Small group monopolistic competition in a GTAP model: meeting the Markusen challenge

Since the 1990s, there have been rapid increases in concentration ratios in many industries in the U.S., Australia and, we suspect, in other countries. Despite this, applications of GTAP (the world's most widely used global economic model) continue to be based on pure competition or Melitz-style Large-Group Monopolistic Competition (LGMC). In either case, all firms are small, there is free entry, and industries make zero pure profits. Markusen challenges modellers to move to Small-Group Monopolistic Competition (SGMC) in which industries have high levels of concentration and firms are aware of the likely behaviour of their rivals. We create a version of GTAP in which some industries are modelled as SGMC. We make two generalization of earlier Melitz-LGMC specifications. First, we treat the perceived elasticity of demand by firms in SGMC industries as a variable. In our SGMC specification, mark-ups over marginal costs, which depend on perceived elasticities, fall when these elasticities are reduced by pro-competition policies. Second, we allow for sticky adjustment of the number of firms in an industry, and simulate situations in which entry is blocked and incumbent firms make excess profits.