Variable costs approach zero

Jan De Loecker and Jan Eeckhout write,

We document the evolution of markups based on firm-level data for the US economy since 1950. Initially, markups are stable, even slightly decreasing. In 1980, average markups start to rise from 18% above marginal cost to 67% now. There is no strong pattern across industries, though markups tend to be higher, across all sectors of the economy, in smaller firms and most of the increase is due to an increase within industry. We do see a notable change in the distribution of markups with the increase exclusively due to a sharp increase in high markup firms

Tyler Cowen brought up the paper in order to criticize it. Greg Ip covered the controversy.

Variable costs are costs that increase as the business produces more output. They include costs of materials and the labor cost that is involved in direct production. My explanation for the two-Jans result is that variable costs are tending toward zero in many industries. (I think that this is also Tyler’s explanation, but I prefer to use more specific examples and less technical jargon.)

My notes on the topic.

1. Fifteen years ago, I noticed the trend toward declining variable costs. I wrote an essay called asymptotically free goods, “where research and development costs are high, but the marginal cost of the final product or service is low.” Think of a pharmaceutical that is expensive to develop but cheap to manufacture. Think of cell phone service providers, where the marginal cost of transmitting another gigabyte of data is close to zero. Think of a hospital, where most of the cost is overhead (if the amount of medical services that a hospital were to supply on a given day declined by 1 percent, the amount by which its actual costs would decline is close to zero). Think of an Internet service, such as Facebook, with high costs of development and maintaining a data center but with extremely low cost of adding another user.

The point of the essay is that under marginal cost pricing, these would be free goods. If variable cost approaches zero, then markup over variable cost approaches 100 percent. [update: a commenter points out that this statement was in error. The ratio of price to variable cost approaches infinity as variable cost approaches zero.] (In the case of Facebook, the marginal cost of serving an ad is close to zero, and the markup that it charges advertises therefore approaches 100 percent).

2. When I taught economics in high school, I would say that “price discrimination explains everything.” That is because most businesses do not operate in the textbook world of perfect competition. Instead, firms are focused on recovering fixed costs. To do so, they apply different markups to slightly different versions of products, trying to recover more fixed costs from the less price-sensitive buyers. That is why movie theaters charge so much for popcorn, why airlines have different classes of seats, why cable TV providers offer bundles, and so on.

3. In manufacturing, the share of production workers is declining, but the share of non-production workers is increasing. Overall, we are producing more output with fewer workers on the assembly line (and I would guess that materials costs also are lower).

4. My guess is that, if anything, the two-Jan’s paper understates the trend toward high markups. That is because my guess is that most corporate data allocates more labor to variable cost than really belongs there. Garett Jones pointed out that these days most workers do not produce widgets. Instead, they produce organizational capital. Garett Jones workers are part of overhead, not variable cost.

5. In textbook economics, the term “monopoly power” is pretty much by definition the ability to charge a price above marginal cost. By that definition, it is very hard to think of real-world businesses that do not have monopoly power. If you want to say that the textbook model of perfect competition is baloney sandwich, I would have to agree with you.

6. But lack of perfect competition does not mean that government regulators know better.

7. Lack of perfect competition does not mean that there is no market discipline. There is still competitive discipline, but a lot of it comes in the form of creative destruction rather than in the form of prices being driven down to marginal costs by copycat entry.

8. Government intervention can easily take the form of trying to stop creative destruction. For example, demand that autonomous vehicles be accident-free, rather than merely less dangerous on average than human-driven cars.

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3 Responses to Variable costs approach zero

  1. Brandon Berg says:

    Doesn’t markup approach infinity as variable cost approaches zero? Or do you mean markup as a percent of total cost, rather than as a percent of variable cost?

  2. Matthew Young says:

    I saw the paper and looked at their chart on mark ups over time. I found another chart that matches: interest expenses in DC relative to GDP.

    We have crowding out, the willingness of tax payers to pay an increasing portion of GDP strongly competes for allocation of reserves. Interest charges to tax payers are about 3% of GDP. Invest in the curve unless you have a higher margin deal.

  3. Handle says:

    Let’s say a lot of innovation and new business in developed countries these days has near zero marginal / variable costs and very high economies of scale. That makes sense in a way, since positive marginal cost production probably has cheaper inputs abroad (e.g. wages for labor intense production). And maybe most of these have no good way to price discriminate or to otherwise recoup overhead and fixed costs, so they’ll never succeed. The only survivors therefore are goods or services for which companies are somehow able to extract high markups, whether from brand premium, quasi-monopoly power, price discrimination, status-signalling, network-effects, etc. Over time, would it not appear that the domestic economy is evolving towards a condition of progressively higher markups and firm concentration?

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