Markups and Marginal Costs Over the Firm Life: Implications for the Optimal Inflation Target

We estimate the dynamics of relative markups, marginal costs and prices over the firm life cycle using detailed firm data from Denmark. Relative marginal costs fall strongly over the first 15 years of firm life, but relative prices fall only weakly because of a strong rise in relative markups. Relative price trends thus underestimate trends in relative productivity. This distorts recent estimates of the optimal inflation target downward by 0.2-1.2% per year. We show that relative markups increase following the introduction of new products and the discontinuation of old products, suggesting that product turnover is important driver of markup dynamics at the firm level. Only about one third of the decrease in relative marginal cost over the firm age is explained by movements in relative productivity, with the remainder being due to non-homotheticities and increasing returns in the production function.