Capital Market Imperfections, Product Market Competition andthe Cyclical Behavior of Price-Cost Markups

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9414141 Scharfstein This research will study the response of pricing, markup, investment and inventory decisions to demand fluctuations for firms experiencing different degrees of liquidity constraints. The study is divided into three parts. In the first part, a model is developed that analyzes the effects of external financing constraints on markups, capital expenditures and inventories. The key arguments made in this part of the study are that firms set prices to attract customers and capture greater market share. If firms do not have to face capital market imperfections, the markups tend to be procyclical because it is easy to capitalize on a state of high customer demand to improve profit margins. If firms face capital market imperfections, the markups tend to be countercyclical. When the model is extended to account for capital expenditures, we derive a general result that shows how borrowing firms tend to be less forward looking and invest less in capital over the long term. The second part of the study uses data from the supermarket industry in the empirical application of the models. The main focus of the empirical work is to ascertain whether firms that are more financially vulnerable to economic downturns tend to raise markups more than their less financially vulnerable rivals. The third part of the study extends the basic framework to a broader range of industries. This project is of significant interest because the results could improve our understanding of the interaction between capital markets and product markets.