Costs of Low Productivity: Intensive and Extensive Margins

This paper discusses welfare costs of a decrease in productivity and argues that there are two important channels which cause a reduction in welfare: a decrease in output per firm (intensive margin) and a decrease in number of operating firms (extensive margin). Traditional Dixit-Stiglitz monopolistic competition framework with constant elasticity of substitution utility and common productivity across firms fail to capture the extensive margin. To address this problem, this paper introduces “continuum-quadratic” utility while keeping the other assumptions unchanged and finds that lowering productivity affects not only the intensive but extensive margin as well. This paper highlights the importance of a second channel and argues that this channel should taken into account while calculating the loss of welfare due to a decrease in productivity. Hence, this paper suggests that alternative class of utility specifications (other than constant elasticity of substitution) have to receive more attention with monopolistic competition framework.