Aggregate markups

What Is Aggregate Markups?

Aggregate markups represent the average difference between the price of goods and services and their marginal cost across an entire economy or a specific industry. In the field of macroeconomics, aggregate markups are a key indicator of market power, reflecting the extent to which firms collectively can influence prices above their production costs. A higher aggregate markup suggests less competition and potentially greater profitability for businesses within that economic scope. This concept helps economists and policymakers understand the competitive landscape and its implications for various economic factors, including inflation and resource allocation⁵⁹, ⁶⁰.

History and Origin

The study of markups, and subsequently aggregate markups, gained significant academic attention as economists sought to understand deviations from perfectly competitive markets. Early economic theories often assumed perfect competition, where prices equal marginal costs, implying zero markups. However, the observable reality of firms setting prices above their costs prompted the development of theories incorporating imperfect competition and market power.

A notable shift in the understanding and measurement of aggregate markups occurred around 1980. Research by economists such as Jan De Loecker and Jan Eeckhout, extensively documented by the National Bureau of Economic Research (NBER), found that average markups in the U.S. economy began a steady rise from approximately 18% above marginal cost in 1980 to 67% by 2017⁵⁸. This increase was not uniform across all firms; instead, it was primarily driven by a sharp rise in markups among high-markup firms, leading to a change in the distribution of markups rather than a widespread increase across all businesses⁵⁷. This observed trend has spurred considerable debate and research into its causes and macroeconomic implications, including effects on labor and capital shares⁵⁶.

Key Takeaways

• Aggregate markups measure the average difference between prices and marginal costs across an economy or industry.
• They serve as a crucial indicator of the overall level of market power and competition.
• Rising aggregate markups can have significant macroeconomic implications, affecting factors such as labor's share of income, investment, and productivity.
• The calculation often involves complex econometric methods using firm-level data, as direct observation of marginal costs is challenging.
• Understanding aggregate markups is vital for competition policy and economic regulation.

Formula and Calculation

The aggregate markup is not a simple direct calculation from readily available financial statements but rather requires econometric estimation using firm-level data. At its core, a firm-level markup ((\mu)) is generally defined as the ratio of price (P) to marginal cost (MC):

$\mu = \frac{P}{MC}$

To arrive at an aggregate markup for an economy or industry, researchers typically use a weighted average of individual firm-level markups. This approach acknowledges that larger firms, or those with greater market share, have a more significant impact on the overall aggregate figure.

One common approach, following methodologies by economists like De Loecker and Warzynski (2012), involves estimating output elasticities from a firm's production function. The markup can then be derived from the ratio of a firm's sales to its total variable costs, adjusted by this output elasticity⁵⁴, ⁵⁵.

For an aggregate markup ((\Psi_t)) at time (t), it can be expressed as a share-weighted average of firm markups ((\mu_{it})):

$\Psi_t = \sum_{i} s_{it} \mu_{it}$

Where:

• (\Psi_t) = Aggregate markup at time (t)
• (s_{it}) = Revenue share of firm (i) in the total economy/industry at time (t)
• (\mu_{it}) = Markup of firm (i) at time (t)

The term marginal cost represents the cost of producing one additional unit of output. The price elasticity of demand also plays a critical role, as firms with more inelastic demand (meaning consumers are less responsive to price changes) tend to have higher markups⁵³.

Interpreting the Aggregate Markups

Interpreting aggregate markups provides insights into the competitive health and structural characteristics of an economy. A high or increasing aggregate markup can signal several economic phenomena:

• Increased Market Power: A rising aggregate markup suggests that firms, on average, possess greater pricing power over their products or services⁵². This can be due to reduced competition, increased concentration, or the emergence of dominant "superstar firms" that gain significant market share and can charge higher prices⁵¹.
• Implications for Factor Shares: Research indicates a strong correlation between rising aggregate markups and a declining labor share of income, meaning a smaller proportion of national income goes to workers⁵⁰. It can also impact the capital share.
• Resource Misallocation: When markups vary significantly across firms or industries (markup dispersion), it can lead to an inefficient allocation of resources. High-markup firms may produce less than socially optimal, while low-markup firms might produce more, leading to overall efficiency losses and depressing aggregate total factor productivity⁴⁸, ⁴⁹.
• Inflationary Pressures: In some contexts, particularly after significant economic shocks, an increase in aggregate markups can contribute to inflationary pressures as firms pass on more than just their increased costs to consumers⁴⁶, ⁴⁷.

Conversely, stable or declining aggregate markups might indicate healthy competition, efficient resource allocation, and a balanced distribution of economic gains between firms, labor, and capital. However, the interpretation must be nuanced, as markups can be influenced by various factors, including intangible investments and overhead costs⁴⁴, ⁴⁵.

Hypothetical Example

Consider a simplified economy with three distinct industries: Technology, Manufacturing, and Services. Each industry has several firms, and we want to calculate the aggregate markup for this economy.

Industry A: Technology

• Firm A1: Price = $100, Marginal Cost = $40. Markup = ($100 / $40) = 2.5
• Firm A2: Price = $80, Marginal Cost = $35. Markup = ($80 / $35) (\approx) 2.29
• Total Revenue (Industry A) = $100 (from A1) + $80 (from A2) = $180

Industry B: Manufacturing

• Firm B1: Price = $50, Marginal Cost = $30. Markup = ($50 / $30) (\approx) 1.67
• Firm B2: Price = $45, Marginal Cost = $28. Markup = ($45 / $28) (\approx) 1.61
• Firm B3: Price = $60, Marginal Cost = $32. Markup = ($60 / $32) = 1.875
• Total Revenue (Industry B) = $50 + $45 + $60 = $155

Industry C: Services

• Firm C1: Price = $70, Marginal Cost = $25. Markup = ($70 / $25) = 2.8
• Firm C2: Price = $65, Marginal Cost = $22. Markup = ($65 / $22) (\approx) 2.95
• Total Revenue (Industry C) = $70 + $65 = $135

Calculating Aggregate Markup:

1. Calculate Economy-Wide Total Revenue:
   Total Revenue = Total Revenue (Industry A) + Total Revenue (Industry B) + Total Revenue (Industry C)
   Total Revenue = $180 + $155 + $135 = $470

2. Calculate Revenue Share for each firm:

   • s_A1 = $100 / $470 (\approx) 0.213
   • s_A2 = $80 / $470 (\approx) 0.170
   • s_B1 = $50 / $470 (\approx) 0.106
   • s_B2 = $45 / $470 (\approx) 0.096
   • s_B3 = $60 / $470 (\approx) 0.128
   • s_C1 = $70 / $470 (\approx) 0.149
   • s_C2 = $65 / $470 (\approx) 0.138

3. Calculate the Weighted Aggregate Markup:
   (\Psi = (0.213 \times 2.5) + (0.170 \times 2.29) + (0.106 \times 1.67) + (0.096 \times 1.61) + (0.128 \times 1.875) + (0.149 \times 2.8) + (0.138 \times 2.95))
   (\Psi \approx 0.5325 + 0.3893 + 0.1770 + 0.1546 + 0.2400 + 0.4172 + 0.4071)
   (\Psi \approx 2.3177)

In this hypothetical economy, the aggregate markup is approximately 2.32, meaning prices are, on average, 132% above marginal costs. This aggregate markup reflects the varying degrees of pricing power across firms and industries. Such a calculation highlights the average level of market efficiency within this simplified system.

Practical Applications

Aggregate markups are a critical metric with diverse applications across economics, finance, and policy-making:

• Competition Policy and Antitrust: Policymakers and antitrust authorities use aggregate markups to gauge the level of competition within industries and the broader economy. A persistently high or increasing aggregate markup can signal reduced competition, potentially triggering investigations into market concentration, mergers, and acquisitions⁴², ⁴³. For instance, a rise in markups has been observed in industries that are more digital-intensive, suggesting a link to technological advancements and market structure⁴¹.
• Macroeconomic Analysis: Economists utilize aggregate markups to understand broad macroeconomic trends. Changes in aggregate markups can explain secular trends such as the decline in the labor share of income, the increase in the capital share, and even slower aggregate output growth³⁹, ⁴⁰. It helps to analyze the drivers of economic growth and its distribution.
• Monetary Policy: Central banks may consider aggregate markup trends when formulating monetary policy. If rising markups contribute to inflationary pressures, it could influence decisions regarding interest rates and other tools to manage the overall price level³⁷, ³⁸.
• Investment and Capital Allocation: High markups can influence investment decisions. Firms with significant market power might invest less, as they face reduced competitive pressure to innovate or expand, potentially impacting overall capital allocation and dynamism in the economy³⁶.
• Business Strategy: While aggregate markups are a macroeconomic measure, understanding the factors driving them can indirectly inform business strategy. Firms operating in industries with rising aggregate markups might consider the implications for market entry, competitive positioning, and potential regulatory scrutiny.

Limitations and Criticisms

Despite their utility, aggregate markups are subject to several limitations and criticisms that warrant careful consideration:

• Measurement Challenges: Accurately measuring marginal cost, a crucial component of markup calculation, is inherently difficult as it is not directly observable from typical financial statements³³, ³⁴, ³⁵. Researchers must rely on econometric techniques and assumptions about production functions, which can introduce biases. The use of revenue data instead of quantity data to estimate production functions can lead to biased markup estimates, particularly for the average level of markups³¹, ³².
• Heterogeneity vs. Aggregation: An aggregate markup provides an average, but it can mask significant heterogeneity at the firm or industry level. A high aggregate markup might be driven by a few "superstar" firms with exceptionally high markups, while the majority of firms experience stable or even declining markups²⁹, ³⁰. This "within-industry" versus "between-industry" effect is a critical distinction²⁸.
• Interpretation of Market Power: While markups are often interpreted as a measure of market power, other factors can influence them. For example, high markups could reflect investments in intangible assets, brand value, or significant fixed costs, rather than solely a lack of competition²⁶, ²⁷. The correlation between markups and traditional measures of market power, like market shares, is not always consistent²⁵.
• Data Limitations: The quality and availability of firm-level data, especially for private companies, can limit the accuracy and representativeness of aggregate markup estimations²⁴.
• Cyclicality: Markups can be cyclical, varying with the business cycle²¹, ²², ²³. Failing to account for these cyclical variations can lead to misleading interpretations of long-term trends or the underlying state of competition.
• Welfare Implications: While high markups can indicate welfare losses due to misallocation of resources, the magnitude and sources of these losses are debated. Some research suggests that while aggregate markups act like a uniform tax, the misallocation caused by markup dispersion is also a significant source of welfare costs¹⁷, ¹⁸, ¹⁹, ²⁰.

These limitations underscore the importance of using aggregate markups in conjunction with other economic indicators and a nuanced understanding of their underlying assumptions and methodologies.

Aggregate Markups vs. Profit Margin

While both aggregate markups and profit margin relate to a firm's pricing and profitability, they represent distinct concepts with different calculation bases and interpretive uses in financial analysis.

The core distinction lies in their base: markups are a percentage over cost, while profit margins are a percentage of revenue¹⁴, ¹⁵, ¹⁶. For example, a 100% markup does not equate to a 50% profit margin¹³. Markups primarily help gauge pricing strategy relative to the direct cost of production, offering insights into market structure and competitive dynamics. Profit margins, on the other hand, provide an overall view of a business's profitability by considering all associated costs relative to sales, reflecting how much of each sales dollar a company keeps¹². Understanding both is essential for a complete picture of financial performance and market positioning.

FAQs

What does a high aggregate markup indicate?

A high aggregate markup generally indicates that firms within an economy or industry have significant market power, allowing them to set prices considerably above their marginal costs. This can suggest reduced competition or the presence of dominant firms.

How do aggregate markups affect the economy?

Aggregate markups can affect the economy in several ways, including influencing the distribution of income between labor and capital, impacting overall productivity and economic growth, and contributing to inflationary pressures⁹, ¹⁰, ¹¹.

Are aggregate markups the same as profit margins?

No, aggregate markups and profit margins are different. Markups are typically calculated as a percentage of cost, reflecting the premium charged over production expenses, while profit margins are calculated as a percentage of revenue, indicating how much profit a company retains from each dollar of sales⁶, ⁷, ⁸.

Why are aggregate markups difficult to measure?

Aggregate markups are difficult to measure primarily because marginal cost, a key component, is not directly observable from standard financial data. Economists must rely on complex econometric models and assumptions to estimate it, which can introduce measurement challenges and biases³, ⁴, ⁵.

Has the aggregate markup changed over time?

Research, particularly for the U.S. economy, suggests that average aggregate markups have risen significantly since the 1980s. This increase is largely attributed to a concentration of market power among a subset of high-markup firms¹, ².