Customer Capital, Markup Cyclicality, and Amplification

This paper studies the importance of firm-level price markup dynamics for business cycle fluctuations.

The first part of the paper uses state-of-the-art IO techniques to measure the behavior

of markups over the business cycle at the firm level. I find that markups are countercyclical

with an average elasticity of -0.9 with respect to real GDP, in line with the earlier industry-level

evidence. Importantly, I find substantial heterogeneity in markup cyclicality across firms, with

small firms having significantly more countercyclical markups than large _rms. In the second

part of the paper, I develop a general equilibrium model that matches these empirical findings

and explore its implications for business cycle dynamics. In particular, I embed customer capital

(due to deep habits as in Ravn, Schmitt-Grohe, and Uribe 2006) into a standard Hopenhayn

(1992) model of firm dynamics with entry and exit. A key feature of the model is that a firm's

decision about markups becomes dynamic { firms accumulate customer capital in the periods

of fast growth by charging low markups, and choose to exploit it by charging high markups

in the downturns. In particular, during recessions, the endogenous higher exit probability for

smaller firms implies that they place lower weight on future profits, leading them to charge

higher markups. This mechanism serves to endogenously increase the dispersion of firm sales

and employment in recessions, a property that is consistent with the data. I further show that

the resulting input misallocation amplifies both the volatility and persistence of the exogenous

productivity shocks driving the business cycle.