Job Market Paper
Price changes affect the distribution of economic resources and the drivers of inflation are central to monetary policy decisions. My paper examines how changes in market structure and product market concentration, specifically firm exit, affect prices. I develop a model in which firms are heterogeneous in their costs and market power. In the model, firms exit when they cannot pay their costs. The model predicts that the remaining firms' markups and prices increase after their competitors exit. I test my model's prediction with Swedish firm-level micro data. I use the exposure of firms to a bank, which was severely affected by the financial crisis, as an instrument to identify the causal relationship between firm exit and prices. I find that the remaining firms increase their prices by 0.3 percent when a set of firms with a combined market share of one percent exit. The estimated rise in prices from an increase in exit puts an upward pressure on inflation during recessions. Thus, my findings help understand the lack of price fall during the financial crisis - referred to as the “missing disinflation” puzzle. My empirical findings, in which the effect of exit on prices is larger than in the model, suggest that the role of entry and exit may be larger than current theoretical models with variable markups predict. I show that the model can be brought into line with the data under the assumption that industries are divided into sub-markets.