Has Greater Competition Restrained U.S. Inflation?

• Author: Duca, John V.

John V. Duca [*]

David D. VanHoose [+]

This paper shows how increased goods market competition affects the behavior of inflation in a multisector economy. By raising the price elasticity of demand, increased goods market competition theoretically lowers inflation and makes the aggregate price level less sensitive to aggregate demand shocks. We find that proxies for the aggregate degree of goods market competition are statistically and economically significant in short-run Phillips curve models of core inflation. Evidence indicates that heightened goods market competition has flattened the slope of the short-run, expectations-augmented Phillips curve and slightly lowered the nonaccelerating inflation rate of unemployment (NAIRU).

1. Introduction

   The U.S. economic expansion of the mid-1990s has been characterized by low CPI inflation despite declines in the unemployment rate to levels previously associated with accelerating inflation. This combination of low unemployment and inflation has sparked debate over whether the economy can operate at higher full-information levels of production and employment without fueling a pickup in inflation. [1] One common argument is that heightened competition has lowered the nonaccelerating inflation rate of unemployment (NAIRU). Some attribute this change to international trade, [2] but past empirical work has found either no role or a limited role for trade variables (e.g., Tootell 1994; Fuhrer 1995). [3] This evidence is consistent with the fact that commodities and nonfood commodities comprise only 43% and 26% of the CPI, respectively, and that services are not (yet) highly tradable across U.S. borders.

   Certainly, increased international trade may have plausibly raised the price elasticity of demand faced by a typical U.S. firm, so the recent emphasis that some observers have placed on international factors is not misplaced. Nevertheless, Milton Friedman (1968) originally pointed out that the NAIRU and its effect on inflation depend on the complete set of microeconomic relations in the goods and labor markets. Since the 1970s, purely domestic elements, such as the deregulation of several major industries, surely have also played a role. Undoubtedly, a number of factors together may have changed the competitive structure of U.S. goods markets.

   In this paper, we seek to determine whether an increased degree of overall competition in U.S. goods markets may have lowered the NAIRU. In addition, we attempt to infer the extent to which altered aggregate competition may have reduced the slope of the short-run Phillips curve for the United States. In the Appendix, we provide an explicit theoretical model that shows how greater goods market competition can reduce the NAIRU and flatten the trade-off between inflation and unemployment. The basic channels giving rise to these effects are easy to understand at an intuitive level, however. With respect to NAIRU, an increase in the aggregate degree of competition in goods markets moves a monopolistically competitive economy closer to the perfectly competitive ideal, so that wedges between actual employment and the long-run employment level are smaller under perfect competition. As a result, increased aggregate competition reduces the NAIRU. At the same time, greater competition raises the price elasticity of dem and for the products sold by individual firms. Consequently, the marginal revenue product of labor at each firm becomes more elastic, making firm-level employment decisions more sensitive to price-level variations.

   These basic effects carry through irrespective of the source of increased competition. Consequently, we focus on examining the empirical relationships between a measure of the aggregate degree of competition in U.S. markets and the inflation-unemployment trade-off and whether aggregate measures of competition help explain the changing behavior of inflation. Our overall index of competition, displayed in Figure 1, is adjusted for cyclical and energy-price-related movements in an aggregate markup variable for the nonfinancial corporate sector (see section 1 for details). This index indicates that the overall degree of competition in the United States has tended to be higher, not so much since the mid-1970s when import penetration jumped, but rather since the early 1980s shortly following the deregulation of many domestic nonfinancial industries (e.g., trucking, airlines, and telephone) and the spread of technological innovations that have reduced the market power of some industries (e.g., the rise of personal computers and the fall of IBM, and telecommunications in general). The view that U.S. goods markets are now generally more competitive is consistent with Federal Reserve Beige Book reports of the mid-1990s, in which retailers and producers reported facing greater competitive pressures that reduced their ability to pass along increased costs to their customers or to raise profit margins in the face of higher industry-wide demand (see Duca 1998).

   Our study departs from two strands of recent research that document the time variation in the NAIRU. One approach uses more modern statistical techniques, such as Staiger, Stock, and Watson (1997), who show how variable the NAIRU is and track changes in it over time. Nevertheless, this approach does not explain why changes in the NAIRU have occurred and how to track the economic factors behind them. Another approach simply attributes time-varying changes in the NAIRU to temporary supply shocks, such as Gordon (1997). A drawback of this approach is that it may miss changes in the underlying structure of the U.S. economy. Our study departs from both recent strands in the NAIRU literature by assessing whether changes in the underlying, aggregate degree of product market competition have significantly affected the inflation process within a NAIRU-like framework.

   Section 2 begins by presenting our empirical specification for evaluating the relationships between competition and NAIRU, measuring the overall degree of goods market competition, and assessing how competition affects the NAIRU and the short-run Phillips curve trade-off. Section 3 then tests whether this index of competition is statistically and economically significant when incorporated into short-run Phillips curve models of inflation. Section 4 concludes.

2. The NAIRU and the Inflation-Unemployment Trade-Off

   To test whether increased competition has reduced the short-run sensitivity of inflation to unemployment rate variations and reduced the NAIRU, we incorporate measures of goods market competition into a benchmark Phillips curve model by jointly estimating regressions of inflation and profits. We first discuss these equations separately before presenting the two-equation system and estimation results.

   According to the basic NAIRU framework,

   [[pi].sub.t] = [beta]([U.sub.t] - [[U.sup.*].sub.1]) + [gamma][E.sub.t-1][[pi].sub.t], (1)

   where [[pi].sub.t] [equivalent to] inflation rate, [U.sub.t] [equivalent to] unemployment rate, and [[U.sup.*].sub.t] [equivalent to] NAIRU, which is unobserved or latent. If one estimates

   [[pi].sub.t] = [alpha] + [beta][U.sub.t] + [gamma][E.sub.t-1][[pi].sub.t], (2)

   then substituting Equation 2 into Equation 1 implies that [[U.sup.*].sub.t] = -([alpha]/[beta]). If a rise in an index of overall competition ([[epsilon].sub.t], discussed in greater detail below) affects the NAIRU ([[U.sup.*].sub.t]) and the slope of the short-run Phillips curve, then we can rewrite Equations 1 and 2, respectively, as:

   [[pi].sub.t] = ([[psi].sub.0] + [[psi].sub.1][[epsilon].sub.t])[[U.sub.t] - ([[micro].sub.0] + [[micro].sub.t][[epsilon].sub.t])] + [[gamma]E.sub.t-1][[pi].sub.t], (3)

   and

   [[pi].sub.t] = [alpha] + [beta][U.sub.t] + [gamma][E.sub.t-1][[pi].sub.t] + [tau][[epsilon].sub.t][U.sub.t] + [phi][[epsilon].sub.t], (4)

   where ([[micro].sub.0] + [[micro].sub.1][[epsilon].sub.1] substitutes for the latent variable [[U.sup.*].sub.t] in Equation 1. Note that the cross-product quadratic term ([[psi].sub.1][[micro].sub.1][[[epsilon].sup.2].sub.t] from Equation 3 is absent from the empirical specification in Equation 4 because it is a second-order effect that proved to be statistically insignificant in other tests, likely because [[[epsilon].sup.2].sub.t] is multicollinear with [[epsilon].sub.t]. The empirically derivable NAIRU in Equation 4 equals -([alpha] + [phi][[epsilon].sub.t])/([beta] + [tau][[epsilon].sub.t]). The slope of the short-run Phillips curve in Equation 3 equals ([[psi].sub.] + [[psi].sub.1][[epsilon].sub.1]), and the empirically derivable slope in Equation 4 equals ([beta] + [tau][[epsilon].sub.t]).

   As noted earlier, our measure of aggregate goods market competition, [epsilon], has noticeably trended up since the late 1970s amid waves of deregulation in the trucking, airline, and communications industries (Figure 1). If greater competition flattens the negative slope of the short-run Phillips curve ([beta] [less than] 0), then the interactive coefficient should be positive ([tau] [greater than] 0). If a rise in competition also lowers the NAIRU, then the overall effect of the noninteractive and interactive coefficients should reduce the value of (-[alpha] - [phi][[epsilon].sub.t]/([[beta].sub.1] + [tau][[epsilon].sub.t]), the expression used to infer the...