Advertising, Innovation, and Economic Growth Laurent Cavenaile Pau Roldan-Blanco University of Toronto Banco de España Universitat de Barcelona February 26, 2019
Motivation Recent literature suggests role of intangibles for firm growth. Gourio and Rudanko (’14), Foster, Haltiwanger and Syverson (‘08), McGrattan and Prescott (’10, ’14), Arkolakis (’15), Fitzgerald and Priolo (‘18) . . . In the growth literature: Firm-level R&D as a key source of economic growth through innovation. Question: What determines R&D investment decision within the firm? Firm’s perspective: Common view: Product quality improvement ⇒ Sales & profits ↑ This paper: Broader choice among intangibles that relate to product quality. 1 / 26
Motivation Recent literature suggests role of intangibles for firm growth. Gourio and Rudanko (’14), Foster, Haltiwanger and Syverson (‘08), McGrattan and Prescott (’10, ’14), Arkolakis (’15), Fitzgerald and Priolo (‘18) . . . In the growth literature: Firm-level R&D as a key source of economic growth through innovation. Question: What determines R&D investment decision within the firm? Firm’s perspective: Common view: Product quality improvement ⇒ Sales & profits ↑ This paper: Broader choice among intangibles that relate to product quality. 1 / 26
Motivation Questions: 1 How does ADV affect R&D investment at the firm level? 2 What are the implications for: Innovation and long-run economic growth? Firm growth and firm dynamics? Design of industrial policy? Why is ADV relevant? 1 ADV and R&D serve similar purposes ⇒ ↑ perceived quality of goods. 2 Both are large shares of U.S. GDP (R&D: 2.51%; ADV: 2.21%, 1981-2006). 3 Marketing literature identifies ADV returns across firm size ( umbrella branding ). 2 / 26
Motivation Questions: 1 How does ADV affect R&D investment at the firm level? 2 What are the implications for: Innovation and long-run economic growth? Firm growth and firm dynamics? Design of industrial policy? Why is ADV relevant? 1 ADV and R&D serve similar purposes ⇒ ↑ perceived quality of goods. 2 Both are large shares of U.S. GDP (R&D: 2.51%; ADV: 2.21%, 1981-2006). 3 Marketing literature identifies ADV returns across firm size ( umbrella branding ). 2 / 26
What We Do Model: Endogenous Growth Model of multi-product firms with ADV and R&D choices. Key Idea: ADV has “spillover effect” across products (Marketing literature). � Dynamic trade-off: Per-product gains from ADV shapes R&D decision. Estimation: Calibration targeting facts across firm size: Figures [Fact #1] Deviations from proportional growth ( Gibrat’s law ). [Fact #2] Decreasing R&D intensity. [Fact #3] Decreasing ADV intensity. [Fact #4] Decreasing R&D-to-ADV ratio. 3 / 26
What We Do Model: Endogenous Growth Model of multi-product firms with ADV and R&D choices. Key Idea: ADV has “spillover effect” across products (Marketing literature). � Dynamic trade-off: Per-product gains from ADV shapes R&D decision. Estimation: Calibration targeting facts across firm size: Figures [Fact #1] Deviations from proportional growth ( Gibrat’s law ). [Fact #2] Decreasing R&D intensity. [Fact #3] Decreasing ADV intensity. [Fact #4] Decreasing R&D-to-ADV ratio. 3 / 26
Preview of Results / Roadmap 1 Theoretical: ADV-R&D interaction provides microfoundation for [Fact #1] & [#2] . 2 Quantitative: R&D-ADV substitution → More efficient ADV decreases economic growth. Policy: R&D subsidies more effective in an economy with ADV than without. 3 Empirical: We find evidence in the U.S. for R&D-ADV substitution at firm-level. 4 / 26
Model 4 / 26
Environment Klette-Kortum (’04) model of multi-product firms (cf. Akcigit and Kerr (’18)). Continuous time, infinite horizon. Continuum of producers in monopolistic competition. Each producer has many goods, does ADV and R&D. Mass of potential entrants (free entry). Preferences: � + ∞ � � e − ρ t ln s.t. ˙ A t = r t A t + w t − C t U 0 = C t dt , 0 where lim t → + ∞ e − � t 0 r s d s A t ≥ 0 and A 0 ≥ 0 given. 5 / 26
Environment Final good: � 1 y j ≡ Quantity of good j 1 q β j y 1 − β Y = � where dj j 1 − β 0 � q j ≡ Perceived quality of good j Perceived Quality: Micro-foundations � � q jt ≡ Intrinsic quality level � q jt = � , d jt where q q jt ���� ���� d jt ≡ Extrinsic quality ‘shifter’ + + q j : function of R&D expenditures → ↑ q j → Sole engine of long-run growth. d j : function of ADV expenditures → ↑ d j → Taste shifter. 6 / 26
Environment Final good: � 1 y j ≡ Quantity of good j 1 q β j y 1 − β Y = � where dj j 1 − β 0 � q j ≡ Perceived quality of good j Perceived Quality: Micro-foundations � � q jt ≡ Intrinsic quality level � q jt = � , d jt where q q jt ���� ���� d jt ≡ Extrinsic quality ‘shifter’ + + q j : function of R&D expenditures → ↑ q j → Sole engine of long-run growth. d j : function of ADV expenditures → ↑ d j → Taste shifter. 6 / 26
Environment Production sector: Endogenous set F (measure F ) of incumbent firms. Firm indexed by ( n , q ), where n ≡ # { products } (firm’s size) and q ≡ { q j } n j =1 . Market structure: Firm owns good j if it has technological leadership. Firms improve goods via internal R&D ( q ↑ ) and ADV ( d ↑ ). Acquire/lose goods through external R&D. − 1 ⇒ p ( y j ) = � q ( q j , d j ) · y β Demand from consumers: j Production function: � 1 y j = ¯ where ¯ Q ℓ j Q ≡ q j d j 0 7 / 26
Environment Production sector: Endogenous set F (measure F ) of incumbent firms. Firm indexed by ( n , q ), where n ≡ # { products } (firm’s size) and q ≡ { q j } n j =1 . Market structure: Firm owns good j if it has technological leadership. Firms improve goods via internal R&D ( q ↑ ) and ADV ( d ↑ ). Acquire/lose goods through external R&D. − 1 ⇒ p ( y j ) = � q ( q j , d j ) · y β Demand from consumers: j Production function: � 1 y j = ¯ where ¯ Q ℓ j Q ≡ q j d j 0 7 / 26
Intrinsic Improvements: R&D q ( q , d ) � Incumbents ( n ≥ 1): 1 Internal R&D (on each owned j ): Technology: Poisson rate z j ⇒ Cost R z ( z j ) → q j , t +∆ t = (1 + λ I ) q jt . Outcome: 2 External R&D (for some random j ): Technology: Poisson rate X ⇒ Cost R x ( X , n ) → q j , t +∆ t = (1 + λ E ) q jt . Outcome: Successful innovation displaces old producer (creative destruction). Entrants ( n = 0, free entry ): Technology: Poisson rate x e ⇒ Cost R e ( x e ) Enter with n = 1 good (through external innovation). 8 / 26
Intrinsic Improvements: R&D q ( q , d ) � Incumbents ( n ≥ 1): 1 Internal R&D (on each owned j ): Technology: Poisson rate z j ⇒ Cost R z ( z j ) → q j , t +∆ t = (1 + λ I ) q jt . Outcome: 2 External R&D (for some random j ): Technology: Poisson rate X ⇒ Cost R x ( X , n ) → q j , t +∆ t = (1 + λ E ) q jt . Outcome: Successful innovation displaces old producer (creative destruction). Entrants ( n = 0, free entry ): Technology: Poisson rate x e ⇒ Cost R e ( x e ) Enter with n = 1 good (through external innovation). 8 / 26
Intrinsic Improvements: R&D q ( q , d ) � Incumbents ( n ≥ 1): 1 Internal R&D (on each owned j ): Technology: Poisson rate z j ⇒ Cost R z ( z j ) → q j , t +∆ t = (1 + λ I ) q jt . Outcome: 2 External R&D (for some random j ): Technology: Poisson rate X ⇒ Cost R x ( X , n ) → q j , t +∆ t = (1 + λ E ) q jt . Outcome: Successful innovation displaces old producer (creative destruction). Entrants ( n = 0, free entry ): Technology: Poisson rate x e ⇒ Cost R e ( x e ) Enter with n = 1 good (through external innovation). 8 / 26
How to Obtain the R&D Facts (without ADV) Total firm-level R&D expenditure: � R ( n ) R ( n ) ≡ R x ( X , n ) + R z ( z j ) ⇒ ց with n in the data [Fact #2] n j To obtain [Fact #2] , it must be that: R x ( nX , n ) > nR x ( X , 1) Decreasing Returns to Scale (DRTS) in R&D: A given growth rate is more costly to achieve for a firm of size n than for n firms of size one each. Parametrization: R z ( z ) ∝ qz � ψ ; and R x ( X , n ) ∝ QX � ⇒ DRTS if � ψ n σ ψ + σ > 1. 9 / 26
Extrinsic Improvements: ADV q ( q , d ) � ADV production function is Cobb-Douglas: d j = θ j m ζ j n η Return to ADV: Components: 1 θ j → Advertising efficiency . 2 m j → Advertising expenditure ( ζ < 1). 3 n → Spillover effect ( η > 0). 10 / 26
Extrinsic Improvements: ADV q ( q , d ) � ADV production function is Cobb-Douglas: d j = θ j m ζ j n η Return to ADV: Components: 1 θ j → Advertising efficiency . 2 m j → Advertising expenditure ( ζ < 1). 3 n → Spillover effect ( η > 0). 10 / 26
Extrinsic Improvements: ADV q ( q , d ) � ADV production function is Cobb-Douglas: d j = θ j m ζ j n η Return to ADV: Components: 1 θ j → Advertising efficiency . 2 m j → Advertising expenditure ( ζ < 1). 3 n → Spillover effect ( η > 0). Literature Simon (’70), Simon and Arndt (’80), Albion and Farris (’81), Berndt (’91), Sutton (’91), Jones (’95), Bagwell (’07). 10 / 26
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