Interpreting information, markups, and the economic cycle

Over at Worthwhile Canadian Initiative, Nick Rowe bemoans the fact that economists keep ignoring the “very short run”, and the transition from that to the short-run.  In the very short-run, we may view a shock (an increase in demand) and interpret as noise – it is only when the shock persists that we may respond.

This reminded me of tacit collusion.  Why … well why not!  In a paper by Green and Porter, discusses collusion and competition between firms with market power in a way that I’ve always found compelling.  Essentially a firm sits around doing what it does, and then it observes a drop in demand for its product.  The question it then has to answer is, “is this due to the other firm undercutting me, or has consumer demand for my product fallen?”.  Given that the firm does not know, under some conditions it will respond as if the drop in demand was due to a cut in prices by the competing firm – leading to a break down in any “tacit collusion” that existed before.  Weak demand therefore leads to price wars!

Now this isn’t the only explanation of price wars – in fact Rotemberg and Saloner showed the opposite.  In their model, there was a greater “prize from deviating”  when demand is high, and so times of high demand see collusion break down!

What does this mean for markups over the business cycle?  Well in the Green and Porter case, where this issue of interpreting information is a key driver of behaviour, markups are procyclical – in the Rotemberg Saloner model, markups are countercyclical.  Furthermore, there are many other models that aim to explain changes in the markup over the business cycle – it isn’t all about models of tacit collusion.

At an industry level, things differ – and so in different cases, the different models are supported empirically when looking at this as an industrial economics issue.  But what about over the economy as a whole, which one holds?  Generally it seems markups have been shown to be procyclical and to be countercyclical… while a fair amount of economic modeling often assumes countercyclical markups (in response to demand shocks).  This is an interesting area, very interesting.