Economic Fluctuations, Market Power, and Returns to Scale: Evidence from Micro Data

Recent research on aggregate fluctuations, coupled with ongoing work in industrial organization, has renewed interest in the existence, magnitude, and cyclical pattern of market power and the extent of increasing returns to scale across industries. By exploiting restrictions from dynamic theory and information from asset markets, we develop a new framework for generating quantitative evidence on market power and returns to scale. Tailoring the econometric model to available data at the firm level, we calculate the percentage differential between price and marginal cost (the Lerner index) in terms of the parameters from the econometric system. Our illustrative results for firms in eleven industries indicate that there is a great deal of heterogeneity in the extent of market power. Industries with significantly positive Lerner indices also have substantial increasing returns in the production technology. We find that there is only a modest relation between our estimated Lerner indices and traditional measures of market power and that our estimates are affected by the level of aggregation. Market power is generally procyclical, and this movement is quantitatively important in a number of industries. Thus, variations in the markup of price over marginal cost may help dampen aggregate economic fluctuations.