Quantifying the Gap Between Equilibrium and Optimum under Monopolistic Competition*

Abstract

Abstract Equilibria and optima generally differ in imperfectly competitive markets. Although this is well understood theoretically, it is unclear how large the welfare distortions are in the aggregate economy. Do they matter quantitatively? To answer this question, we develop a multisector monopolistic competition model with endogenous firm entry and selection, productivity, and markups. Using French and UK data, we quantify the gap between the equilibrium and optimal allocations. We find that inefficiencies in the labor allocation and entry between sectors, as well as inefficient selection and output per firm within sectors, generate welfare losses of about 6%–10% of GDP.