Price and Wage Stickiness, Inflation and Profits

The Manchester School Vol 80 No.
3 263278
doi: 10.1111/j.1467-9957.2011.02241.x
June 2012
PRICE AND WAGE STICKINESS, INFLATION

AND PROFITS*
manc_2241
263..278
by
CARL GWIN
Graziadio School of Business and Management, Pepperdine University
and
DAVID D. VanHOOSE
Hankamer School of Business, Baylor University
This paper investigates the relationship between firm mark-ups and inflation. In sectors of the economy with industries characterized by flexible
prices and sticky wages, mark-ups should respond positively to inflation.
Industry mark-ups in sectors with both flexible prices and flexible wages
theoretically may rise or fall in response to an increase in the price level.
Mark-ups of industries in sectors of the economy in which prices are
sticky should respond negatively to inflation, with an absolutely larger
negative response occurring in sticky-price industries with flexible wages.
Empirical analysis of US industries provides support for nearly all of
these theoretical predictions.
Introduction
How does inflation affect firms profits? Most theories of the inflationprofits
relationship have focused on effects inflation has on the dispersion of product
prices across firms and resulting effects on firm mark-ups. Bnabou (1988,
1992a) and Diamond (1993) suggest that inflation induces consumers to
search for old sticker prices, which increases price dispersion but reduces
market power, thereby resulting in lower mark-ups. In support of this argument, Bnabou (1992b) provides evidence in favor of an inverse relationship
between inflation and mark-ups in the US retail trade sector. Kaskarelis
(1993) likewise concludes inflation and mark-ups are negatively related in the
UK manufacturing sector. Nevertheless, in the context of a monopolistic
competition model, Wu and Zhang (2001) reach a contrary conclusion: inflation decreases the number of firms in an industry and reduces relative firm
size, which leads to higher mark-ups. Van Hoomissen (1988) and Tommasi
(1994) conclude that inflation reduces the information that current prices
provide about future prices, and Tommasi provides empirical support that
inflation thereby results in higher mark-ups. Gwin and Taylor (2004) offer
evidence showing that these differing conclusions about the inflationprofits
* Manuscript received 21.8.09; final version received 10.7.10.

2011 The Authors
The Manchester School 2011 Blackwell Publishing Ltd and The University of Manchester
Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK, and 350 Main Street, Malden, MA 02148, USA.
263
264
The Manchester School
relationship can be explained by relative magnitudes of search costs: in

product markets with lower (higher) search costs, inflation is more likely to
generate lower (higher) mark-ups.
In this paper, we propose that fundamental factors influencing the
responsiveness of profit shares to inflation are the degrees of flexibility versus
stickiness of prices and wages. We contemplate an economy populated by a
mix of sectors with either flexible or sticky product prices and with either
flexible or sticky nominal wages. Firms in these different sectors value real
wages in terms of the sectoral prices that they receive for sale of their products, while workers value real wages in terms of the level of prices of goods
produced across the sectors. We argue that, in this setting, inflation should
most likely be associated with higher profits in industries within a sector in
which nominal wages are sticky in the short run but product prices adjust
flexibly, because inflation likely will raise firms revenues at a faster pace than
their wage costs, which results in higher profits. In a sector with both flexible
prices and flexible wages, both revenues and wage bills rise in response to
inflation, resulting in an ambiguous theoretical impact on industries profit
shares. In contrast, in a sector with sticky product prices, the short-run
impact of inflation is a speedier rise in wage costs relative to revenues, which
should tend to depress firms profits.
To test these predictions, we use inflation and industry-level price and
wage data from the US Bureau of Labor Statistics (BLS) and financial data
from Standard & Poors Compustat database to develop sticky- versus
flexible-price and sticky- versus flexible-wage classifications of US industries
for which sufficient matching data are available. We then conduct panel
regressions relating industry mark-ups to inflation that also employ our
industry price- and wage-stickiness classifications. Overall, our results
provide support for our basic theoretical predictions. We find evidence of
statistically significant positive responses of mark-ups to inflation in industries with flexible prices and sticky wages, while responses of markets to
inflation are inconclusive in industries with both flexible prices and flexible
wages. Statistically significant negative responses of mark-ups to inflation
occur in industries with sticky prices and flexible wages. Consistent with our
theoretical analysis, we find evidence of muted responses of mark-ups to
inflation in industries with sticky prices and sticky wages. Contrary to theoretical considerations suggesting an absolutely smaller negative response of
mark-ups to inflation in these industries, however, we find a slight positive
response, the only result at odds with our predictions.
The next section offers the reasoning behind our predictions, which also
are exposited with a simple model in the Appendix, regarding the responses of
profits to increases in the economy-wide price level depending on whether
product prices and/or nominal wages are flexible or sticky. Section 3 explains
our empirical approach, discusses our data and presents our empirical findings. Section 4 summarizes our conclusions.
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Price and Wage Stickiness, Inflation and Profits
265
2 Flexible versus Sticky Prices and Wages, Inflation

and Profits
A simple static model in the Appendix shows concretely that the responses
of a firms or industrys revenues and costs to inflation differentially depend
on the relative flexibility or stickiness of product prices and nominal wages.
Generalizing this stylized model to a more dynamic, interdependent setting
would necessarily yield a greater scope for theoretical indeterminacies (see,
for instance, Konieczny (1990) and Bnabou and Konieczny (1994) for
analyses that yield indeterminacies for firms with sticky prices and flexible
wages). Basic economic logic suggests, however, that the following fundamental forceswhich are consistent with the analysis provided in the
Appendixultimately will tend to prevail in determining how price and
wage stickiness influence the inflationprofits relationship.
Consider an economy comprised of a number of sectors populated by
immobile price-taking firms and workers. Firms value the real wage they pay
workers in terms of the prices they receive for sale of items produced in their
sectors. In contrast, workers value the real wage in terms of the overall level
of prices of goods produced across all sectors of the economy. A rise in the
economy-wide price level, which we assume arises primarily from a confluence of demand-side factorsproductivity changes generate conflicting
effects on marginal cost and mark-upsboosts aggregate demand for goods
in all sectors, but how profits respond to inflation in each sector depends on
whether or not product prices and nominal wages are sticky.
Within a sector with flexible prices and flexible wages (which we shall
refer to as a FP/FW sector henceforth), the rise in demand caused by an
increase in the aggregate level of prices pushes up the sectoral product price,
which in turn generates an increase in the value of labors marginal product
and hence the demand for labor. Thus, the sectoral wage rate rises. Nominal
wages do not rise in equal proportion with the increase in the rise in the
product price, however. Because firms measure real wages in terms of the
sectoral price while workers calculate real wages in relation to the overall
price level, labor demand and labor supply respond differentially to the rise in
the aggregate price level. Hence, the responses of employment and output to
the price-level increase are non-neutral; both rise somewhat in response to the
price-level increase. Firms revenues and costs both increase, but by differential amounts. The Appendix shows that for the price-taking firms under
consideration, the key determinant of whether revenues rise by more or less
than the wage bill is the elasticity of output with respect to labor. Depending
on the value of this elasticity, the predicted response is theoretically ambiguous and subject to empirical evaluation.
Of course, in a number of industries the existence of explicit or implicit
contracts gives rise to short-run nominal wage rigidities, particularly in
manufacturing subsectors (see, for instance, Ghosal and Loungani, 1996). If
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wages are fixed in the near term in some sectors of the economy but product
prices are not, then an increase in the economy-wide price level generates
qualitatively the same impact on revenues as experienced in a FP/FW sector.
In a flexible-price/sticky-wage (FP/SW) sector, however, employment
increases, but the nominal wage rate does not, so the rise in the wage bill can
be more subdued. As shown in the Appendix, firms profit shares respond
positively to inflation in a FP/SW sector if labor supply is sufficiently inelastic
and the output elasticity with respect to labor is sufficiently large. Estimated
labor supply elasticities typically range between 0.1 and 0.5, suggesting that
this configuration of elasticities likely prevails and that mark-ups should be
positively related to inflation in a FP/SW sector.
In many industries, prices are posted in company price lists, in catalogs,
on websites and so on, and firms face menu costs of changing prices. The
macroeconomic implications of the price stickiness that results if a large share
of industries adjust prices sluggishly have been explored in considerable detail
in the recent literature (see, for instance, Gali and Gertler, 1999; Sbordone,
2002; Woodford, 2003). Estimates derived from macroeconomic data often
suggest that average US and European price-adjustment intervals exceed a
year, although Gwin and VanHoose (2008a) offer evidence indicating that
such estimates likely are overstated. Furthermore, Bils and Klenow (2004)
find that prices of about half of 123 categories of consumer goods and
services adjust within four or five months. In addition, Gwin and VanHoose
(2008b) provide evidence derived from US industry-level data that on average
firms in industries accounting for at least a third of total sales adjust their
prices in less than two quarters. Thus, product price stickiness appears not to
be as widespread as commonly presumed in the macroeconomics literature.
Nevertheless, considerable evidence suggests that short-term product price
stickiness exists in a significant portion of US industries.
In industries in which product prices are rigid but nominal wages are
not, when a rise in the economy-wide price level boosts nominal demand for
the sectors output, the failure of prices to increase will tend to restrain the
resulting rise in revenues. In a SP/FW sector, however, there will be upward
pressure on both wages and employment. Consequently, growth in the wage
bill will outstrip the increase in revenues, leading to the prediction that profits
will unambiguously decline in a SP/FW sector.
If both product prices and nominal wages are sticky, then increases in
both revenues and costs that a price-level increase generates by raising
nominal product demands operate through quantity adjustments in product
and labor markets. In such a sticky-price/sticky-wage (SP/SW) sector, therefore, the predicted direction of the profit response to inflation depends primarily on relative responses of levels of output and employment. The basic
model in the Appendix indicates that, as long as the elasticity of output with
respect to labor is bounded below unity, the wage-bill response will eclipse the
revenue response, so that profits in a SP/SW sector will decrease. If the output
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elasticity is close to unity, however, this negative profit response should be

quantitatively small.
Thus, our reasoning leads to three predictions.
(i) In the short run, an increase in the price level is associated with higher
profits in a flexible-price sector that experience wage rigidities, or a
FP/SW sector, if labor supply is sufficiently inelastic (a stylized fact in
the macro-literature) and the output elasticity with respect to labor is
sufficiently large.
(ii) The short-run response of profits to inflation in a sector in which both
product prices and wages are determined in spot marketsa FP/FW
sectorcould be positive or negative, depending on the magnitude of
the elasticity of output with respect to labor.
(iii) The short-run response of profits to a sudden rise in the price level of
firms in a sector with inflexible product prices should be negative,
whether nominal wages are flexible or sticky, although the effect of
inflation on profits of firms with both sticky prices and sticky wagesa
SP/SW sectorshould be quantitatively smaller than in a sector with
sticky prices and flexible wagesa SP/FW sector.
3
Empirical Approach, Data and Evidence
To accomplish our first task of classifying industries as sticky- or flexibleprice industries and sticky- or flexible-wage industries, we implement an
empirical model based on the exposition of Woodford (2003, p. 225), which
in turn is based on the analysis provided by Erceg et al. (2000). In general,
Woodford argues for relating wage inflation to the output gap, the negative
percentage deviation of real wage from steady state and expected future wage
inflation. Woodford also suggests that it is theoretically appropriate to relate
price inflation to the output gap, the negative percentage deviation of real
wage from steady state and expected future price inflation. Nevertheless, he
likens his model of price inflation to the New Keynesian Phillips Curve
(NKPC) model of Gali and Gertler (1999), which relates price inflation to a
measure of real marginal cost and to expected future inflation, an approach
we use because, as discussed below, we are able to construct industry-level
measures of real marginal cost.
Thus, for purpose of classifying industries as flexible/sticky-price and
flexible/sticky-wage industries, we consider the estimation equations
dwt = w + w GAP + w (wt 1 + CPIt 1 wt 1 ) + Et [ dwt +1 ]
(1)
dpt = p + p st + Et [ dpt +1 ]
(2)
where dwt is contemporaneous wage inflation; GAP is the output gap calculated as the quadratically detrended log of real GDP; wt 1 + CPIt 1 wt 1 is, to
accommodate the timing of wage adjustment in the relatively high-frequency
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quarterly data that we analyze, the negative percentage deviation of the

industry-level real wage from steady state during the previous period;
Et[dwt+1] is expected future wage inflation; dpt is price inflation; st is real
marginal cost; and E[dpt+1] is expected future price inflation. We estimate
these equations by following the method of Gali and Gertler (1999) with a
two-stage least squares (generalized method of moments) linear regression
with instruments as four lags of the range of change of industry price, a proxy
for industry marginal cost, the output gap, wage inflation, commodity price
inflation and the longshort interest rate spread.
To implement the empirical model given by (1) and (2), we employ BLS
price and wage data that are available at the industry level and GDP data
from the US Bureau of Economic Analysis. We use industry-level producer
price indexes (PPI) from the BLS to proxy industry prices. Augmented
DickeyFuller and PhillipsPeron tests allow us to overwhelmingly reject the
null hypothesis of a unit root in both price and wage industry-level inflation
at all common significance levels.
BLS industry-level share (real unit labor cost) data are sparse and available only in an annual frequency. Thus, we follow Gwin and VanHoose
(2008b), who substitute percentage change in average variable cost, dAVCt,
for percentage deviation real unit labor cost from steady state in the NKPC
model of price inflation. The BLS does not collect variable cost data, so we
construct industry average variable cost data from costs available from Standard & Poors Compustat financial information database. Quarterly revenues
(R) and costs of goods sold (VC) for the period 1 Quarter 1961 to 2 Quarter
2007 were available from the Compustat database for 27,751 publicly traded
US firms in 1329 six-digit North American Industry Classifications System
(NAICS) industries. An industrys total revenue is the sum of the N individual firm revenues: Rt = iN=1 Ri ,t . Industry total variable cost is the sum of
the N individual firm cost of goods sold: VCt = iN=1 VCi ,t . Industry average
variable cost (AVCt) is derived as
Pt
VCt
AVCt Qt
= Pt
= AVCt
Rt
Pt Qt
where Pt is the industry PPI from the BLS.

There were 995 six-digit NAICS industry-level PPI series with data
available from the BLS. We dropped 474 industries from the analysis because
the BLS had collected only very recent PPI data due to NAICS reclassifications of industries in 1997, 2002 and 2007. We dropped two industries
because the BLS did not collect PPI data in 2007 and 10 industries that the
BLS only intermittently collected PPI data over the last 10 years. Of the 509
remaining industries, we were able to match 414 to available Compustat data.
Of these 414 industries, 118 were dropped because fewer than 40 quarters of
complete data were available. We were then able to obtain wage data
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(average hourly earnings) from the BLS Current Employment Statistics

program for 292 of the 296 remaining industries.
Estimates of the industry-level NKPC price inflation and Woodford
wage inflation equations are available from the authors upon request. We use
the estimated coefficients to identify sticky- and flexible-price industries by
partitioning the industry ep coefficients into two distinct non-overlapping
groups with Statas kmedians cluster analysis. In an iterative process, each
industry is assigned to the group whose median center is the closest, and then
based on that categorization, new group centers are determined. These steps
continue until no industries change groups. A median center provides a more
stable measure of the group centers, a feature particularly useful for this
application because the flexible-price coefficients are relatively large and
statistically significant whereas the sticky-price coefficients are close to zero
and statistically insignificant. We also classified industries as sticky- or
flexible-wage industries based on a median partition clustering of the ew
coefficients.
Combinations of the above classifications result in four types of industry
groups: flexible price/flexible wage (FP/FW), flexible price/sticky wage (FP/
SW), sticky price/flexible wage (SP/FW) and sticky price/sticky wage (SP/
SW). Table 1 summarizes according to three-digit NAICS codes the
categories into which the 292 industries fall (three-digit NAICS codes are
listed). Table 2 reports summary statistics for the coefficients ep and ew. The
classification routine roughly splits the sample in half for both the price and
wage sector classifications. The median and mean of the coefficients and the
associated t statistics indicate that the flexible price and wage sectors have
relatively large and significant coefficients compared with the associated
sticky classifications. Indeed, analysis of the coefficients verifies that this is
true across the entire distribution of estimated industry coefficient.
Equation (1) is based on Erceg et al.s (2000) framework in which
monopolistically competitive workers supply labor to firms in a setting with
staggered wage contracts, with the consequence that both the output gap and
prior-period wage deviations play a role alongside the forward-looking wage
expectation, whereas equation (2) follows Gali and Gertlers (1999) by relating current price inflation only to real marginal cost and the forward-looking
price expectation. Hence, although both the price and wage equations are
based on theories of Calvo-style pricing, equation (1) appears to offer more
potential latitude for the empirical framework to yield more wage stickiness
than price stickiness. In fact, however, Table 2 indicates that while our
classification method identifies 199 industries, or about 68 per cent of the
industries we examine, as sticky-wage industries, it also suggests that 186
industries, or about 64 per cent of the total, are sticky-price industries.
Consistent with the findings of previous research, manufacturing industries broadly tend to exhibit short-run nominal wage rigidities that likely arise
from explicit or implicit contracts. The same observation holds for the trans 2011 The Authors
270

Table 1
Summary of Industry Classifications by Three-digit NAICS Subsector
NAICS
Subsector description
Sector 11 Agriculture, forestry, fishing and hunting

113
Forestry and logging
Sector 21 Mining
211
Oil and gas extraction
212
Mining (except oil and gas)
213
Support activities for mining
Sector 31 Non-durable goods manufacturing
311
Food manufacturing
312
Beverage and tobacco product manufacturing
313
Textile mills
314
Textile product mills
315
Apparel manufacturing
316
Leather and allied product manufacturing
Sector 32 Natural resource manufacturing
321
Wood product manufacturing
322
Paper manufacturing
323
Printing and related support activities
324
Petroleum and coal products manufacturing
325
Chemical manufacturing
326
Plastics and rubber products manufacturing
327
Nonmetallic mineral product manufacturing
Sector 33 Durable goods manufacturing
331
Primary metal manufacturing
332
Fabricated metal product manufacturing
333
Machinery manufacturing
334
Computer and electronic product manufacturing
335
Electrical equipment, appliance and component
manufacturing
336
Transportation equipment manufacturing
337
Furniture and related product manufacturing
339
Miscellaneous manufacturing
Sector 4849 Transportation and warehousing
484
Truck transportation
486
Pipeline transportation
488
Support activities for transportation
493
Warehousing and storage
Services
515
Broadcasting (except Internet)
517
Telecommunications
531
Real estate
532
Rental and leasing services
541
Professional, scientific and technical services
561
Administrative and support services
621
Ambulatory health-care services
622
Hospitals
623
Nursing and residential care facilities
Total
FP/SW FP/FW SP/SW SP/FW

0
2
1
1
0
0
0
0
4
0
0
6
0
7
1
1
0
2
1
5
0
0
2
0
0
7
3
0
1
5
4
6
2
1
1
2
3
0
4
0
1
11
4
1
1
2
1
2
3
1
1
3
1
2
0
10
3
3
0
0
0
0
2
1
5
5
7
2
10
4
3
3
2
0
2
1
11
13
16
7
2
2
12
0
2
1
1
1
1
1
0
7
3
6
5
1
7
1
1
1
1
0
0
0
0
0
1
0
0
0
0
0
0
0
0
1
1
0
0
0
1
1
76
0
0
0
0
0
0
0
0
0
30
1
1
1
1
3
1
2
2
0
123
0
0
0
0
1
1
0
0
0
63
FP/SW, flexible price/sticky wage; FP/FW, flexible price/flexible wage; SP/SW, sticky price/sticky wage;
SP/FW, sticky price/flexible wage.
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271
Table 2
Summary Statistics for eP and ew
Sector
Flexible price
Sticky price
Flexible wage
Sticky wage
Variable
Count
Median
Mean
Std dev.
Minimum
Maximum
ep
t statistics
ep
t statistics
ew
t statistics
ew
t statistics
150
0.0955
2.99
-0.001
-0.065
-0.1275
-2.515
-0.0085
-0.175
0.2018
4.39
-0.009
-0.18
-0.1822
-2.87
-0.0022
-0.112
0.2405
5.94
0.0323
1.78
0.1824
1.80
0.035
1.04
0.025
0.75
-0.192
-8.89
-1.293
-10.98
-0.054
-4.96
0.944
55.5
0.024
6.67
-0.055
-0.66
0.12
2.75
142
148
144
portation and warehousing subsectors. Broadly consistent with findings of

Leith and Malley (2007), Nakamura and Steinsson (2008) and Gwin and
VanHoose (2008b), sticky prices are most evident in the non-durable and
durable goods manufacturing sectors, whereas the natural resource manufacturing sector has a more even split between industries with flexible and
sticky prices. Most of the service industries fall into the sticky price/sticky
wage category.
Oil and gas industries (NAICS code 211) tend to exhibit flexible prices,
which also accords with results obtained in previous research, but these
industries show evidence of sticky wages. Other mining industries tend to
exhibit sticky prices but a mix of price or wage stickiness. Most of the 292
industries are manufacturing industries (NAICS codes 3133). The majority
of manufacturing industries and also information and service industries
(NAICS codes 51, 53, 54, 56, 61, 62) exhibit sticky prices, and among these
most also exhibit sticky wages.
Differences among industry groups in the response of mark-ups to inflation is estimated in the panel regression,
3
MARGIN i ,t = + t + yt Y + tT + D j t J + i ,t
(3)
j =1
where MARGINi,t is industry i mark-up at time t, which is calculated as (Ri,t

- VCi,t)/Ri,t; pt is alternatively the inflation rate based on the all commodities
PPI from the BLS; yt is the real GDP growth rate; Dj is a dummy variable
associated with each industry group; and mi,t is an error term. Augmented
DickeyFuller and PhillipsPeron tests allow us to overwhelmingly reject the
null hypothesis of a unit root in inflation based on the all commodities PPI
at all common significance levels.
The three hypotheses summarized in Section 2.4 suggest that mark-ups
in flexible price/sticky wage industries should increase in response to inflation. In contrast, industries in the sticky price/flexible wage group should
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272
have the lowest, negative responses of mark-ups to inflation. The other two
groups, flexible price/flexible wage and sticky price/sticky wage, would fall
somewhere in between.
Table 3 shows the results of a fixed-effects panel regression based on
equation (3). The excluded dummy is sticky price/flexible wage, which is the
industry group hypothesized to have the lowest response of mark-up to
inflation.
The results displayed in Table 3 provide support for our hypotheses. As
predicted in hypothesis (i), mark-ups in flexible price/sticky wage industries
do exhibit a positive and significant response to inflation (0.270 - 0.173 =
0.097). For flexible price/flexible wage industries, there is no conclusive result
on the response of mark-ups to the level of inflation, which is consistent with
the theoretically ambiguous hypothesis (ii)s prediction regarding the impact
of inflation on profit shares of firms in such industries.
Hypothesis (iii)s key prediction that mark-ups in sticky price/flexible
wage industries should respond negatively to inflation is supported by the
negative and significant coefficient on the omitted SP/FW sector (-0.173).
There is support for the additional prediction that mark-ups in sticky price/
flexible wage industries should exhibit a smaller response to inflation than in
sticky price/sticky wage industries. These mark-ups, however, exhibit slightly
positive responses to inflation (0.180 - 0.173 = 0.007), which is at odds with
the theoretically predicted negative response.
Table 3
Industry Mark-up Response to Actual Inflation
Fixed-effects panel regression, equation (3)
Dependent variable: Gross margin
Inflation, all commodities PPI
Percentage change in real GDP
Time index
Interaction of inflation and dummy for flexible price/sticky wage industries
Interaction of inflation and dummy for flexible price/flexible wage industries
Interaction of inflation and dummy for sticky price/sticky wage industries
Constant
Observations
Number of NAICS industries
R-squared
Absolute value of t statistics in parentheses.
*Significant at 5 per cent; **significant at 1 per cent.
2011 The Authors
-0.173
(2.39)*
0.098
(1.63)
0.030
(26.58)**
0.270
(2.80)**
0.110
(0.91)
0.180
(2.07)*
24.870
(117.38)**
39952
292
0.02
273
To evaluate whether these results are robust to using the Congressional

Budget Office (CBO)s measure of the output gap instead of computing the
gap as the quadratically detrended log of real GDP, we redid the analysis with
the alternative CBO measure. The classifications of only 93 of the 292 industries changed as a consequence, and Table 4 shows that the qualitative results
for the industry-level inflationprofits relationships remain unaffected by this
change in the gap measure. Of the 93 reclassifications, 45 were from flexible
price to sticky price, 33 from flexible wage to sticky wage and 15 from sticky
wage to flexible wage. The industry coefficient on the CBO measure of output
gap is economically and/or statistically more significant than the coefficient
from detrended real GDP for almost all of the 78 reclassifications from a
flexible price and or wage classification to a sticky one. This may imply that
the CBO measure explains more of the variance in industry price and/or wage
inflation, and thus these 78 industries should rightfully be classified as sticky
price and/or wage. Nevertheless, the key results are unchanged.
In addition, we examined regressions for each industry grouping individually. We obtain results analogous to the dummy-variable approaches
reported in Tables 3 and 4 for the sticky wage/flexible price (a negative
relationship between inflation and the mark-up consistent with theory), flexible price/sticky wage (the predicted positive inflationmark-up relationship)
and sticky price/sticky wage (an estimated positive but insignificant inflation
mark-up relationship) industry groups. For the flexible price/flexible wage
Table 4
Industry Mark-up Response to Actual Inflation
Fixed-effects panel regression, equation (3)
CBO measure of output gap
Dependent variable: Gross margin
Inflation, all commodities PPI
Percentage change in real GDP
Time index
Interaction of inflation and dummy for flexible price/sticky wage industries
Interaction of inflation and dummy for flexible price/flexible wage industries
Interaction of inflation and dummy for sticky price/sticky wage industries
Constant
Observations
Number of NAICS industries
R-squared
Absolute value of t statistics in parentheses.
*Significant at 5 per cent; **significant at 1 per cent.
2011 The Authors
-0.328
(4.84)**
0.098
(1.63)
0.030
(26.62)**
0.574
(5.90)**
0.100
(0.94)
0.435
(5.17)**
24.864
(117.42)**
39,952
292
0.02
274
group, however, the single-equation estimation yields a negative and statistically significant estimated negative effect of inflation on the mark-up.
Although this result potentially could arise empirically since the theoretical
prediction is ambiguous, it contrasts with the statistically and economically
insignificant positive effects reported in Tables 3 and 4. Thus, we obtain
inconclusive overall results regarding the inflationmark-up relationship for
flexible price/flexible wage industries.
Overall, we find conclusive support for the hypothesized positive
response of mark-ups to inflation in industries with flexible prices and sticky
wages and predicted negative response of mark-ups to inflation in industries
with sticky prices and flexible wages. We obtain inconclusive or quantitatively small estimated responses of mark-ups to inflation for industries in
which both prices and wages are flexible or in which prices and wages are
sticky.
Conclusion
Most research investigating the responses of mark-ups to inflation has

focused on the interplay between product price dispersion and search costs.
This paper has examined the roles that the relative flexibility or stickiness of
product prices and wages play in affecting the relationship between markups and inflation. Consideration of a setting in which changes in the
economy-wide price level affects firms revenues and costs differentially
depending on whether prices and wages are flexible or sticky indicates that
mark-ups are likely to respond positively to inflation in industries with flexible prices and sticky wages but exhibit ambiguous responses in industries
with both flexible prices and flexible wages. Mark-ups should respond negatively to inflation in industries with sticky prices and flexible wages and in
industries with sticky prices and sticky wages, with a quantitatively smaller
response predicted for industries in the latter category than in industries in
the former classification.
Using US industry-level data that are amenable to developing classifications of industries according to relative degrees of price and wage flexibility
versus stickiness, panel regressions provide evidence consistent with key theoretical predictions. Mark-ups do indeed respond positively to inflation in
industries classified as having flexible product prices and sticky wages, and
the data reveal no conclusive response of mark-ups to inflation in industries
classified as having both flexible prices and flexible wages. In addition, the
responses of mark-ups to inflation are negative in sticky-price industries with
flexible wages and absolutely larger than the responses of mark-ups to inflation in sticky-price industries with sticky wages. In the latter category,
however, the empirical results indicate a slight positive response of mark-ups
to inflation, which is in contradiction to theory.
2011 The Authors
275
On net, the results are generally supportive of our overall hypothesis that
the relative flexibility or stickiness of product prices and wages play fundamental roles in determining the responses of firms mark-ups to inflation. Our
results indicate that mark-ups respond positively to inflation in industries
with flexible product prices and sticky wages and negatively to inflation in
industries with sticky prices and flexible wages. Responses are either inconclusive or muted in industries either with both sticky prices and sticky wages
or with both flexible prices and flexible wages.
Left unresolved by our analysis is the set of factors that ultimately
determine relative degrees of price and wage stickiness. Attempting to identify these determinants would be a useful agenda for future research.
Appendix
This appendix outlines a theoretical framework based on the models developed in
Duca and VanHoose (2000, 2001), which in turn extend and combine Ball (1988),
Duca (1987) and Duca and VanHoose (1991). There are numerous sectors in the
economy, indexed i, which are distributed uniformly along a unit interval. To preserve
tractability of the analysis, however, we follow Ball (1988) by assuming that within
each sector the numerous firms face a pool of immobile workers in perfectly competitive labor markets. Identical, price-taking firms within each sector produce an identical good. This good is differentiated from the goods produced by firms in other
sectors. The output produced by a given firm in sector i is given by
yi = li
0 < <1
(A1)
where yi is the log of output and li is the log of employment at firm i. The demand for
the output of a firm in sector i as a share of aggregate output is
yi y = i ( pi p )
(A2)
where y yi di is aggregate output, p pi di is the aggregate price level and ei > 1

is the elasticity of demand for the output of firms in sector i. Aggregate demand is
given by the quantity equation
1
0
1
0
y= m p
(A3)
where we simplify by normalizing velocity at unity so that the log of velocity equals
zero. Henceforth, we also normalize the money stock at unity as well, so that m = 0.
In a sector in which both product prices and nominal wages adjust flexibly and
are determined in spot markets, a typical firms revenues in this sector are Ri = YiPi,
and its wage bill is given by Bi = WiLi, where upper-case variables denote the antilogs
of the variables in equations (A1), (A2) and (A3). Maximizing profits yields the labor
demand function (in log form) for a firm in sector i (with the intercept suppressed
because it plays no role in our subsequent analysis):
lid =
(wi pi )
1
where wi ln(Wi). Sectoral labor supply schedule is given by

2011 The Authors
(A4)
276

lis = (w p )
(A5)
where again we suppress the intercept term. Hence, firms within a sector value the real
wage in terms of the sectoral price, pi, received for their output, while workers who
purchase goods across all sectors value the real wage in terms of the aggregate price
level, p. When the nominal wage is flexible and adjusts to satisfy (A4) and (A5)
simultaneously, its equilibrium value is
wi* = pi*
( pi* p )
(1 ) + 1
(A6)
where an asterisk denotes the solution for a spot-market value. Substituting equation (A6) into either (A5) or (A4) then yields equilibrium employment in a sector with
a spot labor market:
li* =
( pi* p )
(1 ) + 1
(A7)
which implies from equation (A1) that output equals yi* = li*. In this FP/FW sector,
the log of revenues is ri* = yi* + pi* , and the log of the wage bill is bi* = li* + wi*. Substituting into these expressions and differentiating with respect to p indicates that revenues rise more (less) than proportionately in relation to the wage bill in response to
an increase in the price level for a >(<) 0.5.
To examine the response of profits to inflation in flexible-price sectors of
the economy that exhibit short-term nominal wage rigidities, we assume that, at
a firm in a FP/SW sector, the nominal wage is fixed at a value w i . Hence, the labor
supply relationship in equation (A5) becomes irrelevant, with the labor demand
function in equation (A4) determining employment (in terms of the sectoral price) at
this fixed wage and output following immediately via equation (A1). Substituting
this output level into (A2) yields an expression for the market-clearing sectoral
price:
p i =
(1 ) ( i 1) p w i
(1 ) i
(A8)
where the ~ denotes the solution in this sticky-wage sector. Substituting equation (A8) and the fixed nominal wage w i into (A4) yields the following expression for
employment:
(1 ) ( i 1) p w i
li =
(1 )[(1 ) i ]
(A9)
where again the output solution for this flexible-price/sticky-wage case follows directly
from equation (A1). After using the above to compute the log of revenues, ri = yi + p i ,
and the log of the wage bill, bi = li + w i , and differentiating with respect to p indicates
that ri p > bi p as long as aei > 1 - a, which is satisfied for a very wide range of
parameter values for which product demands are relatively elastic and the output
elasticity with respect to labor is relatively close to unity. Thus, the model predicts that
profits in FP/SW sectors generally increase as a result of a rise in the economy-wide
price level.
2011 The Authors
277
Within our present framework, in a flexible-wage sector of the economy in which

each firms price is set in advance, the (log of the) product price is fixed at a value of
pi during the current period. Substituting pi and equation (A2) into (A1) therefore
yields the amount of output demanded and, consequently, produced at the contracted
price, given by
yi = ( i 1) p i pi
(A10)
with an overbar denoting the solution for a sticky-price sector, with the quantity of
labor the firm employs to produce this output following directly from equation (A1).
Combining this quantity of labor demanded with the labor supply function equation (A5) yields the market-clearing wage rate:
wi =
( i 1 + ) p i pi
(A11)
Using these solutions in expressions for the log of revenues, ri = yi + pi , and the log of
the wage bill, bi = li + wi , differentiating with respect to p unambiguously yields
ri p < bi p for a SP/FW sector in this basic model of price-taking agents.
Finally, if both the sectoral wage rate and price are sticky, fixed at values w i and
p i in the short-run horizon relevant for the model, then the output solution is
analogous to equation (A10)except with a ^ applying in this caseand the
employment solution follows from equation (A1). It is straightforward in this case to
show that ri p < bi p as long as a, the elasticity of output with respect to labor, is
bounded within the unit interval, in which case employment and the wage bill ultimately are more responsive to an increase in the price level than output and revenues.
Thus, the model predicts that an increase in the overall price level unambiguously
reduces profits in SP/SW sectors.
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2011 The Authors


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