Mark-Up Pricing over the Business Cycle: The Microfoundations of the Variable Mark-Up

While considerable attention has been paid either to the fixity or variability of the markup and thus the profit rate, the existing literature has failed to develop a serious microeconomic underpinning. The purpose of this paper is to construct a microeconomic model for the optimal cyclical behavior of the mark-up and to analyze its implications for mark-up variability. The debate over the variability of the mark-up has been primarily empirical in nature. The major area of contention has centered around the demand sensitivity of the mark-up.' On one hand, proponents of a cyclically fluctuating mark-up consider both cost and demand determinants of the mark-up and focus on the income elasticity of demand to explain mark-ups that rise during the expansion phase of the business cycle and decline during the contraction. On the other hand, there are the cost dominated theories of the mark-up which predominantly argue that the mark-up is constant over the cycle.2 While this debate rages on, neither side has successfully explained the stylized facts of the cyclical mark-up trajectory-mark-ups increase from the initial trough to the midexpansion of the typical business cycle and then decline from that point until the terminal trough.3 This oversight, particularly the inability to explain the midexpansion decline in the mark-up, stems from either the lack of or incomplete consideration of demand determinants of the mark-up. A major shortcoming of traditional mark-up models is the independent, rather than interactive, treatment of the effects of a changing cost structure and a changing set of competitive pressures on price and mark-up determination. The interconnection between cost-induced price increases and the potential intensification of competitive (demand) pres-