This award funds development of a macroeconomic model that incorporates frictions arising from consumer search for information about product characteristics.
Firms spend substantial resources on marketing and sales costs. These expenses are evidence of frictions in product markets; firms must spend money to attract new consumers. These frictions imply that customers tend to remain with the same firm for some time. Therefore, a firm can view its existing customer base as 'customer capital', a valuable firm asset. This research examines the implications of this kind of market friction and customer capital for macroeconomics.
The investigators develop a simple and parsimonious general equilbrium model incorporating this search theory based customer capital. They then analyze the model to answer three different questions. First, they demonstrate that firm-level investment behavior depends on these customer based product frictions. Second, this kind of market friction results in more accurate predictions of macroeconomic time series. For example, the hump shaped responses of macroeconomic aggregates to total factor productivity (TFP) shocks result because firm expansion is slowed down by the expense of attracting new customers. Incorporating product market frictions also means that the model demonstrates how a news shock can generate an economic expansion as firms build up their customer base in advance of increased productivity.
Third, the model provides a new tractable framework for analyzing both firm price-setting decisions and markups. Concerns about maintaining the costemr-base make prices insensitive to firm-specific cost shoks, as well as somewhat insensitive to aggregate cost shocks. Finally, customer capital explains the value premium widely documented in financial markets. Firms with more customer capital may have lower systematic risk, thanks to the flexibility of customer capital.
This project incorporates insights from business management and industrial economics into macroeconomic modeling. The results will be useful for policymakers and forecasters.
Firms spend substantial resources on marketing and selling: marketing expenditures have recently been estimated to make up as much as eight percent of GDP, with advertising alone amounting to 2-3 percent. Why are firms incurring these costs? In this project we interpret this spending as evidence of frictions in product markets, which require firms to spend resources on customer acquisition, and study what other implications this has for firms: the level and volatility of firm investment, profits, value, sales and markups, the timing of firm responses to shocks, as well as the relationship between investment and Tobin's q. We then proceed to document support for these predictions in firm-level data, using cross-industry variation in selling expenses to quantify differences in the degree of friction across markets. We provide a novel micro-founded model of firm dynamics emphasizing the role of customer base concerns. Our theory offers tractability and relatively sharp characterizations, providing a benchmark model to facilitate exploring this under-researched area more thoroughly going forward. We show that adding customer capital to even the simplest quadratic capital adjustment cost model improves the fit of the model substantially relative to the data. While more general model specifications may allow an even better fit, this particular micro-foundation goes a long way. We also show that our theory compares favorably against proposed alternatives in an empirical horse race. This project brings important elements from the industrial organization and marketing literatures into a macroeconomic context. Our findings underscore the role of customer base concerns as an important determinant of firm dynamics, calling for further investigation of these ideas in the economics literature.
