Academic journal article Economic Inquiry

Imperfect Competition and Business Cycles: An Empirical Investigation

Academic journal article Economic Inquiry

Imperfect Competition and Business Cycles: An Empirical Investigation

Article excerpt

IMPERFECT COMPETITION AND BUSINESS CYCLES: AN EMPIRICAL INVESTIGATION

Does imperfect competition increase the magnitude of business cycles? If so, the

variability of an industry's employment and output should be positively related to the

market power of firms in that industry. This paper demonstrates that the opposite is

true: U.S. manufacturing industries with high price-cost margins display less

employment variability than do low-markup industries. These high-markup industries

display less price variability as well. Highly concentrated industries, however, do

display more employment variability. To some degree, markups may reflect labor

hoarding rather than market power; this may account for part, but not all, of the negative

correlation between markups and variability.

I. INTRODUCTION

Recent research has investigated whether deviations from perfect competition, either in goods or labor markets, help explain the existence and magnitude of business cycles. In particular, both theoretical and empirical evidence suggests that imperfectly competitive firms hold prices more rigid in the face of demand shocks than do more competitive firms.(1)

This finding raises the question of whether imperfectly competitive industries also exhibit larger fluctuations in output and employment. This paper examines employment and output data for 446 U.S. manufacturing industries over the years 1958 to 1984. If employment and output fluctuations have been smaller in more competitive industries, this would suggest that imperfect competition may indeed lead to larger business cycle fluctuations.

In fact, my results suggest the opposite: industries with larger price-marginal cost margins display less variability in employment and output (although the output results are not robust). The finding for employment is remarkably robust to a wide range of specifications; in particular, it holds for two different methods of estimating the price-marginal cost margin. In contrast, I find that highly concentrated industries--as opposed to those with high price-marginal cost margins--do display more variability in output and employment than do less concentrated industries. In addition, I confirm the finding of previous studies that industries with high price-cost margins display less price variability. Thus it appears that imperfect competition may reduce variability in both prices and quantities.

The paper proceeds as follows. Section II outlines the theoretical literature and surveys previous empirical work in this area. Section III describes the methodology of the paper, and section IV describes the estimation of the price-marginal cost margin. Section V presents the results, and section VI discusses possible explanations. Section VII concludes.

II. THEORETICAL LITERATURE AND PREVIOUS WORK

Many theoretical models suggest that imperfectly competitive industries ought to display more cyclical variability of output than perfectly competitive industries. The common thread in all these theories is real price rigidity.(2) Some reason is offered why an imperfectly competitive firm does not adjust its (relative) price in response to a demand shock as much as would a perfectly competitive firm. The less prices adjust, the more output (and employment) must adjust. Therefore, the argument goes, imperfect competition may exacerbate the size of business cycle fluctuations.(3) This basic argument dates back to Means [1935].

Prices may be relatively acyclical or even countercyclical in industries with market power for one of two reasons: either marginal cost is relatively flat, or markups are relatively countercyclical. The following theories of real price rigidity may be classified as falling into one of these two categories:

* Firms with market power are assumed

to maintain excess capacity, perhaps as

a barrier to entry by new firms. …

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