What the Cyclical Response of Advertising Reveals about Markups and other Macroeconomic Wedges

Theory suggests advertising should be 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 modern macroeconomics, wedges are potent sources of fluctuations in employment. The profit margin or markup ratio is a leading example. In an important class of fluctuations models, profit margins rise in recessions and mediate the decline in employment. 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 or wedge that has the same effect as an increase in sales taxes. The cyclical behavior of advertising should point macroeconomics in a somewhat different direction in explaining employment fluctuations.