Research paper challenges conventional thinking on economics

Published 1:30 am Friday, September 29, 2017

Most published economic research papers pass unnoticed by anyone but the authors. A few attract critical reviews by other economists. And fewer still attract the attention of non-economists — the analysts, investors, and policy makers who are interested in how our economy works and how it is doing.

A research paper by two academic economists belongs to the last category and it hasn’t even been published yet. Its central conclusion is that since 1980, firms have been able to expand substantially the margin between marginal cost and price.

The authors, Jan De Loecker and Jan Eeckhout, are both esteemed economists and are not timid at recognizing the implications of their research finding. They believe that the increasing market power that this expansion of the margin demonstrates is responsible for the major economic changes we have seen since then, including, “1. decrease in labor share; 2. decrease in capital share; 3. decrease in low skill wages; 4. decrease in labor force participation; 5. decrease in labor flows; 6. decrease in migration rates; 7. slowdown in aggregate output.”

This could be the blockbuster economic theory breakthrough of our time … or it could be the economics version of a late-night TV commercial.

The research is data-driven, and the authors are forthcoming in explaining the strengths and weaknesses of the data on publicly traded firms that they used. There is no such thing as perfect data in macroeconomics and they have done an admirable job in structuring the statistical data so that it could support an economic theory argument.

Some questions about the conclusion remain, though. The first is rooted in basic arithmetic. There are two possible reasons why there could be an increase in the margin between cost and price. The first is an increase in price; and the second is a reduction in cost. The authors prefer the price explanation, which is the accepted theory of both economists and government regulators. There is good reason for this, since that economic theory tells us that market power results in higher prices paid by consumers and lower output.

This was a very good explanation of the U.S. economy’s experience up until the 1980s and was the reason behind the anti-trust movement and the government’s regulation of corporate mergers.

The decades since the 1980s have been characterized by outsourcing — both domestic and foreign. As we all know, lower-cost imported goods have come to dominate U.S. consumer markets. Foreign suppliers enjoyed such an edge, mostly in labor costs initially, that U.S. producers almost disappeared from the markets.

The sheer volume of lower-cost imports could certainly explain an increase in the margin between cost and price and perhaps makes even more common sense than corporations wielding market power. In fact, the link between market power and price seemed weakened. In many areas, consumers enjoyed stable prices even as business margins increased.

Size is no longer an absolute indicator of market power, nor is it even a reliable predictor of margin.

The authors of this economic research report found that “…markups tend to be higher, across all sectors of the economy, in smaller firms….” Sometimes the corporate elephants can dance like Gregory Hines or Fred Astaire.

Amazon.com, for example, is the current target of choice for analysts and regulators who think it is too big.

There is no doubt that Amazon has market power, but it uses it primarily on the “buy end” rather than on the “sell end.”

Consumers most often pay lower prices, not higher, and Amazon succeeds not by lurching around markets but by being nimble — seeing opportunities where others do not. It got its start by launching itself into an already over-crowded market — retail books — believing that the long-range lower cost of having warehouses and outsourcing final delivery to customers would be lower than the costs of bricks-and-mortar retail stores across the nation.

A second question about the authors’ conclusions deals with the decrease in the shares of both capital and labor. Here the cause may be lodged in how we define and calculate cost. In an economy dominated by the service sector, as ours, the costs of computers and information systems are generally considered as indirect, or overhead, since it is very difficult to assign specific information technology costs to a specific service delivered to a customer. This shift in costs may not have been reflected in the data used by the authors.

Despite these questions, and others, the authors of this research paper deserve praise for putting some excitement back into economic theory. The paper is so challenging to customary economics that it is bound to attract critics of both the data model used and the conclusions drawn. But that is the way economic thought is sharpened and our understanding becomes fuller.

James McCusker is a Bothell economist, educator and consultant.