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The Cyclical Behavior of Prices and Costs

  • Julio J. Rotemberg
  • Michael Woodford

Because inputs are scarce, marginal cost should be an increasing function of output. Without changes in this real marginal cost schedule, aggregate output can vary if and only if the markup of price over marginal cost varies. In this review, we discuss the extent to which observed fluctuations in aggregate economic activity depend upon such variations in average markups. We first study whether, empirically, real marginal cost rises in cyclical expansions. Average real labor cost is not very procyclical, but, for reasons such as overhead labor and adjustment costs, marginal labor cost should be more procyclical. Measures of marginal cost based on materials costs and inventories also appear procyclical. We next show that countercyclical markup variation may, depending upon how costs are modeled, account for a substantial fraction of cyclical output movements. We also show that the observed procyclical variations in productivity and profits are consistent with the hypothesis that cyclical variations in output are primarily due to markup variations than to shifts in the real marginal cost schedule. Finally, we survey theories of endogenous markup variation. These include both models of sticky and models in which firms' desired markup varies over time.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6909.

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Date of creation: Jan 1999
Date of revision:
Publication status: published as Handbook of Macroeconomics, Vol.1B, Taylor, J.B., and M. Woodford, eds., Amsterdam: North-Holland, 1999.
Handle: RePEc:nbr:nberwo:6909
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