Monopolistic Competition and Optimal Product Diversity with Heterogeneous Firms
I extend the Dixit-Stiglitz (1977) model of monopolistic competition by relaxing the assumption of a single technology. The main objective is to study whether the equivalence of the monopolistically competitive equilibrium to the social optimum still holds in the extended model. I show that the answer crucially depends on the nature of the technological heterogeneity. If firms are free to choose technology, and free entry/exit condition holds to ensure a zero profit equilibrium, then the Dixit-Stiglitz result is robust to the existence of heterogeneous firms. However, if firm-level productivity is drawn from a heterogeneous distribution so that some infra-marginal firms earn positive profits then the market equilibrium no longer has the same desirable properties.
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