Network Lerner Index: Demand and Distortions across Industries

Abstract

What determines demand elasticities and distortions across industries, acknowledging that firms’ demand and pricings are interdependent in input-output networks? I propose a modeling approach of competition in markups, which micro-founds demand elasticities and markups via “network Lerner indexes” based on the network structure of the economy in general equilibrium. At the equilibrium, each firm’s markup depends on four industry-level network statistics—cycle, substitution in production, substitution in consumption, and impact on consumer price, in addition to its market share. Empirical analysis of Compustat firms from 1997 to 2019 confirms the theory predictions. Taking into account the sectoral heterogeneity explains about three times more variations in markups. Under the theory-predicted markups, the loss in total factor productivity (TFP) due to misallocation is about 13% over the sample period, which is four times larger than the implied TFP loss that ignores sectoral heterogeneity.

Keywords: production networks, endogenous markups, sectoral heterogeneity, concentration, distortions, misallocation.

JEL Classification: C72, D21, D24, D43, D5, D57, E1, L16, O4