Aggregate spillovers and imperfect competition: The implications for business cycles and the welfare effects of tax reform

Todd Alan Knoop, Purdue University

Abstract

The neoclassical assumptions of perfect competition and constant returns to scale are commonly used within most areas of macroeconomic research. This is generally true of existing research on business cycles and universally true of previous studies investigating the welfare benefits of taxation reform. However, a substantial amount of empirical evidence suggests that aggregate spillovers and market power exist within the U.S. economy. In this dissertation, I examine exactly how important these deviations from the standard neoclassical framework are to the propagation of business cycles and to the costs of distortionary taxation. In Chapter 1, I show that the inclusion of aggregate spillovers, or external increasing returns to scale, in a standard general equilibrium model with distortionary taxes, technology shocks, and government spending shocks mimics the business cycle behavior of the U.S. economy as well as a perfectly competitive version of the same model. In Chapter 2, I show that aggregate external increasing returns to scale, even of very small degrees, lead to proportionally large increases in the benefits of tax reform. These results indicate that the existence of external increasing returns to scale is a potentially important key to understanding both the implications of changes in fiscal policy and the propagation of U.S. business cycles. Chapter 3 demonstrates that the macroeconomic effects of market power within models of monopolistic competition depend critically upon the cyclical behavior of economic profits. If instantaneous procyclical net entry is possible so that economic profits are driven to zero in every period, the productivity spillovers generated by this new entry magnifies both the propagation of exogenous shocks and the potential welfare benefits of taxation reform. However, if net entry is impossible and economic profits move procyclically outside of the steady state, the existence of market power diminishes the responsiveness of the economy to exogenous shocks and reduces the costs of distortionary taxation as compared to perfectly competitive models. Thus, the cyclical behavior of profits is potentially more important to understanding the macroeconomic effects of market power than the actual extent to which market power exists.

Degree

Ph.D.

Advisors

Carlson, Purdue University.

Subject Area

Economics|Economic theory|Finance

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