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.
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 quarter of the observed average net markup and its dispersion. We next study the optimal linear taxation/subsidization of advertising. We find that the optimal advertising tax is quite high. Such taxation could simultaneously increase dynamic efficiency, contain excessive spending on advertising due to inefficient “rat race”, and raise revenue while still maintaining most of the benefits of advertising via improving efficiency in resource allocation.
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 individual firm heterogeneity in the stock market impact of aggregate events, using data on both stock and options prices. Our method impounds the effects of event anticipation. We apply the method to the passage of the Tax Cuts and Jobs Act (TCJA), which exhibits both anticipation and heterogeneity. We estimate that the market anticipated the probability of passage to be 95% 30 days before the event. The full value impact of the TCJA is 12.36%, compared to 0.68% when market anticipation is ignored. Large, innovative firms with high growth prospects are 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.