Markups, Financial Constraints, and Misallocation
Paper Session
Friday, Jan. 3, 2025 2:30 PM - 4:30 PM (PST)
- Chair: Yueran Ma, University of Chicago
Risky Business and the Process of Development
Abstract
Risk is an important factor that affects investment decisions, especially for undiversified entrepreneurs in less developed economies. Yet standard macro models of financial frictions do not incorporate risk: short-term returns are known in advance, and investment is fully reversible. Thus, even if entrepreneurs are risk averse and credit constrained, they will invest all of their assets in the firm, until the marginal product of capital equals the interest rate. As a result, standard models often find that productive entrepreneurs quickly save their way out of credit constraints, limiting the effect of financial frictions on output and aggregate productivity. We incorporate risk into a model of financial frictions, by making investment partially irreversible. Productive entrepreneurs accumulate capital substantially more slowly than in the first-best, leading to a reduction in aggregate productivity. Credit can play a role in undoing these frictions if firms have an option to default. Default creates a state-contingent contract, in which the entrepreneur repays if productivity stays high and defaults if productivity falls; this encourages investment and improves welfare through risk-sharing with the bank.Borrowing Constraints, Markup Dispersion, and Misallocation
Abstract
We document new facts that link firms’ markups to borrowing constraints: 1) firms with looser constraints have higher markups, especially when assets are difficult to borrow against and firms rely more on borrowing against earnings; 2) industries where assets are difficult to borrow against have higher markup dispersion. We explain these relationships using a standard Kimball demand model augmented with borrowing against assets and earnings. The key mechanism is a two-way feedback between markups and borrowing constraints. First, firms with looser constraints charge higher markups, as looser constraints allow them to enjoy lower marginal costs and higher market shares. Second, higher markups relax borrowing constraints when assets are difficult to borrow against and firms rely on borrowing against earnings, as higher markups lead to higher earnings. Introducing borrowing constraints changes the allocative efficiency implications of markups. High markup firms can be too big because they face looser constraints and become larger. Introducing borrowing constraints also lowers the overall welfare consequence of markup dispersion.International Diversification, Reallocation, and the Labor Share
Abstract
How does growing international financial diversification affect firm-level and aggregate labor shares? We study this question using a novel framework of firm labor choice in the face of aggregate risk. The theory implies a cross-section of labor risk premia and labor shares that appear as markups in firm-level data. International risk sharing leads to a reallocation of labor towards riskier/low labor share firms alongside a rise in within-firm labor shares, matching key micro-level facts. We use cross-country firm-level data to document a number of empirical patterns consistent with the theory, namely: (i) riskier firms have lower labor shares and (ii) international financial diversification is associated with a reallocation towards risky/low labor share firms. Our estimates suggest the reallocation effect has dominated the within effect in recent decades; on net, increased financial integration has reduced the corporate labor share in the US by about 2.5 percentage points, roughly one-third of the total decline since the 1970s.JEL Classifications
- E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy
- E3 - Prices, Business Fluctuations, and Cycles