocks – to prices in the US.
Mitigation of the price impact of supply shocks through markups
Our first key result is consistent with the view and evidence from past studies that high markups can act as absorbers of cost-push shocks (e.g. Kouvavas et al 2021). Figure 1 summarises this finding, focusing on the one-year ahead response of producer price index (PPI) inflation to a positive oil supply shock. As expected, PPI inflation falls following such a shock, that is, following a cut in the price of oil. However, PPI inflation is typically less sensitive to oil supply shocks in sectors where firms charge higher markups. For instance, a supply-induced reduction of 1 percentage point in the real oil price leads to a 0.2 percentage point decline in PPI inflation one year later in a sector where the median markup is 1.1, but it does not have any material impact on PPI inflation in a sector where the median markup is 1.9 or more.
Figure 1 High markups reduce the pass-through of supply shocks to sectoral inflation
Source: Authors’ calculations; see the working paper for details.
Note: The figure shows the oil supply shock pass-through to one-year-ahead sectoral inflation across the sectoral median markup distribution. The oil supply shock corresponds to a 1 percentage point decrease in the growth rate of real oil prices. Dashed lines display the 90% confidence interval. Global oil supply shocks are provided by Baumeister and Hamilton (2019). Markups for North American Industrial Classification System (NAICS) sectors are first computed at the firm level following the production function approach outlined in De Loecker and Warzynski (2012) and then revenue-weighted at the sector level.
Asymmetric cushioning effects of markups
Distinguishing shocks that raise the price of oil from those that reduce the price provides additional insights. The left-hand panel in Figure 2 shows that positive oil supply shocks – those that cut the price of oil – are associated with lower PPI inflation, but noticeably less so in high-markup sectors. Conversely, the right-hand panel in Figure 2 shows that negative oil supply shocks – those that increase the price of oil – are associated with higher PPI inflation. Yet, markups do not materially affect the extent of pass-through in this case (confidence intervals for red and blue lines overlap).
In a nutshell, high markups act as shock absorbers when input costs are falling, but not when they are rising. Figure 2 also shows a striking difference in the timing of the pass-through. While the peak impact of positive oil supply shocks (left panel) takes place within one year, the pass-through of negative oil supply shocks (right panel) keeps increasing over three years.
Figure 2 High markups reduce the pass-through of positive supply shocks
Source: Authors’ calculations; see the working paper for details.
Note: The left-hand panel shows the pass-through of positive oil supply shocks for high- and low-markup sectors defined at the 90th and 10th percentiles, respectively. The right-hand panel shows the pass-through for negative oil supply shocks. The oil supply shock corresponds to a 1 percentage point decrease in the growth rate of real oil prices. Dashed lines display the 90% confidence interval.
Dissecting the asymmetric impact of markups
The evidence from our analysis leads to the question: why do markups have different effects on the pass-through of the two different types of shocks?
One possibility is that high-markup firms raise their markups following positive oil supply shocks, but not after negative oil supply shocks (intensive margin). If this is so, the sector-wide markup would increase after positive oil supply shocks, and more so in sectors where firms charge higher markups, thereby attenuating the impact of the oil shocks.
Another possibility is that following a positive oil supply shock, firms with relatively high markups grab a larger share of the market (extensive margin). This also would help to increase the sector-wide markup and dampen the impact of disinflationary oil supply shocks.
The intensive margin
We investigate how firms adjust their markups in response to oil shocks by estimating the likelihood that firms with different initial markups raise or cut them.
Figure 3 plots the estimated change in the markup following positive oil supply shocks of different intensities for firms that start with a high markup (blue line) and those that start with a low markup (red line). Positive oil supply shocks typically lead firms that charge relatively high markups to raise their markups, while firms that charge relatively low markups barely change theirs. However, even the markup change for high-markup firms is relatively small: they raise their markups by about 2 percentage points more than low-markup firms for high-intensity oil shocks, that is, shocks at the 75th percentile of the sample distribution. To put this number in perspective, the standard deviation of markup changes observed in the sample is about 0.2, or ten times larger.
Figure 3 High-markup firms raise their markups more in response to positive supply shocks
Source: Authors’ calculations; see the working paper for details.
Note: The blue line shows the average change in markup for a firm whose markup is at the 90th percentile of the initial markup distribution. The red line shows the average change in markup for a firm whose markup is at the 10th percentile of the initial markup distribution.
The extensive margin
Next, we investigate the possibility that the pass-through of disinflationary oil shocks could be lower in high-markup sectors, by exploring how firm revenues respond to oil shocks depending on markups.
Firms that start with higher markups tend to systematically outgrow their low-markup peers following positive oil supply shocks, implying that sector-wide markups are more likely to increase in sectors where firms already charge high markups. Consistent with this result, our evidence indicates that high-markup firms grow their profits more relative to low-markup firms following positive oil supply shocks.
Together, these results suggest that the asymmetric impact of markups on the pass-through of oil supply shocks reflects a combination of intensive and extensive margin effects. On the intensive margin, positive oil supply shocks, especially large ones, allow high-markup firms to raise their markups more relative to low-markup firms. Similarly, on the extensive margin, positive oil supply shocks allow high-markup firms to outgrow their low-markup peers.
Concluding remarks
High margins are often considered to be effective buffers against sudden and unexpected inflationary pressures. Yet, looking at the experience of the US over the last two decades, we find little empirical support for this belief. Our results suggest that the conventional view about markups would benefit from a nuanced refinement recognising the asymmetries involved.
References
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De Loecker, J, J Eeckhout, and G Unger (2020), “The rise of market power and the macroeconomic implications”, Quarterly Journal of Economics 135(2): 561–644.
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Gerinovics, R and L Metelli (2023), “The evolution of firm markups in the US and implications for headline and core inflation”, VoxEU.org, 18 December.
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Kharroubi, E, R Spigt, D Igan, K Takahashi, and E Zakrajšek (2023), “Markups and the asymmetric pass-through of cost push shocks”, BIS Working Papers No. 1150.
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