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Monopoly Power and Endogenous Product Variety: Distortions and Remedies

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Author Info
Florin O. Bilbiie
Fabio Ghironi
Marc J. Melitz

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Abstract

We study the efficiency properties of a dynamic, stochastic, general equilibrium, macroeconomic model with monopolistic competition and firm entry subject to sunk costs, a time-to-build lag, and exogenous risk of firm destruction. Under inelastic labor supply and linearity of production in labor, the market economy is efficient if and only if symmetric, homothetic preferences are of the C.E.S. form studied by Dixit and Stiglitz (1977). Otherwise, efficiency is restored by properly designed sales, entry, or asset trade subsidies (or taxes) that induce markup synchronization across time and states, and align the consumer surplus and profit destruction effects of firm entry. When labor supply is elastic, heterogeneity in markups across consumption and leisure introduces an additional distortion. Efficiency is then restored by subsidizing labor at a rate equal to the markup in the market for goods. Our results highlight the importance of preserving the optimal amount of monopoly profits in economies in which firm entry is costly. Inducing marginal cost pricing restores efficiency only when the required sales subsidies are financed with the optimal split of lump-sum taxation between households and firms.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14383.

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Date of creation: Oct 2008
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Handle: RePEc:nbr:nberwo:14383

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Find related papers by JEL classification:
D42 - Microeconomics - - Market Structure and Pricing - - - Monopoly
H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
L16 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Industrial Organization and Macroeconomics; Macroeconomic Industrial Structure

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    Other versions:
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  16. Andrew B. Abel, 2007. "Optimal Capital Income Taxation," NBER Working Papers 13354, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Kristian Behrens & Yasusada Murata, 2009. "Trade, Competition, and Efficiency," Cahiers de recherche 0940, CIRPEE. [Downloadable!]
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