Working Paper no. 110
By Erik Britton, Jens Larsen and Ian Small
In a dynamic general equilibrium (DGE) model where goods markets are imperfectly competitive, we characterise the dynamics of the mark-up of prices over marginal costs under two different sets of assumptions about market structure. In the customer market model, firms lower their mark-up when current output is low relative to future profits, foregoing current profits in order to capture future market share. In markets characterised by implicit collusion, firms lower their mark-up when current output is high relative to future profits in order to lower the incentives to undercut the implicit cartel. We characterise the dynamics by analysing the response of the mark-up, employment and output to shocks to demand (identified by innovations in government expenditure), TFP growth, and to prices of imported materials. Though the two mark-up models have quantitatively similar properties in terms of the dynamics of output and employment, they differ qualitatively - the implicit collusion model increases the output response to shocks to government expenditure and to the price of imported materials, while the customer market model dampens fluctuations in response to these shocks. Only the customer market model generates mark-up dynamics that conform with the empirical evidence on mark-up pricing in the United Kingdom, such as Small (1997), that finds procyclical mark-ups at the sectoral level, and with the priors embedded in typical macroeconometric models, such as the one used at Bank of England. The empirical evidence is at odds with the evidence for the United States and our theoretical investigation suggests that at a macroeconomic level, the only way to reconcile these two facts is to assume different models of pricing behaviour.