The Cyclical Response of Advertising Refutes Counter-Cyclical Profit Margins in Favor of Product-Market Frictions
According to the standard model, advertising is remarkably sensitive to profit margins. Firms advertise to stimulate demand for their products. They advertise high-margin products aggressively and low-margin ones hardly at all. In macroeconomics, variations in profit margins over the business cycle have a key role. A widening of margins can explain the rise in unemployment in recessions. A higher margin implies a lower real wage. A variety of models ranging from Keynesian to search-and-matching map a decline in wages to higher unemployment. But a rise in profit margins should expand advertising by a lot. Really a lot. Advertising should be highly countercyclical. Instead, it is somewhat procyclical. The ratio of advertising spending to private GDP falls when the economy contracts. The behavior of advertising refutes the hypothesis that profit margins rise. But it is true that the labor share of income falls. Hence there must be another factor that lowers the labor share without raising profit margins. The only influence that fits the facts is a rise in a product-market friction that has the same effect as an increase in sales taxes.
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This paper was revised on November 8, 2012