Entry, Variable Markups, and Business Cycles

The creation of new businesses declines in recessions. In this paper, I study the effects of pro-cyclical business formation on aggregate employment in a general equilibrium model of firm dynamics. The key features of the model are that the elasticity of demand faced by firms falls with their market share and that adjustment costs slow the reallocation of employment between firms. In response to a decline in entry, incumbent firms' market shares increase, their elasticity of demand falls, and they increase their markups and reduce employment. To quantify the model, I study the relationship between variable input use and revenue in panel data on large firms. Viewed through the lens of my model, my estimates imply that for large firms, the within-firm elasticity of the markup to relative sales is 25 percent. I use the calibrated model to study shocks to entry, finding that a fall in entry can lead to a significant contraction in employment. A shock to entry that replicates the decline in the number of businesses during the Great Recession generates a prolonged 2.5 percent fall in employment in the model. Finally, I show that the declining correlation between revenue and variable input use over the past 30 years implies that the effect of entry on the business cycle has become stronger over time.

What is the Impact of Increased Business Competition?

This paper studies the macroeconomic effect and underlying firm-level transmission channels of a reduction in business entry costs. We provide novel evidence on the response of firms' entry, exit, and employment decisions. To do so, we use as a natural experiment a reform in Portugal that reduced entry time and costs. Using the staggered implementation of the policy across the Portuguese municipalities, we find that the reform increased local entry and employment by, respectively, 25% and 4.8% per year in its first four years of implementation. Moreover, around 60% of the increase in employment came from incumbent firms expanding their size, with most of the rise occurring among the most productive firms. Standard models of firm dynamics, which assume a constant elasticity of substitution, are inconsistent with the expansionary and heterogeneous response across incumbent firms. We show that in a model with heterogeneous firms and variable markups the most productive firms face a lower demand elasticity and expand their employment in response to increased entry.

International Shocks, Variable Markups, and Domestic Prices

How strong are strategic complementarities in price setting across firms? In this article, we provide a direct empirical estimate of firms’ price responses to changes in competitor prices. We develop a general theoretical framework and an empirical identification strategy, taking advantage of a new micro-level dataset for the Belgian manufacturing sector. We find strong evidence of strategic complementarities, with a typical firm adjusting its price with an elasticity of 0.4 in response to its competitors’ price changes and with an elasticity of 0.6 in response to its own cost shocks. Furthermore, we find evidence of substantial heterogeneity in these elasticities across firms. Small firms exhibit no strategic complementarities in price setting and complete cost pass-through. In contrast, large firms exhibit strong strategic complementarities, responding to both competitor price changes and their own cost shocks with roughly equal elasticities of around 0.5. We show that this pattern of heterogeneity in markup variability across firms is important for explaining the aggregate markup response to international shocks and the observed low exchange rate pass-through into domestic prices.

Competition and the Welfare Gains from Transportation Infrastructure: Evidence from the Golden Quadrilateral of India

A significant amount of resources is spent every year on the improvement of transportation infrastructure in developing countries. In this paper, we investigate the effects of one such large project, the Golden Quadrilateral in India. We do so using a model of internal trade with variable markups. In contrast to the previous literature, our model incorporates several channels through which transportation infrastructure affects welfare. In particular, the model accounts for gains stemming from improvements in the allocative efficiency of the economy. We calibrate the model to the Indian manufacturing sector and find real income gains of 2.7%. We also find that allocative efficiency accounts for 7.4% of these gains. The importance of allocative efficiency varies greatly across states, and can account for up to 18% of the overall gains in some states. The remaining welfare gains are accounted for by changes in labor income, productive efficiency, and average markups that affect states’ terms of trade.