STEG Working Paper Series Research Theme 1: Firms, Frictions and Spillovers, and Industrial Policy

Demand for Quality, Variable Markups and Misallocation: Evidence from India

WP064 Gupta DemandForQualityVariableMarkupsAndMisallocation.pdf

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Demand for Quality, Variable Markups and Missallocation

Markups vary systematically across firms and generate misallocation, yet empirical evidence on sources driving markup variation is limited. I study how demand-side factors affect markups. Using detailed firm-product-level data from India, I document that both marginal costs and markups are increasing in firm-size. Changes in markups across the firm-size distribution in response to exogenous demand shocks to poor households lend support to the demand-based markup channel: producing better quality and selling to wealthier, less demand elastic households leads larger firms to incur higher costs and charge higher markups. Accounting for the demand-based channel reduces estimated misallocation losses by 30 percent.

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