CapitalMarket Imperfections and Countercyclical Markups: Theory and Evidence

During recessions, output prices seem to rise relative to wages and raw-material prices. One explanation is that imperfectly competitive firms compete less ag-gressively during recessions. That is, markups of price over marginal cost are countercyclical. We present a model of countercyclical markups based on capital-market imperfections. During recessions, liquidity-constrained firms boost short-run profits by raising prices to cut their investments in market share. We provide evidence from the supermarket industry in support of this theory. During re-gional and macroeconomic reces.sions. more financially con.strained supermar-ket chains raise their prices relative to less financially constrained chains. {JEL E32, D43, G31) Simple models of business cycles based on aggregate demand shocks imply that during booms, factor prices fall relative to output prices. This follows from the standard as-sumption that, at high output levels, marginal products are low. However, this implication is difficult to square with the facts. During booms, wages and raw-material prices tend to rise relative to output prices—that is, real fac