Industry Concentration and Aggregate Price Dynamics

Abstract

The inflation episode following Covid-19 reflects the confluence of several factors: swings in consumer demand, supply-chain bottlenecks, and expansionary fiscal and monetary policies. Corporate profits appear as one of the main contributors to the initial inflation surge and this paper develops a general equilibrium framework for aggregate price dynamics around industry competition. It accounts for differences in pricing power across firms, cross-price effects, and firm-specific shocks. The model builds upon a set of established facts. Industry leaders are usually much larger than other firms and charge a higher markup. They focus on preserving market share and their pricing behavior differs: they limit the pass-through of idiosyncratic cost shocks, but are strategic and match price changes by rival firms. Meanwhile, trailing firms are generally much smaller and set prices monopolistically. On this basis, the framework yields several key results. First, due to strategic complementarity in pricing, the implied cost pass-through for industry leaders after an aggregate shock is around 25 percent higher than for an idiosyncratic shock, which aligns with evidence from Gödl-Hanisch and Menkhoff (2023). Second, due to differences in firms’ demand schedules, aggregate shocks have an uneven impact and the model explains differences in business cycle fluctuations across firms. Finally, if a negative productivity shock affects small firms more, industry leaders raise prices, resulting in ‘excess’ profits. In this case, the additional markup distortion amplifies the adverse impact of the shock by around 25%.