A Theory of Monopolistic Competition with Horizontally Heterogeneous Consumers

Our novel approach to modeling monopolistic competition with heterogeneous firms and consumers involves spatial product differentiation, in either a geographical space or a space of characteristics. In addition to price, each firm chooses location in space. We formulate conditions for positive sorting—more-productive firms serve larger market segments and face tougher competition—and for existence and uniqueness of equilibrium. To quantify the role of sorting, we calibrate the model using haircut market data and perform counterfactual analysis. Inequality in gains among consumers caused by positive market shocks can be substantial: gains for consumers at more-populated locations are three to four times higher.