A Risk Map of Markups: Why We Observe Mixed Behaviors of Markups

Abstract

This paper proposes an explanation for mixed evidence on the behaviors of markups. The key mechanism consists of two complementary channels of risk internalization that arise when firms face uninsurable business risks. One channel is based on passive risk consideration, through which firms raise prices to abide by riskier business thereby associating higher production with higher prices. The other channel is based on active risk management, through which firms lower prices to handle riskier business thereby associating higher production with lower prices. The relative responsiveness of the two channels to a shock depends on each firm’s fundamental characteristics and leads to a sharp division of markup cyclicality across sectors.

Keywords: markups, risk internalization, technology, market power, cost channel, hedging channel

JEL Classification: D21, E32