Income Dispersion and Counter-Cyclical Markups

Chris Edmond and Laura Veldkamp

ABSTRACT:
Recent advances in measuring cyclical changes in the income distribution raise new questions: How might these distributional changes affect the business cycle itself? We show how counter-cyclical income dispersion can generate counter-cyclical markups in the goods market, without any preference shocks or price-setting frictions. In recessions, heterogeneous labor productivity shocks raise income dispersion, lower the price elasticity of demand, and increase monopolistically competitive firms' optimal markups. The calibrated model explains not only many cyclical features of markups, but also cyclical, long run and cross-state patterns of standard business cycle aggregates.