The Oligopoly Lucas Tree: Consumption Risk and Industry-Level Risk Exposure
70 Pages Posted: 26 May 2020 Last revised: 3 Jun 2020
Date Written: June 3rd, 2020
We develop a novel quantitative asset pricing framework with concentrated industries, consumer inertia, and strategic competition, in which competition intensity endogenously intensifies as the expected growth declines or the discount rate rises, because firms compete more aggressively for current cash flows by undercutting each other as the present value of future cooperation decreases. We quantitatively decompose the beta of stock returns with the consumption risk into two components, reflecting news about the expected growth and discount rate. In equilibrium, more profitable industries have higher exposure to the discount-rate component of consumption risk because of higher consumer inertia, while value industries have higher exposure to the expected-growth component. More important, after controlling for the book-to-market ratio, the gross profitability premium becomes more pronounced. Finally, we exploit exogenous variation in market structures and growth loadings, such as large tariff cuts and natural disasters, to test the core competition and growth mechanisms directly.
Keywords: Product market friction, Imperfect substitutable consumption, Discount rates, Expected growth, Consumption risk
JEL Classification: G12, L13, O33, C73
Suggested Citation: Suggested Citation