Markups, Gaps, and the Welfare Costs of Business Fluctuations

Our approach builds on a stimulating paper by Hall (1997) that analyzes the cyclical behavior of the neoclassical labor market equilibrium. Specifically, Hall first demonstrates that the business cycle is associated with highly procyclical movements in the difference between the observable component of the household’s marginal rate of substitution and the marginal product of labor. He then presents some evidence to suggest that this difference is of central importance to employment fluctuations. Also relevant is Mulligan (2002) who examines essentially the same measure of the labor market wedge, though focusing on its low frequency movements. Specifically, he constructs an annual series of this variable, using data spanning more than a century. He finds that marginal tax rates correlate well at low frequencies with this labor market wedge. Finally, Chari, Kehoe and McGrattan (2004) find that the labor market wedge plays a critical role in accounting for the drop in employment during the Great Depression.

As with Hall, we focus on the behavior of the labor market wedge at the business cycle frequency. We differ in several important ways, however. First, his framework treats this wedge simply as an exogenous driving force, interpretable for example as reflecting shifts in preferences.² We instead stress countercyclical markup variations as the key factor accounting for the cyclical fluctuations in this variable and present evidence in support of this general hypothesis. Second, given our “markup interpretation,” we are able to use the Hall residual as the basis for a measure of the efficiency costs of business cycles.

In particular, with some auxiliary assumptions, it is possible to derive a measure of the lost surplus in the labor market at each point in time based directly on movements in our gap variable. Fluctuations generate efficiency costs on average because, as we show, the surplus lost from a decline in employment below its natural level exceeds the gain from a symmetric rise above its natural level. In this respect, our approach differs significantly from Lucas (1987, 2003) who examines the welfare costs of consumption variability associated with the cycle. While the Lucas measure does not really take account of the sources of fluctuations, our measure instead isolates the costs associated with the inefficient component of fluctuations. Accordingly, our metric may give a better sense of the potential gains from improved stabilization policy.

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