Style Over Substance? Advertising, Innovation, and Endogenous Market Structure

54 Pages Posted: 15 Mar 2021 Last revised: 9 May 2022

See all articles by Laurent Cavenaile

Laurent Cavenaile

University of Toronto at Scarborough; University of Toronto - Rotman School of Management

Murat Alp Celik

University of Toronto - Department of Economics

Pau Roldan-Blanco

Banco de España

Xu Tian

University of Georgia - Terry College of Business - Department of Finance

Date Written: April 29, 2022

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.

Keywords: innovation, advertising, markups, growth, industry dynamics, misallocation, business dynamism

JEL Classification: E20, L10, M30, O30, O40

Suggested Citation

Cavenaile, Laurent and Celik, Murat Alp and Roldan-Blanco, Pau and Tian, Xu, Style Over Substance? Advertising, Innovation, and Endogenous Market Structure (April 29, 2022). Available at SSRN: https://ssrn.com/abstract=3804065 or http://dx.doi.org/10.2139/ssrn.3804065

Laurent Cavenaile

University of Toronto at Scarborough ( email )

1265 Military Trail
Scarborough, Ontario M1C 1A4
Canada

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Murat Alp Celik (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George St.
Toronto, ON M5S 3G7
Canada

HOME PAGE: http://muratcelik.faculty.economics.utoronto.ca/

Pau Roldan-Blanco

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

Xu Tian

University of Georgia - Terry College of Business - Department of Finance ( email )

620 S Lumpkin St
Athens, GA 30602
United States

HOME PAGE: http://www.xutianur.com

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