Heterogeneous Markups, Growth, and Endogenous Misallocation

Abstract

Markups vary systematically across firms and are a source of misallocation. This paper develops a tractable model of firm dynamics where firms' market power is endogenous and the distribution of markups emerges as an equilibrium outcome. Monopoly power is the result of a process of forward‐looking, risky accumulation: firms invest in productivity growth to increase markups in their existing products but are stochastically replaced by more efficient competitors. Creative destruction therefore has pro‐competitive effects because faster churn gives firms less time to accumulate market power. In an application to firm‐level data from Indonesia, the model predicts that, relative to the United States, misallocation is more severe and firms are substantially smaller. To explain these patterns, the model suggests an important role for frictions that prevent existing firms from entering new markets. Differences in entry costs for new firms are less important.