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.