A new way to measure pricing power

You’re searching for some noise-cancelling headphones to buy, but why do different brands that offer a similar spec charge such different prices? Are some companies just making larger profits? Not necessarily.

Higher prices may reflect a business that has invested significant time and research into creating its product. Or it could also mean that there’s a lack of competition, so the main producer of a product has the power and freedom to raise prices.

To help ensure competitive markets, economists and governments need reliable ways to assess firms' pricing power. But when assessing profits, how can economists know whether success results from being genuinely more productive—or simply from having greater power to set prices?

These are commonly debated questions about competition, innovation, and economic growth. Policymakers rely on evidence about firms' pricing power when deciding whether markets are working well, whether mergers should be approved, or whether competition needs to be encouraged. Until now, it has been difficult to answer these questions because most available datasets do not include detailed price information.

A study by Ivan Kirov (Analysis Group), Paolo Mengano, Assistant Professor in the Department of Economics, Finance and Accounting at Esade, and James Traina (NYU Stern Abu Dhabi), published in the International Journal of Industrial Organization, introduces a new way to estimate firms' markups—the difference between selling prices and production costs—even when researchers only have access to revenue data rather than detailed information on prices.

Why are markups important?

Economists often use the markup as a measure of market power. It helps create an understanding of the level of freedom companies have to set prices.

Healthy competition helps prevent firms from gaining excessive market power and charging higher prices than they could in a more competitive market. This serves to stop one company from gaining a monopoly and increasing prices unfairly. That being said, higher markups don’t necessarily equate to a lack of competition. A business may choose to sell at a high markup to reflect successful innovation, in-depth R&D, better products, stronger brands, or more efficient production.

Conversely, high markups can also signal reduced competition or other barriers that make it harder for new firms to enter a market. Understanding why markups may be high or low helps define policy response. For example, should governments support successful firms so they can continue innovating, or should they intervene to encourage greater competition?

In recent years, many economists have argued that markups have risen across many industries, sparking a debate among policymakers—is this a result of a healthy level of innovation, improved efficiency, or growing market dominance?

Consumers are feeling the pinch of surging inflation globally. This is why economists and policymakers need to understand whether higher prices are driven by genuinely higher costs for businesses, or whether companies are increasing their profit margins—a phenomenon that has been referred to as ‘greedflation.’ Answering that question hinges on being able to distinguish pricing power from authentic improvements in productivity, which is exactly the challenge Mengano and his co-authors have sought to address.

The hidden problem

Markups are a common topic of economic study, but it has always been problematic to access the necessary information to accurately measure them.

"The empirical challenge is that most production datasets offer only revenue information, not price," the study’s authors explain.

Revenue figures only tell us how much a company earned in total and don’t give insight into the amount of the markup itself.

Did the company generate higher revenue because it sold more products? Because it produced them more efficiently? Or because its dominance of the market enabled it to charge higher prices?

The problem is easier to envisage if you imagine you’re comparing two restaurants based on their daily takings. They may report the same revenue figures, but it’s still possible that one has a higher markup than the other. One restaurant may have served twice as many customers. The other may simply have doubled the prices on the menu. Looking only at revenue doesn’t reveal the markup.

Previous methods have struggled to separate these effects. As a result, estimates of firms' market power can be distorted because they confuse productivity with pricing power. This has been an enduring challenge for economists trying to understand competition across industries.

A new way to separate prices from performance

The authors of the study propose a new approach.

"Our method helps researchers estimate firms' markups using widely available revenue data, overcoming a long-standing obstacle that has limited previous research," they say.

The statistical approach makes better use of existing data, correcting a well-known source of bias and allowing researchers to distinguish more reliably between a firm's productivity and its pricing power.

Typically, business databases contain financial information such as revenues and costs, but not the individual prices charged for products. Until now, that data gap has limited researchers' ability to measure markups consistently, but with this new methodology, more accurate results are possible.

The new approach is flexible and applicable across many market settings, making it relevant to researchers studying competition in a wide range of sectors.

Real-world relevance

While the study is focused on economic methodology, there are wider-reaching implications.

If economists can estimate markups more accurately, policymakers can make better-informed decisions about competition policy, mergers, industrial strategy, and market regulation.

More reliable estimates enable deeper research into productivity, innovation, labor markets, international trade, and business dynamism. Rather than attributing higher revenues to market power alone—or assuming they are a direct result of greater efficiency—researchers can develop a clearer picture of what is actually happening inside businesses.

As the study explains, the approach can be utilized for existing datasets already used by researchers, making it relevant for studies in fields ranging from macroeconomics to trade, labor, and finance.

The method gives economists a more reliable way to measure market power, rather than unintentionally capturing differences in productivity or prices.

Innovation or market power?

By making it possible to measure markups more accurately using the data already available, Mengano and his co-authors have given researchers a stronger foundation for future studies. Better evidence can help policymakers distinguish between markets that reward innovation and those where companies may be benefiting from limited competition. Over time, that could support better-informed policies that encourage more competitive markets—and ultimately give consumers greater choice and fairer prices.