Asset bubbles and product market competition

Abstract

This paper studies the interactions between rational bubbles and product market competition. It offers two main insights. The first is that, by providing an entry or production subsidy, asset bubbles may reduce entry barriers and force incumbents to reduce markups. The second is that imperfect competition relaxes the conditions for the existence of rational bubbles. When they have market power, firms restrict output and investment to enjoy monopoly rents. This depresses the interest rate, making rational bubbles possible even when capital accumulation is dynamically efficient. I use anecdotal evidence from the British railway mania of the 1840s and the dotcom bubble of the late 1990s to support the model’s hypotheses and predictions.