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6.

Monopolistic competition

ISHISE, Hirokazu

6. Monopolistic competition
Goals
to master a useful model of price setting, monopolistic competition
to understand the loss associated with monopolistic competition

Basic monopolistic competition model

Motivation
Under perfect competition, agents take prices as given
Want to include a price setting behavior
A (relatively) simple device is monopolistic competition
Used in many models in growth theories, international trade theories, etc.
Basic premise is to consider variety of goods
e.g., not just bottled green tea but distinguishing each dierent brand

1.1
1.1.1

Household demand
Set-up of two goods case

The utility function of the HH is given by


u(c),

(1)

where c is composed of two types of consumption goods, and they are not perfectly substitutable each other,

) 1
( 1
1

c = c1 + c2
,

(2)

where > 1. The budget constraint is


p1 c1 + p2 c2 = M,

(3)

where M is the wealth.


Maximization of u(c) is achieved by maximizing c
The function is called constant elasticity of substitution (CES)

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6. Monopolistic competition

1.1.2

ISHISE, Hirokazu

Demand of two goods case

Set-up a Lagrangian,

( 1
) 1
1

L = c1 + c2
+ (M p1 c1 p2 c2 ) .

(4)

( 1
) 1
1 1
1
1

c1 + c2
cj
= pj ,

(5)

FOCs for j = 1, 2

and then

( 1
) 1
1 1
1

c1 + c2
cj = pj cj .

(6)

Summing up the condition for j = 1, 2 to obtain

( 1
) 1
)
1 ( 1
1
1

c1 + c2
c1 + c2
= (p1 c1 + p2 c2 )
{z
}
|
|
{z
}
M

(7)

that is,
= c/M.

(8)

Then,

c cj = pj c/M,

(9)

or
cj = c(1) M p
j .

(10)

Demand if price of the good


Demand if total wealth
1.1.3

Alternative representation of the demand function

From FOCs,
1
( 1
) 1
1
1

cj = pj ,
c1 + c2

(11)

or
2

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6. Monopolistic competition

ISHISE, Hirokazu

( 1
) 1
1
1
1

c1 + c2
cj = 1 p1
,
j

(12)

Summing up the equation for j = 1, 2 to obtain


( 1
) 1
+1
1
1
(
)

c1 + c2
= 1 p1
+ p1
,
1
2

(13)

or
1
) 1
1 ( 1
= p1 + p1
.
2

(14)

That is, 1/ is an average price of the two goods. Let p denote 1/. Since = c/M ,
pc = M.

(15)

p is the price of the composite consumption good, c.


Using this p,
(
cj =
1.1.4

p
pj

)
c.

(16)

Many goods case

Consider n goods extension as


(
c=

) 1

cj

(17)

j=1

and the budget constraint is


n

pj cj = M.

(18)

i=1

The result is straightforward:


cj = c(1) M p
j .

(19)

The price of the composite is


p=

( n

1
) 1

p1
j

(20)

j=1

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1.1.5

ISHISE, Hirokazu

Continuum of goods

Remember that summation and integral are similar (except for technical dierence). Consider
(

c=

) 1

c(j)

dj

(21)

and the budget constraint is

p(j)c(j)dj = M.

(22)

The result is straightforward:


c(j) = c(1) M p(j) .

(23)

and
(

1
) 1

n
1

p(j)

p=

dj

(24)

(25)

Moreover, when we consider a special case that n = 1,


(

c(j)

c=

) 1

dj

The demand function is the same as (23).


Dierent from the discrete case, there are infinitely many values between 0 and 1 (0.1,
0.11, 0.111, ...)

1.2

Final good firm

The meaning of the average price p is simpler if we consider a final good producing sector.
1.2.1

Final goods producer

Consider instead that there is a representative firm which produces the final goods y using
y(j) as intermediate inputs. The final goods firms sell the final goods with price p.
1
py
p(j)y(j)dj
(26)
0

where
(
y=

y(j)

) 1

dj

(27)

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1.2.2

ISHISE, Hirokazu

Demand for intermediate goods


(

max p

y(j)

{y(j)}

) 1

dj

p(j)y(j)dj

(28)

FOC
(

y(j)

) 1
1

dj

y(j)

1
1

= p(j).

(29)

From this equation,


1

py y(j)

= p(j),

(30)

and hence the demand for good y(j) is


(
y(j) =

p
p(j)

)
y.

(31)

The demand function is the same as before


Demand if price of the input
Demand if price of the output
Demand if output production
1.2.3

Zero profits

From (29)
(

y(j)

) 1
1

dj

y(j)

= p(j)y(j).

(32)

Integrating this equation from j = 0 to j = 1 to obtain


(
p

y(j)

) 1
1

dj

y(j)

dj =

p(j)y(j)dj,

(33)

and hence
(
0=p

y(j)

) 1

dj

p(j)y(j)dj,

(34)

the profits of the final goods firms are zero.

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6. Monopolistic competition

1.2.4

ISHISE, Hirokazu

Determination of output price

Another expression from (29) is


(

y(j)

1
) 1

y(j)

dj

= p(j),

(35)

or
(
p

y(j)

)1
y(j)

dj

= p(j)1 ,

(36)

and integrating this equation to obtain


( 1
)1
1
1
p
y(j) dj
0

y(j)

p(j)1 dj,

dj =

(37)

or
(
p=

p(j)(1) dj

1
) (1)

(38)

The price of the output is a (geometric) weighted average of the input prices.

1.3

Intermediate good firm

An intermediate good producer produces a type of intermediate goods facing the demand
function of the final good producer.
1.3.1

Simplified version of intermediate good firms problem

Consider that intermediate good firm produces intermediate good using labor only,
y(j) = z(j)l(j),

(39)

where z(j) is labor productivity (as well as TFP) of the firm. The profit maximization
problem is to choose p(j), y(j), and l(j) to maximize
p(j)y(j) wl(j),

(40)

subject to the demand (31), taking w, p and y as given. That is


max

{p(j),y(j),l(j)}

s.t.

p(j)y(j) wl(j)
y(j) = z(j)l(j)
(
)
p
y.
y(j) =
p(j)

A specification of Lagrangian is
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6. Monopolistic competition

ISHISE, Hirokazu

((
L = p(j)y(j) wl(j) + (j)

p
p(j)

)
y y(j) + (j) (z(j)l(j) y(j)) ,

(41)

FOCs
0 = y(j) (j)p p(j)1 y
0 = p(j) (j) (j)
0 = w + (j)z(j)

(42)
(43)
(44)

Note first that


(j) = w/z(j),

(45)

this is the marginal and average costs of production. By eliminating (j) and using constraints
to obtain

p(j) =

(j) =
.
1
1 z(j)

(46)

This is the profit-maximizing price. Using (31) and (46), y(j) is easily derived.
Under perfect competition, p(j) = w/z(j), the marginal and average costs
/( 1) > 1 because > 1
Price under monopolistic competition is higher than marginal cost
The ratio is called the mark-up
Price under monopolistic competition is mark-up times the marginal cost
Given above price setting behavior, profits of the firm is

p(j)y(j) wl(j)

w
=
z(j)l(j) wl(j)
1 z(j)
1
=
wl(j).
1

(47)

The firm earns positive profits.

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6. Monopolistic competition

1.3.2

ISHISE, Hirokazu

Intermediate good firm with capital

Production function of intermediate goods firms


y(j) = z(j)k(j) l(j)1 ,

(48)

The profit maximization problem is


p(j)y(j) rk(j) wl(j),

(49)

subject to the demand (31), taking r, w, p and y as given.

L =p(j)y(j) rk(j) wl(j)


((
)
)
(
)
p
+(j)
y y(j) + (j) z(j)k(j) l(j)1 y(j) ,
p(j)

(50)

FOCs
0 = p(j) (j) (j)
0 = y(j) (j)y(j)/p(j)
0 = r + (j)y(j)/k(j)
0 = w + (j)y(j)/l(j)

(51)
(52)
(53)
(54)

By eliminating (j) and using constraints to obtain


p(j) =

(j).
1

(55)

This is exactly the same as before. What is (j) now? From constraints and FOCs,

(j) =

rk(j) + wl(j)
,
y(j)

(56)

that is, (j) again represents the average cost of producing y(j). Since the production function
is CRS, the average cost is the same as the marginal cost. Specifically, from FOCs,
r w1
.
(j) =
(1 )1 z(j)

(57)

Monopolistic competition in the growth model

Lets now introduce the monopolistically competitive intermediate goods producer into the
growth model. We normalize the output price to be one, pt = 1.

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6. Monopolistic competition

2.1
2.1.1

ISHISE, Hirokazu

Decentralized economy
Household

Utility function
max

{ct ,kt+1 (j),xt (j)}


t=0

Period budget constraint

ct +

E0

xt (j)dj = wt lt + rt
0

(58)

t=0

t u(ct , lt ).

t (j)dj.

kt (j)dj +

(59)

Households own capital, and rent it to firms. Capital stock follows


kt+1 (j) = (1 )kt (j) + xt (j),

(60)

Merging capital evolution and the period budget constraint into one

kt+1 (j)dj = wt lt + (rt + 1 )

ct +
0

kt (j)dj +

t (j)dj

(61)

Lagrangian

L =E0

[
t u(ct , lt )

t=0

+ t wt lt + (rt + 1 )

t (j)dj ct

kt (j)dj +

1
0

)]

kt+1 (j)dj

(62)

First order conditions


uct = t ,
ult = t wt ,
Et t+1 (rt+1 + 1 ) = t .

(63)
(64)
(65)

lim T T kT +1 (j) = 0.

(66)

TVC

By eliminating t in the FOCs, we have the labor supply condition and Euler equation
ult
,
uct
uct = Et (rt+1 + 1 ) uct+1 .
wt =

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6. Monopolistic competition

2.1.2

ISHISE, Hirokazu

Final good firms

The final good producer maximize the profits


1
pt yt
pt (j)yt (j)dj

(69)

where
(

yt =

yt (j)

) 1

dj

(70)

This is already analyzed in the previous section. The results are


)
pt
yt (j) =
yt ,
pt (j)
1
+1
pt
=
pt (j)+1 dj
(

(71)
(72)

Note that pt = 1 by normalization (called numeraire).


2.1.3

Intermediate good firms

Production function of intermediate goods firms


yt (j) = zt (j)kt (j) lt (j)1 ,

(73)

The profit maximization problem is


pt (j)yt (j) rt kt (j) wt lt (j),

(74)

subject to the demand (31), taking r, w, p and y as given. This is again already described in
the previous section. The results are
yt (j) 1
pt (j),
kt (j)
yt (j) 1
wt = (1 )
pt (j)
lt (j)
rt =

2.1.4

(75)
(76)

Market clearing conditions

ct +
1

xt (j)dj = yt ,

(77)

lt (j)dj = lt .

(78)

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2.1.5

ISHISE, Hirokazu

Definition of the competitive equilibrium

Definition:
A Competitive equilibrium is a sequence of quantities
{ct , yt , {kt+1 (j), lt (j), yt (j), xt (j), t (j)}j(0,1) }
and prices {wt , rt , {pt (j)}j(0,1) }
t=0
t=0
for given {k0 (j)}j(0,1) , {{zt (j)}j(0,1) }
t=0 which satisfy household optimality conditions,
final goods production firms optimality conditions, intermediate goods production
firms optimization conditions, and market clearing conditions.
This is not a perfectly competitive equilibrium
The intermediate goods markets are monopolistically competitive
Other markets are perfectly competitive
2.1.6

Characterization of the competitive equilibrium

From HH and intermediate goods firm conditions


ult
1
yt (j)
=
pt (j)(1 )
uct

lt (j)

(79)

together with the final goods firm condition,

ult
1
=
uct

yt
yt (j)

) 1

(1 )

yt (j)
.
lt (j)

(80)

Similarly, from the Euler equation and conditions of firms


(
uct = Et

2.2
2.2.1

yt+1
yt+1 (j)

)
yt+1 (j)

+ 1 uct+1
kt+1 (j)

(81)

Social planners problem


Problem
max

{ct ,kt+1 (j),xt (j)}


t=0

11

) 1

E0

t u(ct , lt ).

(82)

t=0

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Constraints are following:


kt+1 (j) = (1 )kt (j) + xt (j),
1
ct +
xt (j)dj = yt ,
0
1
lt (j)dj = lt ,

(83)
(84)
(85)

yt (j) = zt (j)kt (j) lt (j)1 ,

) 1
( 1
1
yt =
yt (j) dj
.

(86)
(87)

2.2.2

Characterization of the Pareto ecient allocation

L =E0

[ (
t u ct ,

lt (j)dj

t=0

((

yt (j)

+ t

) 1

dj

+ (1 )

kt+1 (j)dj ct
0

(
) ]
t (j) zt (j)kt (j) lt (j)1 yt (j) dj

kt+1 (j)dj
0

(88)

one constraint with t


continuum of dierent constraints with t (j)
FOCs

uct = t ,

(89)

ult = t (j)(1 )zt (j)kt (j) lt (j) ,

( 1
) 1
1
1
1

t
yt (j) dj
yt (j) 1 = t (j),
(0
)
Et t+1 (1 ) + t+1 (j)zt+1 (j)kt+1 (j)1 lt+1 (j)1 = t

(90)
(91)
(92)

From them
ul,t
=
uct

uct = Et

yt
yt (j)
((

) 1

(1 )

yt+1
yt+1 (j)

) 1

yt (j)
,
lt (j)

)
yt+1 (j)

+ 1 uct+1
kt+1 (j)

(93)
(94)

Compare this with conditions of CE


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CE allocation is not PE
Source of ineciency:
Check what happens if

2.3

Steady states

Assume that
u(ct , lt ) = ln ct + (1 ) ln(1 lt )
zt (j) = zt
zt = exp(
zt )
zt =
zt1 + t ,

t iid N (0, 1).

Under this assumption of the TFP, the model has no trend growth. Moreover, since zt (j) = zt ,
the problem of the intermediate firm is symmetric. Hence,
pt (j) = pt = 1.
2.3.1

(95)

Steady state of the competitive equilibrium

Consider that zt = 1. Using the Euler equation,


r =

1
1 + .

(96)

Note that p = 1, the rest is the same as usual.

2.4
2.4.1

Impulse response functions


Calibration

What is the reasonable value of ?


Remember that /( 1) is mark-up ratio
Based on micro evidences, mark-up ratio is around 1020%
= 611
Note also that if , then the economy is identical to perfectly competitive model

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2.4.2

ISHISE, Hirokazu

Log-linearization

The log-linearized version of the economy is following:


zt+1 =
zt + t
x
kt+1 = (1 )kt + xt
k
Et ct+1 +
rEt rt+1 =
ct
l
lt
wt = ct +
1 l
yt = zt + kt + (1 )lt
yyt = cct + xxt
rt = yt kt
wt = yt lt

(97)
(98)
(99)
(100)
(101)
(102)
(103)
(104)

Notice that does not directly appear. It is included in l (see Exercise) and hence in other
steady state values.
2.4.3

Impulse response functions

In the figure, red-broken line shows the IRFs when = 6

Two lines are very close each other


There is an eciency in the steady state (see Exercise)
However, it does not make a big dierence in terms of the dynamics around the steady
state

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6. Monopolistic competition

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1
A

0.5
0

0.5
0

10

20

30

10

20

1
Y

1
0

0
0

10

20

30

10

20

X
0

10

20

30

10

10

20
W

15

30

1
R

30

10

0.5
0

30

0.5
0

10

20

30

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30

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ISHISE, Hirokazu

Exercise

3.1

Many goods case

Consider the problem in section 1.1.4.


(
c=

) 1

cj

(105)

j=1

and the budget constraint is


n

pj cj = M.

(106)

i=1

Let p denote the price of the aggregate goods


pc = M.
3.1.1

(107)

Question 1

Set-up a Lagrangian and derive FOC.


(
L=

) 1

cj

(
+ M

)
pj cj

(108)

j=1

j=1

FOC
( n

) 1
1

cj

cj

= pj ,

(109)

j=1

3.1.2

Question 2

Confirm that the Lagrange multiplier of the problem is 1/p.


From FOC,
( n

) 1
1

cj = pj cj .

cj

(110)

j=1

Summing up the condition for all j to obtain


c = M

(111)

Since pc = M , = 1/p.

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3.1.3

Question 3
(
) 1
n
1 1
Show p =
.
j=1 pj
From FOC,
( n

1
) 1

cj = pj ,

cj

(112)

j=1

or
(

) 1
1

cj = 1 p1
,
j

cj

(113)

j=1

Summing up the equation for all j to obtain


(

1
) 1
+1

= 1

cj

( n

)
p1
j

(114)

j=1

j=1

or
(

1
=

1
) 1

p1
j

(115)

(116)

j=1

Since = 1/p, The price of the composite is

p=

( n

1
) 1

p1
j

j=1

3.1.4

Question 4

Show cj = (p/pj ) c.
From FOC,
( n

1
) 1

cj = pj ,

cj

(117)

j=1

or
1

c cj = pj /p,

(118)

and the result is obtained by a straightforward rearrangement.

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3.2

ISHISE, Hirokazu

Two-step approach of price determination

Consider the problem of section 1.3.2. Instead of applying the Lagrangian to the entire
problem, lets consider a two-step approach. The first step is to consider the following costminimization problem.
min rk(j) + wl(j)

(119)

s.t. z(j)k(j) l(j)1 = y(j).

(120)

{k(j),l(j)}

3.2.1

Question 1

Attach a Lagrange multiplier (j) to the constraint. Set-up a Lagrangian and derive the
FOCs.
(
)
L = rk(j) + wl(j) + (j) y(j) z(j)k(j) l(j)1

(121)

FOCs are
r = (j)z(j)k(j)1 l(j)1

(122)

w = (j)(1 )z(j)k(j) l(j)

3.2.2

(123)

Question 2

Combine the FOCs to express the Lagrange multiplier as a function of parameters and exogenous variables (r, w and z(j)).
r w1
(j) =
.
(1 )1 z(j)
3.2.3

(124)

Question 3

By comparing the results in section 1.3.2, you have shown that the Lagrange multiplier
expresses the marginal cost of production. Using the logic of the Lagrange method, explain
why the multiplier captures the marginal cost of production.
The multiplier in general represents the marginal change of the objective when the constraint is marginally relaxed. In this specification, the multiplier represents the marginal
cost associated with an increase in the production. Hence, this should be the marginal
cost of production.
3.2.4

Question 4

Consider the following second-step problem:


max p(j)y(j) (j)y(j)
(
)
p
s.t. y(j) =
y.
p(j)

{p(j),y(j)}

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(126)

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6. Monopolistic competition

ISHISE, Hirokazu

Set-up the Lagrangian, derive the FOCs, and express the price as a function of (j).
((
L = p(j)y(j) (j)y(j) + (j)

p
p(j)

)
y y(j)

(127)

FOCs
0 = p(j) (j) (j),
0 = y(j) (j)p p(j)1 y.

(128)
(129)

y(j)p(j) = (j)y(j),

(130)

From the second equation,

and hence
0 = p(j) (j)

p(j)
,

(131)

or
p(j) =

3.3

(j).
1

(132)

Increasing returns to scale

Suppose that for an operation, a firm needs to employ f > 0 units of labor adding to labor
proportional to output. A firm chooses p(j), y(j) and l(j), for taking r, w, p, y and f as
given.
max

p(j)y(j) wl(j) wf

{p(j),y(j),l(j)}

s.t.

y(j) = zl(j)
(
)
p
y(j) =
y.
p(j)

Note that the productivity z is the same across goods.


3.3.1

Question 1

Set-up a Lagrangian and derive FOCs.

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((
L = p(j)y(j) wl(j) wf + (j)

p
p(j)

)
y y(j) + (j) (zl(j) y(j)) ,

(133)

FOCs
0 = y(j) (j)p p(j)1 y
0 = p(j) (j) (j)
0 = w + (j)z
3.3.2

(134)
(135)
(136)

Question 2

Derive the expression of p(j).

p(j) =

3.3.3

w
1 z

(137)

Question 3

Derive the expression of y(j) and l(j).

y(j) = ( 1) p yw z
l(j) = ( 1) p yw z 1
3.3.4

(138)
(139)

Question 4

What is the marginal cost of production, that is, the additional cost for producing an additional unit of output?

w/z
3.3.5

(140)

Question 5

What is the average cost of production, that is, total cost divided by the total output?
wl(j) + wf
w
= + f ( 1) p y 1 w z
y(j)
z
3.3.6

(141)

Question 6

Is the price proportional to the marginal cost? How about the average cost?
The price is proportional to the marginal cost, not the average cost.
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6. Monopolistic competition

3.3.7

ISHISE, Hirokazu

Question 7

Derive the expression of the profits of the firm. Are the profits zero?
w
zl(j) wl(j) wf
1 z
1
wl(j) wf
=
1
1
=
w ( 1) p yw z 1 wf
1
= ( 1)1 p yw+1 z 1 wf

p(j)y(j) wl(j) wf =

(142)

The profits are not zero in general.


3.3.8

Question 8

Do the price, output, labor and profits dier across firms? Explain the reason.
Since the right hand sides of the expressions do not dier across firms, price, output,
labor and profits are the same across firms. Since each firm faces the symmetrically
treated, there are no dierences among firms.

3.4

An equilibrium of the economy with increasing returns to scale

Consider a production function of the previous question. Suppose that there are L representative households who consume these output y(j) from 0 to n (not necessarily from 0 to 1) as
consumption goods. Each household supplies one unit of labor. Hence, the total labor supply
of the economy is L. The utility of the household is given as
u=c

(143)

where
(
c=

) 1

c(j)dj

(144)

Since there are L households, the goods market clearing condition is


Lc(j) = y(j) for all j.
3.4.1

(145)

Question 1

Write down the household budget constraint.

p(j)c(j)dj = w.

(146)

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Graduate Introductory Macroeconomics

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6. Monopolistic competition

3.4.2

ISHISE, Hirokazu

Question 2

Write down the labor market clearing condition.

(l(j) + f ) dj = L.

(147)

3.4.3

Question 3

If a firm earns positive profits, then we expect that a new entrant appears to exploit this
opportunity. Hence, in the equilibrium, we impose an additional condition, zero-profits
condition. Write down the zero-profits condition of this economy.

p(j)y(j) wl(j) wf = 0 for all j


3.4.4

(148)

Question 4

Define the equilibrium. Remember that you need to add the zero-profits condition adding to
other conditions included in the usual definitions.
3.4.5

Question 5

Derive the demand function of the good c(j) (without using p). Combine the demand function
with the market clearing condition, and then compare this with the demand function given
in the previous question. What is y?
c(j) = c+1 w p(j) .

(149)

Since Lc(j) = y(j),


(
+1

Lc

w p(j)

p
p(j)

)
y,

(150)

or
y = Lp c+1 w .
3.4.6

(151)

Question 6

Derive the expression of c as a function of exogenous variables and parameters (hint: use the
zero-profits condition and obtained expression of y).

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6. Monopolistic competition

ISHISE, Hirokazu

The zero-profits condition implies that


( 1)1 p yw+1 z 1 = wf,

(152)

( 1)1 p Lp c+1 w w+1 z 1 = wf,

(153)

or

or

c = zL 1 f 1 1 ( 1).
1

3.4.7

(154)

Question 7

Derive the expression of y(j) and l(j).

3.4.8

y(j) = ( 1) p yw z
= ( 1) p Lp c+1 w w z
=( 1)zf.

(155)

l(j) = y(j)/z = ( 1)f.

(156)

Question 8

Derive the expression of n (hint:

n
0

f dj = nf ).

L=

(l(j) + f ) dj = nf.
0

Hence,
n = L/f.
3.4.9

(157)

Question 8

Suppose that L increases. Determine the eect of an increase in L on n and u.

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Graduate Introductory Macroeconomics

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6. Monopolistic competition

ISHISE, Hirokazu

n L
= 1.
L n

(158)

One percent increase in L increases n by one percent.


Remember that u = c, so the elasticity is
u L
1
=
> 0.
L u
1

(159)

One percent increase in L increases u by 1/( 1) percent.

3.5

Steady state labor of the competitive equilibrium

Consider a model described in section 2.1.


3.5.1

Question 1

Starting from the section 2.3.1, calculate steady state value of labor, l.
Using the intermediate good firms FOC,
( )1
k
1
r =
.

(160)

c + x = y,

(161)

From the resource constraint

or

(1 l)(1 )
1

( )
()
( )
k
1
k
k
+ l = l,
l

l
l

(162)

or

1
1
l = l,
(1 l)(1 )
+
1

(163)

or
(
l =

3.5.2

1 1
1+
1

1
1
1+

))1
.

(164)

Question 2

Is l increasing or decreasing in ? Give an intuition.


l is increasing in . As described in the text, if , the model is the same as
the perfectly competitive model. Due to the ineciency in production coming from the
monopolistic competition, labor supply is lower, and production is lower.
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Graduate Introductory Macroeconomics

Summer 2014

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