Why Market Power Matters for Inflation

This has been a remarkable recovery for workers. There are now between 2.7 and 3 million more jobs, with unemployment 1.2 percent lower and labor force participation a third of a percent higher, than what the CBO projected without the American Rescue Plan. Estimates of labor market dynamism—depressed for decades before the COVID-19 pandemic—have skyrocketed, enabling workers to move up the career ladder and quit their jobs to seek better and more productive ones. We are also recovering to the pre-COVID macroeconomic trend for consumption—something we never did after the Great Recession, which represented a loss of trillions of dollars.

Yet this recovery has also featured higher-than-expected inflation. This has occurred alongside record high corporate profit margins, and the relationship between these two trends has been one of the central debates of this recovery.

According to the National Accounts, corporate profit margins are at their highest rate since 1950. And since 2020, 40 percent of the increases in prices for nonfinancial corporate businesses is reflected in higher corporate profits, compared with just 22 percent from employee wages. This is in stark contrast to the previous 40 years, where these values were 11 percent for corporate profits and 62 percent for wages.

Researchers at the Federal Reserve Bank of New York have found a connection between higher prices and gross profit margins—a connection that is especially high in this recovery.

There is also a growing disconnect between the price increases for inputs to business and the comparatively larger increases in the prices of goods that consumers pay—especially for goods like automobiles. However, without firm-level data, it is difficult to determine the exact relationship between the increase in markups—the difference between revenues and the marginal costs of production—and inflation. Research I’ve done with my Roosevelt Institute colleague Niko Lusiani was among the first since the pandemic to explore the size and distribution of markups across 3,700 firms with public data operating in the US in 2021 against 270,000 observations going back to 1955.

We reproduced the analysis of De Loecker, Eeckhout, and Unger (2020) who found that markups increased in a steady and dramatic fashion from 1980 through the 2010s, driven by firms in the top of the markups distribution. Our paper updated this work through 2021, relying on Compustat, the research standard for publicly traded firm-level data, which pulls and standardizes publicly disclosed data.

We found that markups and profits skyrocketed in 2021 to their highest recorded level since the 1950s. Further, firms in the US increased their markups and profits in 2021 at the fastest annual pace since 1955. This was also driven largely by firms at the very top of this distribution; markups increased the most at the very top.

Most importantly, we found that markups from before the pandemic were a strong predictor of the increase in markups during 2021, suggesting that market power had a role in driving inflation. More specifically, a 10 percent higher level of size-adjusted markups before the pandemic was associated with an increase of markups between 1.6 and 2.7 percent in 2021.

Inflation has broadened since these 2021 results. Though in 2022 inflation is more driven by services—and especially housing—goods inflation still remains high and has also not seen any real deflation back to prior prices. If corporate power allows margins and goods inflation to continue to be this elevated, then there is no real path back to pre-pandemic levels of inflation without severely driving down demand for services, harming our economy.

Inflation is a global phenomenon, and corporate profits are just one reason it remains high. But since corporate profit margins have become so unusually high, there is room for reversing them with little economic harm and huge societal benefit, including lower prices in the short term, and less inequality and more innovation in the medium term. This is true no matter their origins. Such a high profit margin also means that there’s room for wages to increase without necessarily raising prices—an important dynamic in a strong labor market. We believe the evidence presented by our analysis points to tackling inflation with an all-of-government administrative, regulatory, and legislative approach.