[Full Text] [SSRN] [Marginal Revolution]
The Law of Diminishing Elasticity of Demand (Harrod 1936) conjectures that price elasticity declines with income. I provide empirical evidence in support of Harrod's conjecture using data on household transactions and wholesale costs. Over the observed set of purchases, high-income households pay 14pp higher retail markups than low-income households. Half of the differences in markups paid across households is due to differences in markups paid at the same store. Conversely, products with a high-income customer base charge higher markups: a 10pp higher share of customers with over $100K in income is associated with a 4–8pp higher retail markup. A search model in which households' search intensity depends on their opportunity cost of time can replicate these facts. Through the lens of the model, changes in the income distribution since 1950 account for a 14pp rise in retail markups, with 30% of the increase since 1980 due to growing income dispersion. This rise in markups consists of within-firm markup increases as well as a reallocation of sales to high-markup firms, which occurs without any changes to the nature of firm production or competition.
with David Rezza Baqaee and Emmanuel Farhi
R&R, The Review of Economic Studies
[Full Text] [VoxEU Summary] [Code for Evaluating Demand System] [Replication Code]
How does an increase in market size, say due to globalization, affect welfare? We study this question using a model with monopolistic competition, heterogeneous markups, and fixed costs. We characterize the change in welfare in the decentralized equilibrium, and decompose it into changes in technical efficiency and allocative efficiency. Allocative efficiency changes due to three different types of reallocations: (1) reallocations across firms with heterogeneous price elasticities due to increased entry, (2) reallocations due to the exit of marginally profitable firms, and (3) reallocations due to changes in firms’ markups. Whereas the second and third effects have ambiguous implications for welfare, the first effect, which we call the Darwinian effect, always increases welfare regardless of the shape of demand curves. We non-parametrically calibrate residual demand curves with firm-level data from Belgian manufacturing firms and quantify our theoretical results. We find that mild increasing returns at the micro level can catalyze large increasing returns at the macro level. These aggregate gains are due to the Darwinian effect, which reallocates resources from low- to high-markup firms, and not the death of unproductive firms (2) or changes in markups (3). Our results suggest that a policy-maker can harness Darwinian reallocations in an economy with fixed resources by subsidizing firm entry costs.
with David Rezza Baqaee and Emmanuel Farhi
R&R, Journal of Political Economy
[Full Text] [VoxEU Summary]
We propose a supply-side channel for the transmission of monetary policy. We show that in an economy with heterogeneous firms and endogenous markups, demand shocks have first-order effects on aggregate productivity. If high-markup firms have lower pass-throughs than low-markup firms, as is consistent with the empirical evidence, then a monetary easing reallocates resources to high-markup firms and alleviates misallocation. In this case, positive “demand shocks” are accompanied by endogenous positive “supply shocks” that raise output and productivity, lower inflation, and flatten the Phillips curve. We derive a tractable four-equation dynamic model and use it to show that monetary shocks generate a procyclical hump-shaped response in TFP and endogenous cost-push shocks in the New Keynesian Phillips curve. A calibration of the model suggests that the supply-side effect increases the half-life of a monetary shock’s effect on output by about 30% and amplifies the cumulative effect on output by about 70%. We provide empirical evidence of the micro-level reallocations that generate procyclical TFP using identified monetary shocks.
with Paul Brest, Shereen Griffith, Damira Khatam, Demoni Newman, Reirui Ri, Alessandra Santiago, Mengyi Xu, and Lucie Zikova
Impact investing often takes place in developing or frontier markets, and, as a result, impact investors will likely encounter problems unique to investing in countries where legal institutions are weak, ineffective, or entirely absent. The absence of credible legal institutions—and hence the lack of credible penalties for misbehavior—exposes the impact investor to a wider berth of actions from counterparties, as well as political and market uncertainties often present in these settings. This paper discusses the various risks and describes mitigation techniques.
Rampant informality in developing economies proves to be a major obstacle to public revenue collection, limiting investment in crucial public infrastructure. The model presented in this paper sheds light on inter-firm mechanisms that motivate firms to either transact formally or transact informally and evade taxes. The formulation allows us to predict comparative statics on a variety of parameters, including the effective tax rate, the likelihood of audit, the penalties levered against firms caught transacting informally, and the distribution of firm sizes in the economy. Empirical support for each of these predictions is discussed. In particular, the model provides theoretical underpinnings for predicting the effect of multinational entry and trade liberalization on the size of the informal sector.