Rising Marginal Costs, Rising Prices?

TL;DR

This paper empirically examines how demand shocks influence prices depending on industry returns to scale, revealing that market structure significantly affects inflation dynamics and monetary policy effectiveness.

Contribution

It provides new empirical evidence linking demand shocks, returns to scale, and price changes, with implications for macroeconomic policy and market competition theories.

Findings

Demand increases raise prices in decreasing returns industries.

Demand increases stabilize prices in increasing returns industries.

Market structure influences inflation and monetary policy effectiveness.

Abstract

We present empirical evidence on the relationship between demand shocks and price changes, conditional on returns to scale. We find that in industries with decreasing returns to scale, demand increases (which raise costs) correspond to price increases. Whereas, in industries with increasing returns to scale, demand increases (which lower costs) correspond to stable prices. We interpret the results with a theory of imperfect competition and returns to scale. For prices to remain stable following a cost decrease, markups necessarily rise. For prices to increase as cost increases, it is not necessary for markups to change but does not preclude their role. From a macroeconomic perspective, our results imply that inflation dynamics and the effectiveness of monetary policy depend on market structures.