The Economics Seminar Series brings guest speakers from universities, government agencies and research institutions around the world to VCU Business to share current research across a range of economic topics.
Thomas Hasenzagl, Ph.D., of the Federal Reserve Bank of Richmond will present “Precautionary Pricing and Markup Cyclicality.”
Abstract
Why are markups cyclical, and why does their cyclicality vary across firms, sectors, and business-cycle episodes? We develop a theory of pricing under uncertainty in which risk-averse firms set prices before costs and demand are realized. In this environment, pricing serves a precautionary role and optimal markups incorporate a risk adjustment reflecting the firm's desire to limit its exposure to uninsurable fluctuations in cost and demand. Greater cost uncertainty raises markups, and greater demand uncertainty lowers them.
A central implication of the theory is that markup cyclicality reflects two forces: the composition of risk firms face, which determines how markups respond to cost and demand uncertainty; and the cyclicality of those risks, which determines whether each source of uncertainty amplifies or dampens markup fluctuations over the business cycle. Using U.S. manufacturing data, we find that cost and demand uncertainty have the predicted opposing effects on markups, both across industries and firms, and we measure their contributions to markup dynamics.
We also embed this precautionary-pricing mechanism in a standard general-equilibrium model of firm dynamics, and find that precautionary pricing raises welfare and boosts business formation despite amplifying misallocation and inequality between workers and entrepreneurs.