Asset Bubbles and Product Market Competition Francisco Queirós* Universitat Pompeu Fabra February 9, 2018 Abstract This paper studies the effects of rational bubbles in an economy characterized by imperfect competition in product markets. It provides two main insights. The first 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 supernormal profits. This depresses the interest rate, making rational bubbles possible even when capital accumulation is dynamically efficient. The second is that by providing a production or entry subsidy, asset bubbles may have a pro-competitive effect and force firms to expand and cut profit margins. However, once they get too large they can lead to overinvestment and sustain corporate losses. 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. JEL Classification: D43, E32, E44, O40 Key words: rational bubbles, competition, market power, dotcom bubble, British railway mania *Address: Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain. e-mail:
[email protected]. I am greatly indebted to my advisors, Fernando Broner and Jaume Ventura, for their guidance and motivation. I also thank Matt Delventhal, Luca Fornaro, Alberto Martin, Haozhou Tang, Tomas Williams and participants of the CREI International Lunch for helpful discussions and suggestions. I also thank Gareth Campbell and John Turner for sharing their data on railway share prices. I acknowledge financial support from the Portuguese Science Foundation (grant SFRH/BD/87426/2012).