Demand Externalities Research Articles

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The paradox of Mexico's export boom without growth: A demand-side explanation

In recent decades the Mexican economy has seen a dramatic expansion of exports of manufactured goods and imports of manufactured inputs. Mexico's integration with global production chains, however, has failed to produce sustained output and productivity growth. In this paper we propose an explanation for slow growth that hinges on the negative demand externalities of input outsourcing. We make two contributions. First, using input–output data we show that outsourcing has lowered domestic demand for the manufacturing sector, especially for capital-intensive basic industries. Second, we develop a model of outsourcing and capital accumulation and show that lower costs of outsourcing can hurt accumulation if, for the aggregate manufacturing sector, the negative effect of domestic demand shortfalls on profitability exceeds the offsetting effects of lower input costs and of export expansion. Our findings complement the broader literature on the apparent paradox of Mexico's success as an exporter of manufactures amid sluggish growth.

Liquidity traps, capital flows

Motivated by debates surrounding international capital flows during the Great Recession, we conduct a positive and normative analysis of capital flows when a region of the global economy experiences a liquidity trap. Capital flows reduce inefficient output fluctuations in this region by inducing exchange rate movements that reallocate expenditure towards the goods it produces. Restricting capital mobility hampers such an adjustment. From a global perspective, constrained efficiency entails subsidizing capital flows to address an aggregate demand externality associated with exchange rate movements. Absent cooperation, however, dynamic terms-of-trade manipulation motives drive countries to inefficiently restrict capital flows, impeding aggregate demand stabilization.

Law and Macroeconomics as Aggregate Demand Externalities: An Application to Optimal Tort Law

This paper presents one method for introducing macroeconomic concerns into the standard microeconomic models of law, using the canonical economic model of tort law as an example. When an economy suffers from inadequate aggregate demand, expendi-tures on precautions to avoid injuries have aggregate demand externalities. In addition to reducing damages from injury, expenditures on precautions raise incomes for the sellers of precautions (e.g., car brake mechanics). With higher incomes, the sellers, in turn, con-sume and invest more. This multiplier effect of the original expenditure on total spending and output can be modelled as an aggregate demand externality and incorporated into the standard economic models of law. When I introduce aggregate demand externalities into the seminal economic model of tort law, we come to very different conclusions than is standard. Specifically, the strict liability rule and the Hand Rule for negligence both pro-duce inefficient outcomes with respect to expenditures on precaution and activity levels. Instead, negligence rules with more stringent standards of care than the Hand Rule be-come more efficient. If standards of care get too high, however, then an enhanced negligence rule no longer yields a better outcome than strict liability or the Hand Rule. Optimal tort law therefore looks very different when we introduce aggregate demand ex-ternalities. If efficient tort law changes when we introduce macroeconomic effects, then we can presume that our law and microeconomic conclusions regarding other areas of law will change as well.

PERSISTENCE AND VOLATILITY OF BEVERIDGE CYCLES

AbstractThis article explains the cyclical behavior of the fluctuations in unemployment and vacancies by demand externalities. Adding such externalities to an otherwise standard search and matching model reduces the need for exogenous shocks in explaining these fluctuations. Under plausible parameter values, the equilibrium dynamics include a stable limit cycle that resembles the empirically observed counterclockwise cycles around the Beveridge curve. Calibrated to the duration of the business cycle, these endogenous “Beveridge cycles” are as persistent as the data, without losing any of the amplification of the standard model.

Moral Hazard Misconceptions: The Case of the Greenspan Put

Policy discussions on financial regulation tend to assume that whenever a corrective policy is used ex post to ameliorate the effects of a crisis, there are negative side effects in terms of moral hazard ex ante. This paper shows that this is not a general theoretical prediction, focusing on the case of monetary policy interventions ex post. In particular, we show that if the central bank does not intervene by monetary easing following a crisis, an aggregate demand externality makes borrowing ex ante inefficient. If instead the central bank follows the optimal discretionary policy and intervenes to stabilize asset prices and real activity, we show examples in which the aggregate demand externality disappears, reducing the need for ex ante intervention.

Mortgage Design with Demand Externalities

Mortgage Design with Demand Externalities

Dynamic Coordination and the Optimal Stimulus Policies

This article studies stimulus policies in a simple macroeconomic model featuring a dynamic coordination problem that arises from demand externalities and fixed costs of investment. In times of low economic activity, firms face low demand and hence have lower incentives for investing, which reinforces their low‐demand expectations. In a benchmark case with no shocks, the economy might get trapped in a low‐output regime and a social planner would be particularly keen to incentivise investment at times of low economic activity. However, this result vanishes once shocks are considered.

Optimal Sales Force Compensation in Dynamic Settings: Commissions vs. Bonuses

This paper studies optimal sales force compensation plans in a multiperiod moral-hazard model when the firm wants to implement high effort in every period but only obtains aggregate information on sales. The sales agent chooses effort each period after observing previous sales, and his incentive responsiveness might change over time. The paper derives conditions under which a linear incentive scheme—a pure commission—dominates a bonus plan and vice versa. A commission is optimal if the agent is most difficult to motivate in the last period. Otherwise, combining the commission with a bonus plan can lower the firm’s cost of providing incentives in earlier periods. The results are robust to different types of cost externalities and demand externalities across periods. However, if the firm obtains intermediate sales information, bonus plans dominate commissions. This paper was accepted by J. Miguel Villas-Boas, marketing.

Optimal Banking Structure under Demand Externality

This paper studies optimal banking structure under demand externality. Firms operate under demand externalities. Investors choose the optimal banking coalition sizes and then try to maximize profits by optimal lending under Cournot competition. The focus of the paper is on optimal banking structure which maximizes bank profitability. It is shown that due to the demand externality facing firms, the privately optimal bank coalition has the minimum size but high lending.

Social Business Hybrids: Demand Externalities, Competitive Advantage, and Growth Through Diversification

Organization scholars have recently studied the internal challenges and opportunities faced by companies that combine business and social logics (i.e., social business hybrids). By adopting a demand-side perspective, this paper addresses the implications of hybridity for strategic choices with products and businesses by focusing on the role of social business hybrids’ customers. In the conceptual framework, social identity theory explains how hybridity generates both positive and negative demand-side externalities. Thus, hybridity can be a source of competitive advantage in the marketplace, but also create hurdles to firms’ ability to scale up their business. Diversification represents a potential choice that simultaneously generates growth, preserves hybridity, and avoids negative demand-side externalities. This paper analyzes the optimal type, timing, and scope of such diversification.

Percentage rent contracts between co-stores

High rental rates and space scarcity in popular retail areas are encouraging retailers to share available space, creating co-stores. Co-stores with complementary products enjoy a boost in foot traffic, thus higher sales. When the space is owned by one, a common practice for retailers is to engage in a revenue sharing agreement. We study the optimal design of a percentage rent contract between two co-stores, each having his/her own random sales, dependent on effort levels of both retailers. Since the effort level exerted by a retailer is often unverifiable, it results in a double moral hazard problem. We show that a linear percentage rent, which is composed of a sales share and a based rent, achieves the second-best effort levels. The landlord may also find it optimal to set a fixed rent by setting the sales share to zero. With Cobb-Douglas sales and power disutility of effort functions, we obtain closed-form expressions for the optimal contract. We show that the landlord charges a high sales share for a tenant with low demand externality and a high sales scale. The landlord is better off renting out space to a small but high revenue generating retailer, rather than one generating larger traffic, but with lower sales scale. When the landlord’s externality potential is low, but he is successful in generating sales, optimal sales share is low, but the base rent is high. The percentage rent can increase the landlord’ profit by up to 13% compared to the conventional fixed rent.

Aggregate Demand and the Dynamics of Unemployment

We introduce an aggregate demand externality into the Mortensen-Pissarides model of equilibrium unemployment. Because firms care about the demand for their products, an increase in unemployment lowers the incentives to post vacancies which further increases unemployment. This positive feedback creates a coordination problem among firms and leads to multiple equilibria. We show, however, that the multiplicity disappears when enough heterogeneity is introduced in the model. In this case, the unique equilibrium still exhibits interesting dynamic properties. In particular, the importance of the aggregate demand channel grows with the size and duration of shocks, and multiple stationary points in the dynamics of unemployment can exist. We calibrate the model to the U.S. economy and show that the mechanism generates additional volatility and persistence in labor market variables, in line with the data. In particular, the model can generate deep, long-lasting unemployment crises.

The Impact of Walmart Supercenter Conversion on Consumer Shopping Behavior

This paper presents an empirical study of the impact of Walmart supercenter conversion on consumer shopping behavior. By using a difference-in-difference estimator, we find that Walmart gains 41% in weekly revenue from the conversion. Decomposing the revenue gains into components attributable to store visits and per-visit expenditures, we find that the majority of these gains were due to larger expenditures, with a much smaller impact from store visits. By contrast, among competing retailers, grocery stores experience the most significant loss (20% weekly revenue) mostly from fewer store visits, with a much smaller impact attributable to per-visit expenditure. Taken together, these findings show that consumers may benefit from reduced shopping costs by making fewer overall trips and increasing their Walmart basket sizes. In addition, we find that overall revenue gains for Walmart from conversion outweigh the small cannibalization loss at the existing Walmart supercenters located farther away. Finally, from category-level analyses, we find evidence of increases in category-level spending in preexisting categories in the converted supercenter. However, we also find that positive demand externality is more pronounced in food categories, mainly as a result of increased purchase incidence. We discuss the implications of our findings for academics and retail managers. This paper was accepted by Pradeep Chintagunta, marketing.

Price cap regulation in a two-sided market: Intended and unintended consequences

This paper studies intended and unintended consequences of price cap regulation in the two-sided payment card market. The recent U.S. debit card regulation was intended to lower merchants' card acceptance costs by capping interchange fees at the issuer cost, but for small-ticket transactions the interchange fee instead rose post-regulation. To address the puzzle, I construct a two-sided market model and show that card demand externalities between large-ticket and small-ticket transactions rationalize card networks' pricing response. Based on the model, I provide a welfare assessment of the issuer cost-based interchange regulation and discuss alternative regulatory approaches.

A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

We propose a theory of monetary policy and macroprudential interventions in financial markets. We focus on economies with nominal rigidities in goods and labor markets and subject to constraints on monetary policy, such as the zero lower bound or fixed exchange rates. We identify an aggregate demand externality that can be corrected by macroprudential interventions in financial markets. Ex post, the distribution of wealth across agents affects aggregate demand and output. Ex ante, however, these effects are not internalized in private financial decisions. We provide a simple formula for the required financial interventions that depends on a small number of measurable sufficient statistics. We also characterize optimal monetary policy. We extend our framework to incorporate pecuniary externalities, providing a unified approach to both externalities. Finally, we provide a number of applications which illustrate the relevance of our theory. [web URL: http://onlinelibrary.wiley.com/doi/10.3982/ECTA11883/abstract]

Why and When Firms Franchise

Franchising is a business model decision. The franchise model provides leveraged growth and entrepreneurial flexibility when the firm’s cash flow is uncertain. The theory of franchising provides firm-specific and location-specific conditions that explain when and why some firms franchise and others do not. The firm-specific conditions suggest that when the cash flow appropriability is more uncertain, the firm may choose to franchise the outlets; thus, the rate of franchising will be higher. The location-specific conditions suggest that unless the demand variability is low and the demand externality high, the franchisor will choose to franchise the outlets in the region, not own them. Franchisees possess high-powered entrepreneurial incentives that provide an entrepreneurial surplus. The franchising mechanism provides entrepreneurial leverage to enhance and sustain the firm’s competitive position when the cash flow appropriability is more uncertain and the firm’s economic rent is subject to competitive dissipation.

Responsible Sourcing via Vertical Integration and Supply Chain Partnership

Taylor Guitars purchased an ebony mill in Cameroon to ensure corporate social and environmental responsibility (CSER) in sourcing, and shared the responsibly-sourced supply of ebony with competitors through horizontal sourcing. Inspired by this case, we investigate vertical integration as an alternative strategy for CSER in sourcing in which a firm can vertically integrate with its supplier in order to ensure responsible practices in the supply chain. In a competitive setting, an exposed CSER violation in one supply chain may increase the competing supply chain’s demand (positive externalities) due to substitution, or decrease the competing supply chain’s demand (negative externalities) due to public’s suspicion about industry’s social and environmental practices. Furthermore, NGOs’ scrutiny and reporting policies may influence the chance of a violation exposure, as well as demand externalities between the competing supply chains. We examine horizontal sourcing as a potential strategy for mitigating the impact of a CSER externality caused by a competing supply chain. When horizontal sourcing is infeasible, we find that higher violation exposure externalities induces better CSER, but overly intensive violation scrutiny alongside strongly negative externalities may backfire and discourage CSER. By contrast, when horizontal sourcing is feasible, intensive violation scrutiny induces CSER, but strongly positive externalities may impair industry-wide CSER. These findings have instructive implications for firms interested in ensuring CSER in their supply chain, as well as for NGOs’ violation scrutiny and reporting policies.

Exclusionary pricing in markets with interdependent demands

In this paper I use a simple model to study the competitive effects of exclusionary pricing involving two markets related by a positive demand externality. It is shown that below-cost pricing on one of these markets can allow an incumbent firm to exclude (from both markets) a more efficient rival which does not have a customer base yet. However, when exclusion occurs, it is always socially optimal. In addition, under some circumstances, there is inefficient entry: the entrant wins both markets while the social optimum would require the incumbent to win them.

Coordinating Business Cycles

We develop a quantitative theory of business cycles with coordination failures. Because of a standard aggregate demand externality, firms want to coordinate production. The presence of a non-convex capacity decision generates multiple equilibria under complete information. We use a global game approach to show that, under incomplete information, the multiplicity of equilibria disappears to give rise to a unique equilibrium with two stable steady states. The economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. In our calibration, the coordination channel improves on the neoclassical growth model in terms of business cycle asymmetries and skewness. The model also accounts for features of the 20072009 recession and its aftermath. Government spending is harmful in general as the coordination problem magnifies the crowding out. It can, however, increase welfare — without nominal rigidities — when the economy is about to transition to the bad steady state. Simple subsidies implement the efficient allocation.