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

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