Reconsidering the Microeconomic Foundations of Price-Setting Behavior

Although the Dixit-Stiglitz aggregator is the workhorse specification of monopolistic competition, this framework and related variants abstract from a key stylized fact from empirical studies of consumer behavior and product marketing, namely, that the price elasticity of demand for a given brand is primarily determined by the extensive margin (i.e., changes in the number of customers purchasing that product) rather than the intensive margin (i.e., changes in the specific quantity purchased by each individual customer). In this paper, we begin by analyzing household scanner data to confirm the salient empirical results. We then proceed to formulate a new dynamic stochastic general equilibrium modelling framework that captures both the intensive and extensive margins of demand, and we investigate the implications of this framework under two alternative sources of firm-level heterogeneity. First, in the case of idiosyncratic productivity shocks, we obtain analytic results for consumer demand and firms’ price-setting behavior and we show that the implications of the model are consistent with the key stylized facts. Second, in the case of staggered nominal price contracts, we show that the presence of customer search has important consequences for the welfare costs of inflation variability and hence for the design of monetary policy.