Are Markups Too High? Competition, Strategic Innovation, and Industry Dynamics
with Laurent Cavenaile and Xu Tian
Revise and Resubmit at the Review of Economic Studies
Abstract: Since the 1970s, there have been significant changes in firm dynamics within and across industries in the US. Industries are increasingly dominated by a small number of large firms (“superstars”). Markups, market concentration, profits, and R&D spending are increasing, whereas business dynamism, productivity growth, and the labor share are in decline. We develop a unified framework to explore the underlying economic mechanisms driving these changes, and the implications for economic growth and social welfare. Our theoretical framework combines a detailed oligopolistic competition structure featuring endogenous entry and exit with a new Schumpeterian growth model. Within each industry, there are an endogenously determined number of superstars that compete a la Cournot and a continuum of small firms which collectively constitute a competitive fringe. Firms dynamically choose their innovation strategies, cognizant of other firms’ choices. The model is consistent with the changes in the macroeconomic aggregates, and it replicates the empirical relationship between innovation and competition within and across industries. We estimate the model to disentangle the effects of separate mechanisms on the structural transition, which yields striking results: (1) While the increase in the average markup causes a significant static welfare loss, this loss is overshadowed by the dynamic welfare gains from increased innovation in response to higher profit opportunities. (2) The decline in productivity growth is largely driven by the increasing costs of innovation, i.e., ideas are getting harder to find.
Does the Cream Always Rise to the Top? The Misallocation of Talent in Innovation
Accepted for the Carnegie-Rochester-NYU Conference on Public Policy (April 2022)
Abstract: The misallocation of talent between routine production versus innovation activities is shown to have a first-order impact on the welfare and growth prospects of an economy. Surname level empirical analysis combining patent and inventor micro-data with census data reveals new stylized facts: (1) People from richer backgrounds are more likely to become inventors; but those from more educated backgrounds are not. (2) People from more educated backgrounds become more prolific inventors; but those from richer backgrounds exhibit no such aptitude. Motivated by this discrepancy, a heterogeneous agents model with financial frictions on the household side, and endogenous productivity growth on the firm side is developed. Individuals compete against each other for scarce inventor training in a tournament setting. Those from richer families can become inventors even if they are of mediocre talent by excessive spending on credentialing. This is individually rational but socially inefficient, and creates a negative link between wealth inequality and economic growth. The model is calibrated to match the new stylized facts via indirect inference. A thought experiment in which the credentialing spending channel is shut down (i.e., meritocratic allocation of talent) reveals that the rate of innovation can be increased by 10% of its value. Optimal progressive bequest taxes serve to increase social welfare by 6.20% in consumption-equivalent terms, increasing economic growth and decreasing consumption inequality simultaneously.
Agency Frictions, Managerial Compensation, and Disruptive Innovations
with Xu Tian
Abstract: Whether a manager leads the innovation efforts of a firm in line with shareholder preferences is key for firm value and growth. This, in turn, influences aggregate productivity growth and welfare. Data on US public firms reveals that (i) firms with better corporate governance tend to adopt highly incentivized contracts rich in stock options and (ii) such contracts are more likely to lead to disruptive innovations — patented inventions that are in the upper tail of the distribution in terms of quality and originality. Motivated by these empirical results, we develop and estimate a new dynamic general equilibrium model of firm-level innovation with agency frictions and endogenous determination of executive contracts. The model is used to study the joint dynamics of corporate governance, managerial compensation, and disruptive innovations, as well as the consequent aggregate implications on growth and welfare. Better corporate governance can reduce the influence of the manager in determining the compensation structure. This leads to more incentivized contracts and boosts innovation, with substantial benefits for the shareholders as well as the broader economy through knowledge spillovers. Removing agency frictions leads to contracts richer in stock options, boosting growth by 0.51pp, and welfare by 7.3% in consumption-equivalent terms. These findings are robust to incorporating short-termism. Short-termism itself is also detrimental, the removal of which increases welfare by 1.5%. Alleviating both frictions at the same time leads to amplified gains in growth and welfare.
Style Over Substance? Advertising, Innovation, and Endogenous Market Structure
with Laurent Cavenaile, Pau Roldan-Blanco, and Xu Tian
Abstract: Firms use both innovation and advertising to increase their profits, markups, and market shares. While they serve the same purpose from the firms’ perspective, their broader implications vary substantially. In this paper, we study the interaction between these two intangible inputs and analyze the implications for competition, industry dynamics, economic growth, and social welfare. To this end, we develop an oligopolistic general-equilibrium growth model with firm heterogeneity in which market structure is endogenous, and firms’ production, innovation, and advertising decisions strategically interact. We estimate the model to fit the non-linear relationship between innovation, advertising, and competition observed in the data. We find that advertising has significant macroeconomic effects: it improves static allocative efficiency through reducing misallocation, but it also depresses economic growth through a substitution effect with R&D. On the net, advertising is found to be welfare-improving. It is responsible for one third of the observed average net markup, and a quarter of its dispersion. We next study the optimal linear taxation/subsidization of advertising. We find that the optimal tax is quite high, yet finite, which serves to simultaneously increase dynamic efficiency and raise revenue, while still maintaining most of the benefits of advertising in the form of reduced misallocation, without the excessive spending due to the advertising rat race.
Identifying the Heterogeneous Impact of Highly Anticipated Events: Evidence from the Tax Cuts and Jobs Act
with Paul Borochin, Xu Tian, and Toni Whited
Abstract: We develop a method for estimating the stock market impact of aggregate events. Based on using data on both stock and options prices, our technique accounts for two important sources of bias present in traditional methods. First, our method takes into account market anticipation, without the need for information on specific firm characteristics. Many event studies only measure a fraction of an event’s full value effect, so the measured market reaction at event resolution can be misleading, particularly in the case of a very high degree of market anticipation. Second, our method is robust to the possibility of the event being good news for some firms and bad for others, without prior specification of this heterogeneity. We apply the method to the passage of the Tax Cuts and Jobs Act (TCJA), which exhibits both anticipation and heterogeneity. We estimate the market anticipated the probability of passage to be as high as 95% 30 days before the event. The full value impact of the TCJA is found to be 12.36%, compared to 0.68% when market anticipation is ignored. The firm-level impact of the TCJA is considerably heterogeneous, with large and innovative firms with high growth prospects being the largest winners.
Patents as Collateral and Directed Technical Change
with Ufuk Akcigit, Olga Itenberg, and Guillermo Ordonez
Abstract: In recent years, and in spite of their intangible nature, patents have been increasingly used as collateral. We show that this financial innovation has disproportionately drawn firm entry into more crowded innovative industries, those where patents are easier to trade. We study the effects of the use of patents as collateral in a multi-sector endogenous growth framework with expanding input varieties, where the intermediate sectors differ in market size. Our model predicts that the use of patents as collateral directs future technological progress towards sectors with more patenting firms, which are not necessarily the most productive sectors. Even though the use of patents as collateral relaxes financial frictions, they also have the potential to direct technological innovation inefficiently, which we explore quantitatively.