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Monopoly Power and Endogenous Variety in Dynamic Stochastic General Equilibrium: Distortions and Remedies

  • Marc J. Melitz

    (Princeton University)

  • Fabio Ghironi

    (Boston College)

  • Florin O. Bilbiie

    (Nuffield College, Oxford)

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 Society for Economic Dynamics in its series 2007 Meeting Papers with number 772.

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Date of creation: 2007
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Handle: RePEc:red:sed007:772
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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  1. Jeffrey Campbell, 1998. "Entry, Exit, Embodied Technology, and Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(2), pages 371-408, April.
  2. Campbell, John, 1994. "Inspecting the Mechanism: An Analytical Approach to the Stochastic Growth Model," Scholarly Articles 3196342, Harvard University Department of Economics.
  3. A. P. Lerner, 1934. "The Concept of Monopoly and the Measurement of Monopoly Power," Review of Economic Studies, Oxford University Press, vol. 1(3), pages 157-175.
  4. Kim, Jinill, 2004. "What determines aggregate returns to scale?," Journal of Economic Dynamics and Control, Elsevier, vol. 28(8), pages 1577-1594, June.
  5. Michael Spence, 1976. "Product Selection, Fixed Costs, and Monopolistic Competition," Review of Economic Studies, Oxford University Press, vol. 43(2), pages 217-235.
  6. Feenstra, Robert C., 2003. "A homothetic utility function for monopolistic competition models, without constant price elasticity," Economics Letters, Elsevier, vol. 78(1), pages 79-86, January.
  7. Benassy, Jean-Pascal, 1996. "Taste for variety and optimum production patterns in monopolistic competition," Economics Letters, Elsevier, vol. 52(1), pages 41-47, July.
  8. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  9. Judd, Kenneth L, 1985. "On the Performance of Patents," Econometrica, Econometric Society, vol. 53(3), pages 567-85, May.
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