Determining the ratio of product price to the marginal cost of production, otherwise known as the markup, is a key question in economics. In terms of the overall economy, markup variation affects the dynamics of inflation, the fluctuation of output and employment over business cycles, and the transmission of macroeconomic policies. At the firm level, variation reflects time-varying market power, which influences a firm’s cash flow, customer base development, financial decisions, risk management, and valuation.

However, while there is a large body of literature on the subject, there is still a knowledge gap regarding the theoretical link between markup dynamics and financial constraints in the presence of dynamic corporate liquidity management. Hence, a recent study by Winston Wei Dou and Yan Ji aims to determine how firms set product markups in the presence of external financing costs and customer capital. In particular, they focus on the trade-off between setting low markups to invest in their future customer base as opposed to setting high markups to benefit from their existing customer base. Although this customer–market mechanism has been developed and used in various dynamic equilibrium models, which usually exogenously specify financial decisions, the authors break from the norm by allowing firms to optimally make financial decisions and manage corporate liquidity.

In their continuous-time industry equilibrium model, Wei Dou and Yan Ji treat corporate liquidity and customer base as two endogenous state variables, thus characterising the interactions between financial constraints and customer base, as well as their effect on a firm’s markup decisions. In doing so, they present several new theoretical insights and predictions. First, they characterise how firms’ equilibrium markups are determined by the interaction between financial limitations and customer base by showing that when a firm is more liquidity constrained, its markup is less sensitive to its financial condition but less sensitive to its opportunities to develop its customer base. Second, they look at how firms’ financial decisions are influenced by product market threats, thereby building upon existing corporate theories with endogenous cash flows microfounded by firms’ optimal markup decisions.

The study reveals the importance of markups in terms of connecting firms’ decisions in the product and financial markets. For instance, when a firm becomes more financially constrained, they raise markups to gain higher short-term cash flows at the cost of a lower customer base in the future. Alternatively, when the market structure is more competitive, they will charge lower markups, thus resulting in lower cash flows. These lower cash flows mean that is more likely for firms to be financially constrained, thus motivating firms to have more conservative financial policies. Specifically, the authors’ model shows that firms facing greater product market competition hold more cash and liquid assets and are less likely to offer dividend payouts – a situation that is more pronounced during periods of higher external financing costs.

Wei Dou and Yan Ji use their industry equilibrium model to study the effect of financial constraints on markup dynamics, as well as the quantitive implications of the aforementioned customer–market mechanism. By simulating the economy with increased external financing costs in order to mimic the 2007–2009 financial crisis, they find that the markup dynamics of low-liquidity firms are quantitively consistent with existing data. The authors are quick to point out that while being primarily theoretical, their paper empirically supports the implication of product market competition on financial policies. As mentioned earlier, not only does their research show that industries with greater fluidity are associated with fewer share repurchases and higher cash holdings, implying that firms adopt more conservative financial policies, the study also reveals that the negative effect of product market threats on industry share repurchases and cash holdings during the 2007–2009 financial crisis was more significant, meaning that the industry-level evidence of Wei Dou and Yan Ji’s paper is consistent with the firm-level evidence found in existing studies.