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

I study how demand-side factors affect markups and propose a new methodology to correct for bias in misallocation losses generated by variable markups. Using data on Indian firms, I first document two key correlations: marginal costs and markups are increasing in firm size. I then explore how these correlations are driven by two factors: the assortative matching of wealthier consumers to larger firms, and the lower demand elasticity of wealthier consumers. Results on how firms across the size distribution change their markups in response to exogenous demand shocks to poor households provide support to the demand-based markup channel: producing better quality and selling to wealthier, less demand elastic households lead larger firms to incur higher costs and charge higher markups. This demand-driven markup dispersion lowers gains from reallocation because firms also adjust their markups in response to policies that may improve allocative efficiency. I show that firms' pass-through of changes in their costs into prices is a sufficient statistic to account for these endogenous markup adjustments. Gains from reallocation are 50 percent lower due to demand-driven variable markups.