Ebook Markups, Gaps, and the Welfare Costs of Business Fluctuations
To the extent that there exist price and wage rigidities, or possibly other types of market frictions, the business cycle is likely to involve inefficient fluctuations in the allocation of resources. Specifically, the economy may oscillate between expansionary periods where the volume of economic activity is close to the social optimum and recessions that feature a significant drop in production relative to the first best. In this paper we explore this hypothesis by developing a simple measure of aggregate inefficiency and examining its cyclical properties. The measure we propose - which we call “the inefficiency gap” or “the gap”, for short - is based on the size of the wedge between the marginal product of labor and the marginal rate of substitution between consumption and leisure. Deviations of this gap from zero reflect an inefficient allocation of employment. By constructing a time series measure of the inefficiency gap, we are able to obtain some insight into both the nature and welfare costs of business cycles.
From a somewhat different perspective, we show that the inefficiency gap correponds to the inverse of the markup of price over social marginal cost. Procyclical movements in the inefficiency gap accordingly mirror countercyclical movements in this markup. Our approach, however, differs from much of the recent literature on business cycles and markups by using the household’s marginal rate of substitution between consumption and leisure to measure the price of labor, as opposed to wages. As a matter of theory, of course, the household’s consumption/leisure trade-off is the appropriate measure of the true social cost of labor. Wage data are not appropriate if either wages are not allocational or if labor market frictions are present that drive a wedge between market wages and the labor supply curve. As we demonstrate, our markup construct is highly countercyclical. In addition, it also leads directly to a measure of aggregate efficiency costs at each point in time.
Our approach builds on a stimulating paper by Hall (1997) that analyzes the cyclical behavior of the neoclassical labor market equilibrium. Specifically, Hall first demonstrates that the business cycle is associated with highly procyclical movements in the difference between the observable component of the household’s marginal rate of substitution and the marginal product of labor. He then presents some evidence to suggest that this difference - which we refer to as the Hall residual - is of central importance to employment fluctuations. Also relevant is Mulligan (2002) who examines essentially the same measure of the labor market residual, though focusing on its low frequency movements. Specifically, he constructs an annual series of this variable, using data spanning more than a century. He finds that marginal tax rates correlate well at low frequencies with this labor market wedge.
As with Hall, we focus on the behavior of the labor market wedge at the business cycle frequency. We differ in several important ways, however. First, his framework treats this wedge simply as an exogenous driving force, interpretable for example as reflecting shifts in preferences. We instead stress countercyclical markup variations as the key factor accounting for the cyclical fluctuations in this variable and present evidence in support of this general hypothesis. Second, given our “markup interpretation,” we are able to use the Hall residual as the basis for a measure of the efficiency costs of business cycles.
From our gap variable it is possible to derive a measure of the lost surplus in the labor market at each point in time. Fluctuations generate efficiency costs on average because, as we show, the surplus lost from a decline in employment below its natural level exceeds the gain from a symmetric rise above its natural level. In this regard, our approach differs significantly from Lucas (1987, 2003) who examines the welfare costs of consumption variability associated with the cycle. While the Lucas measure does not really take account of the sources of fluctuations, our measure instead isolates the costs associated with the inefficient component of fluctuations. In this regard, our metric may give a better sense of the potential gains from improved stabilization policy.
An equally important distinction is that our approach permits not only a measure of the costs of fluctuations on average, but also an assessment of the costs of particular episodes. We find, for example, that while efficiency costs of fluctuations are not large on average, they may be quite significant during major recessions, even after netting out the gains from the preceding boom. This consideration is highly relevant because it may be that the principle benefit from good stabilization policies may be avoiding severe recessions. To the extent that centrals banks have had either good skill or good luck in keeping to a minimum the number of severe downturns, it may be that on average the costs of fluctuations are not large. This kind of unconditional calculation, however, masks the kind of losses that can emerge if luck and/or skill suddenly turn bad. For this reason, an examination of episodes where matters clearly did seem to go awry can shed light on the importance of good policy management.
In section 2 we develop a framework for measuring the inefficiency gap in terms of observables, conditional on reasonably conventional assumptions about preferences and technology. We also show that it is possible to decompose the gap into price and wage markup components In section 3 we present empirical measures of this variable for the postwar U.S. economy. The inefficiency gap exhibits large procyclical swings. In addition, under the assumption that wages are allocational, most of its variation is associated with countercyclical movements in the wage markup. The price markup shows, at best, a weak contemporaneous correlation. In section 4 we consider the possibility that purely exogenous factors (e.g. unobserved preference shifts) underlie the variation in our gap measures. Specifically, we present evidence that suggests that the Hall residual is endogenous and thus cannot simply reflect exogenous variation in preferences. The evidence is instead consistent with our maintained hypothesis that endogenous variation in markups is largely responsible for the movement in the inefficiency gap. Section 5 characterizes both theoretically and empirically the link between the labor market distortion and the output gap. In Section 6 we then use this link to examine both the unconditional efficiency costs of recessions and the conditional costs associated with the major boom/bust episodes. Concluding remarks are in section 7.
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