Market Interactions, Endogenous Dynamics and Stabilization Policies

Abstract

We review a recent literature that shows that interactions between markets, created by the market entry and exit behavior of boundedly rational firms, may cause complex endogenous dynamics. In particular, these models predict that welfare decreases if firms rapidly switch between markets. Against this background, we show that policy makers have the opportunity to stabilize markets and thus to enhance welfare by regulating interacting markets. For instance, imposing profit taxes reduces the markets’ profit differentials and thus slows down the firms’ market entry and exit behavior. However, these stabilization policies may also lead to undesirable side effects, such as coexistence of attractors, hysteresis effects and, in a multi-region setting, failure of policy makers to coordinate on the globally optimal policy. Moreover, regulation may be subject to the lobbying efforts of special interest groups and thus not be optimal.