Resurrecting the Role of the Product Market Wedge in Recessions

Employment and hours appear far more cyclical than dictated by the behavior of productivity and consumption. This puzzle has been labeled "the labor wedge" -- a cyclical wedge between the marginal product of labor and the marginal rate of substitution of consumption for leisure. The wedge can be broken into a product market wedge (price markup) and a labor market wedge (wage markup). Based on the wages of employees, the literature has attributed the wedge almost entirely to labor market distortions. Because employee wages may be smoothed versions of the true cyclical price of labor, we instead examine the self-employed, intermediate inputs, and work-in-process inventories. Looking at the past quarter century in the U.S., we find that price markup movements are at least as important as wage markup movements -- including in the Great Recession and its aftermath. Thus sticky prices and other forms of countercyclical markups deserve a central place in business cycle research, alongside sticky wages and matching frictions.