Toward a Theory of Monopolistic Competition

Abstract

We propose a general model of monopolistic competition which encompasses existing models while being flexible enough to take into account new demand and competition features. Even though preferences need not be additive and/or homothetic, the market outcome is still driven by the sole variable elasticity of substitution. We impose elementary conditions on this function to guarantee empirically relevant properties of a free-entry equilibrium. Comparative statics with respect to market size and productivity shock are characterized through necessary and sufficient conditions. Furthermore, we show that the attention to the constant elasticity of substitution (CES) based on its normative implications was misguided: constant mark-ups, additivity and homotheticity are neither necessary nor sufficient for the market to deliver the optimum outcome. Our approach can cope with heterogeneous firms once it is recognized that the elasticity of substitution is firm-specific. Finally, we show how our set-up can be extended to cope with multiple sectors.