Monopolistic Competition and Optimum Product Diversity

Stiglitz, Joseph E.; Dixit, Avinash K.

This article focuses on the impact of scale economies on whether a market solution will yield the socially optimum kinds and quantities of commodities in welfare economics. This article develops some models to study various aspects of the relationship between market and optimal resource allocation in the presence of some nonconvexities. The monopoly power, which is a necessary ingredient of markets with nonconvexities, is usually considered to distort resources away from the sector concerned. However, in the analysis monopoly power enables firms to pay fixed costs, and entry cannot be prevented, so the relationship between monopoly power and the direction of market distortion is no longer obvious. In the central case of constant elasticity utility function, the market solution was constrained Pareto optimal, regardless of the value of that elasticity. With variable elasticities, the bias could go either way, and the direction of the bias depended not on how the elasticity of demand changed, but on how the elasticity of utility changed. We suggested that there was some presumption that the market solution would be characterized by too few firms in the monopolistically competitive sector.



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American Economic Review

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May 1, 2013