Entry Deterrence, Coordinating Advertising and Pricing in Markets with Consumption Externalities

This paper extends the entry deterrence literature by examining coordinating advertising and pricing in markets with consumption externalities using a stochastic success function. Optimal advertising and pricing strategies are analysed when an incumbent firm faces a challenger with a product of equal quality. I show that strategic entry deterrence using advertising is possible and optimal entry deterrence involves strategic pre-commitment to over-investment relative to the non-strategic simultaneous advertising benchmark. I show that when entry deterrence is not possible the incumbent does not possess a first mover advantage and optimal entry accommodation involves strategic investment in advertising with intensified price competition congruent with the non-strategic simultaneous advertising benchmark. The findings suggest that an incumbent’s ability to deter entry through coordinating advertising in a market with products of equal quality is sensitive to the size of the fixed cost of entry that the challenger must incur and the consumption externality parameter.

AGGREGATE AND DISTRIBUTIONAL EFFECTS OF TAX POLICY WITH INTERDEPENDENT PREFERENCES: THE ROLE OF “CATCHING UP WITH THE JONESES”

This paper analyzes the aggregate growth and distributional effects of tax policy using an endogenous growth model with heterogeneous agents having “catching up with the Joneses” (CUJ) types of preferences. We characterize the aggregate equilibrium of this economy, as well as its distributional properties, and show that the consumption externality present with CUJ preferences produces greater income inequality than is obtained with conventional time-separable preferences. The consumption externality substantially alters the effects of tax policy, mostly quantitatively, but in some cases qualitatively as well. Extensive numerical simulations are conducted and used to compare the consequences of different modes of taxation, highlighting the tradeoffs involved.

INTRODUCTION TO MACROECONOMIC DYNAMICS SPECIAL ISSUE: PUBLIC POLICY, EXTERNALITIES, AND ECONOMIC GROWTH

Externalities are a fundamental aspect of any modern interdependent economy. The fact that agents interact with one another makes it inevitable that their decisions will influence one another directly, in addition to any indirect impact that may occur through the market place. Ever since the earliest stages of the discipline, externalities have been of prime concern to economists, who have long argued that they provide an important motive for (economic) decision making. To cite one prominent example, in The Theory of Moral Sentiments, Adam Smith notes that “Though it is in order to supply the necessities and conveniences of the body that the advantages of external fortune are originally recommended to us, yet we cannot live long in the world without perceiving that the respect of our equals, our credit and rank in the society we live in, depend very much upon the degree in which we possess, or are supposed to possess those advantages. The desire of becoming the proper objects of this respect . . . is perhaps the strongest of all our desires” [Smith (1759, pp. 348–349)]. In modern terminology, Adam Smith is referring to a consumption externality.

Trade Liberalization, Standards and Protection

As conventional trade barriers fall, nations may increasingly resort to product standards to protect domestic industries. While ostensibly protecting their citizens from the environmental and health side-effects of a particular product, countries could enact standards that are facially-neutral, but impose greater compliance costs on foreign producers. This paper examines the impact of trade liberalization on standard setting by using a two-country Cournot duopoly model in which the Domestic government imposes a standard to mitigate a consumption externality. The standard increases production costs for both Domestic and Foreign firms, especially for the latter. The paper finds that one cannot make an unequivocal connection between falling tariffs and subsidies and rising standards. If the initial tariffs or subsidies are prohibitive, reducing subsidies and tariffs to allow minimal import penetration will generally create incentives for the Domestic government to impose higher standards. If the ex ante tariffs are not prohibitive, however, it is only optimal for the government to raise standards following tariff cuts if (i) tariff revenues are an important component of the welfare calculus and the ex ante tariff rate is high, or (ii) the standard's effect on the per unit externality is large. Likewise, if the initial subsidies are small enough to allow imports the government should only raise standards following subsidy reductions if the per unit externality is substantial, or the standard's impact on the per unit externality is large.