The failure of ‘trickle down economics’

Updated: Sep 26, 2021

The IMF has published a research paper (Diez et al. 2018) stating that an increase in markups does not lead to an increase in investment, as has been hypothesised in classical economic theory. Rather, in industries with a higher concentration of monopoly power, they just lead to higher profits.

This raises moral and social concerns for policy-makers who are tasked with protecting consumers from unchecked avidity. Pharma giant Pfizer is an interesting case study as it has been found that whilst its net profit margin has nearly doubled from 2006, R&D expenses have declined. Perhaps it should be used to reflect on who our current economic system favours and who it hinders.

IMF researchers have found significant and robust evidence that the relationship between markups and innovation is non-linear. In other words, at differing levels of markups, innovation increases and then decreases. Price markups are the ratio between the cost of a good and its selling price and have increased steadily since the 1980s. The paper shows that they have since arrived at a GDP-weighted average of 39% in advanced economies. This behaviour is driven by a small number of “superstar firms” (Diez et al. 2018) who are able to impose increasing price hikes without losses. In addition, they found that the labour share of income declines: as companies increase their monopoly power they retain a growing portion of rents from production, leaving lower shares for labour.

So, if a price hike does not end up in investment and does not result in higher wages for employees, where does the extra revenue go? The paper suggests it simply ends up in the firm’s profit margins.

Looking at Pfizer, the story seems to be corroborated. Late last year, the corporation announced that it would increase the prices of 10% of its product portfolio in January of this year. In 2016, Pfizer received a record £84 million pound fine after Britain’s competition watchdog found it was charging “excessive and unfair prices” for a drug used in epilepsy treatment. The multinational corporation obviously has price-setting power and holds majority shares in many market segments. In 2015 it held 76% of the infectious and respiratory diseases segment and the same percentage for consumer healthcare and vaccines. It would thus be uncontroversial to say the corporation holds some degree of monopoly power.

This monopoly power translates to high profit margins: in 2006 net margins were 26%, and this number has risen to 45% in 2018, with dividends rising from $0.20 in 2011 to $0.36 in 2018. While Pfizer’s R&D spending did increase in the same time-span from around 17% to 18.5% of revenue, the increase seems ludicrous when compared to their profits. However, to see real-life proof of the research’s verdict, we should observe decreasing investment and increasing monopoly power. If we take net profit margin as an indication of the latter, and the proportion of revenue invested in R&D as the former, we actually find the relationship holds true in the years from 2016 onwards. In the mentioned time frame you can see increasing net profit margins coupled with decreasing R&D spending as a proportion of revenue.

The paper published this past July isn’t the first academic attempt to justify such behaviour, Aghion et al, (2005) have constructed a model where the relationship between market competition and innovation may be represented as a U-shaped curve. Some degree of supernormal profits are necessary to generate the incentives to invest in R&D but, above a certain threshold of market power, firms no longer face the competitive pressures to innovate, introduce new products and invest to raise the efficiency of their production processes.

For policy-makers, the paper has several important implications: monopoly power must be reined in after a certain level, and perhaps net profit margins should be capped to spur investment and innovation. Our 2019 WES guest speaker, EU Commissioner for competition Joaquìn Almunia has fought to curtail monopoly power, and in his tenure employed tools like fines to promote competition. In 2013 he announced Microsoft would have to pay £484 million pounds for engaging in anti-competitive behaviour, proving that consumers should be protected from uninhibited capitalism.

Valentina Calvi


Federico J. Díez, Daniel Leigh, and Suchanan Tambunlertchai (2018) ‘Global Market Power and its Macroeconomic Implications’. IMF Working Paper. Accessed online at: