Changing Patterns of
Market Power and Contestability
Discussion
Chris Edmond
University of Melbourne
OECD Global Forum on Productivity
June 2019

Market Power and Contestability
• Chiara has given us a very interesting interpretation of some key
facts on productivity dynamics, markups, and concentration
1

Market Power and Contestability
• Chiara has given us a very interesting interpretation of some key
facts on productivity dynamics, markups, and concentration
• John makes the following important conceptual points
– market power implies markups
but, in the absence of further assumptions,
– markup data (or concentration) does not imply market power
And this provides a challenging environment for competition policy
1

Market Power and Contestability
• Chiara has given us a very interesting interpretation of some key
facts on productivity dynamics, markups, and concentration
• John makes the following important conceptual points
– market power implies markups
but, in the absence of further assumptions,
– markup data (or concentration) does not imply market power
And this provides a challenging environment for competition policy
• I agree, and will use a structural macro model to help explain why
1

Structural Model
• Based on my paper “How Costly Are Markups?” with Virgiliu
Midrigan and Daniel Yi Xu
• Dynamic general equilibrium model with heterogeneous firms and
endogenously variable markups
– larger firms face less elastic demand, set higher markups
– new firms choose initial investments to maximize expected
discounted profits, which depend on markups
2

Structural Model
• Based on my paper “How Costly Are Markups?” with Virgiliu
Midrigan and Daniel Yi Xu
• Dynamic general equilibrium model with heterogeneous firms and
endogenously variable markups
– larger firms face less elastic demand, set higher markups
– new firms choose initial investments to maximize expected
discounted profits, which depend on markups
• Calibrated to replicate recent patterns of sales and employment
concentration observed in US industry
– substantial welfare costs of markups
(e.g., 6% or 7% in consumption-equivalent terms)
– second-best policies to reduce concentration can backfire
2

“Fixed Point Problem”
• Firm size determines markups
size ⇒ demand elasticity ⇒ markups
3

“Fixed Point Problem”
• Firm size determines markups
size ⇒ demand elasticity ⇒ markups
• Markups determine firm size
markups ⇒ sunk investments ⇒ size
3

“Fixed Point Problem”
• Firm size determines markups
size ⇒ demand elasticity ⇒ markups
• Markups determine firm size
markups ⇒ sunk investments ⇒ size
• Concentration, market power etc simultaneously determined
• Determined by underlying technologies, regulatory policies, etc
• Evaluating policies targeting concentration, market power etc
requires taking a stand on this underlying structure
3

Three Distortions
• Market power distortions operate through three channels
(1) reduction in employment, investment, output
(aggregate markup channel )
(2) reduction in aggregate productivity
(misallocation channel )
(3) reduction in number of firms
(entry channel )
4

Three Distortions
• Market power distortions operate through three channels
(1) reduction in employment, investment, output
(aggregate markup channel )
(2) reduction in aggregate productivity
(misallocation channel )
(3) reduction in number of firms
(entry channel )
• Bulk of the costs of markups due to the aggregate markup channel
• Smaller role for misallocation. Negligible role for entry.
4

Welfare Costs of Markups
Total Costs Aggregate Misallocation
percentage deviation from benchmark with no distortions
welfare costs, CEV, % 6.6 4.9 1.3
output 37.0 33.0 3.2
consumption 28.8 28.7 1.2
employment 16.5 15.6 −0.3
number of firms 13.1 6.3 −2.9
physical capital 51.0 47.0 3.2
aggregate efficiency 2.9 1.0 0.3
Large costs of markups. Mostly due to aggregate markup channel.
5

How Much Concentration Should There Be?
Efficient allocation has more concentration. Large firms expand
log e
-1 0 1 2 3
logl
-10
-5
0
5
10
Employment
equilibrium
planner
Rising concentration may reflect increased allocative efficiency.
6

Tax on Concentration
Benchmark Tax on Concentration
top 1% sales share 0.30 0.18
aggregate markup 1.15 1.13
7

Tax on Concentration
Benchmark Tax on Concentration
top 1% sales share 0.30 0.18
aggregate markup 1.15 1.13
misallocation loss, % 0.8 7.3
percentage change from benchmark
number of firms 20.5
aggregate efficiency −4.0
output −5.3
consumption −8.3
employment 4.7
Reduces aggregate markup. But large increase in misallocation.
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Negligible Gains from Entry
• Aggregate markup M weighted average of firm markups µi
M =
i
µi ωi
(theoretically correct weights are cost weights)
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Negligible Gains from Entry
• Aggregate markup M weighted average of firm markups µi
M =
i
µi ωi
(theoretically correct weights are cost weights)
• Entry has offsetting direct and compositional effects
– direct effect, individual firm markups µi fall
– compositional effect, weight ωi on large firms increases
• Small firms shrink a lot, large firms shrink much less.
8

Negligible Gains from Entry
Individual markups all fall. But weight on large firms increases.
Tripling number of firms reduces M from 1.150 to 1.149
9

Sectors with Fewer Firms Have Higher Markups
Simulated relationship between markups and number firms per sector
But this reduced-form correlation is not a good guide to policy.
10

When is Entry More Effective?
• These results depend on amount of productivity dispersion
• Productivity dispersion chosen to deliver observed concentration
• In this calibration, new firms typically not as productive as large
incumbents, mostly a threat to small incumbents
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When is Entry More Effective?
• These results depend on amount of productivity dispersion
• Productivity dispersion chosen to deliver observed concentration
• In this calibration, new firms typically not as productive as large
incumbents, mostly a threat to small incumbents
• But suppose instead entry from large foreign competitors,
comparably productive to large domestic incumbents
Then entry can be much more effective
Key is putting large incumbents under head-to-head competition.
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What Explains Rise in Markups?
• Some popular explanations
– technology, e.g., higher returns to scale
(given productivity dispersion leads to more markup dispersion)
– regulation, e.g., less effective antitrust/competition policy, or greater
barriers to entry
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What Explains Rise in Markups?
• Some popular explanations
– technology, e.g., higher returns to scale
(given productivity dispersion leads to more markup dispersion)
– regulation, e.g., less effective antitrust/competition policy, or greater
barriers to entry
• But as we have just seen, there are important empirical challenges
to the barriers to entry explanation
– hard to generate the magnitude of the increase in markups
– should see decreasing concentration as increased barriers to entry
disproportionately shield small incumbents
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Summary
• So welfare costs of markups may well be substantial
• But not easy to identify simple corrective policies
– if firms differ substantially in productivity, even large changes in the
number of firms may have only small effects on average markup
– size-dependent policies can backfire, reducing average markup but
also reducing aggregate productivity by increasing misallocation
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Summary
• So welfare costs of markups may well be substantial
• But not easy to identify simple corrective policies
– if firms differ substantially in productivity, even large changes in the
number of firms may have only small effects on average markup
– size-dependent policies can backfire, reducing average markup but
also reducing aggregate productivity by increasing misallocation
• Observed changes in concentration reflect a complex mix of
underlying technological and regulatory factors
• Policy evaluation requires models that take a stand on the
underlying details that determine markups, market structure
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