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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
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
(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)
(3)
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6. Monopolistic competition
1.1.2
ISHISE, Hirokazu
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)
( 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)
From FOCs,
1
( 1
) 1
1
1
cj = pj ,
c1 + c2
(11)
or
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6. Monopolistic competition
ISHISE, Hirokazu
( 1
) 1
1
1
1
c1 + c2
cj = 1 p1
,
j
(12)
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
pj
)
c.
(16)
) 1
cj
(17)
j=1
pj cj = M.
(18)
i=1
(19)
( n
1
) 1
p1
j
(20)
j=1
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6. Monopolistic competition
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)
p(j)c(j)dj = M.
(22)
(23)
and
(
1
) 1
n
1
p(j)
p=
dj
(24)
(25)
c(j)
c=
) 1
dj
1.2
The meaning of the average price p is simpler if we consider a final good producing sector.
1.2.1
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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6. Monopolistic competition
1.2.2
ISHISE, Hirokazu
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)
py y(j)
= p(j),
(30)
p
p(j)
)
y.
(31)
Zero profits
From (29)
(
y(j)
) 1
1
dj
y(j)
= p(j)y(j).
(32)
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)
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6. Monopolistic competition
1.2.4
ISHISE, Hirokazu
y(j)
1
) 1
y(j)
dj
= p(j),
(35)
or
(
p
y(j)
)1
y(j)
dj
= p(j)1 ,
(36)
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
An intermediate good producer produces a type of intermediate goods facing the demand
function of the final good producer.
1.3.1
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)
{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)
(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)
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6. Monopolistic competition
1.3.2
ISHISE, Hirokazu
(48)
(49)
(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)
(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)
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 +
E0
xt (j)dj = wt lt + rt
0
(58)
t=0
t u(ct , lt ).
t (j)dj.
kt (j)dj +
(59)
(60)
Merging capital evolution and the period budget constraint into one
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)
(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 =
(67)
(68)
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6. Monopolistic competition
2.1.2
ISHISE, Hirokazu
(69)
where
(
yt =
yt (j)
) 1
dj
(70)
(71)
(72)
(73)
(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)
ct +
1
xt (j)dj = yt ,
(77)
lt (j)dj = lt .
(78)
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6. Monopolistic competition
2.1.5
ISHISE, Hirokazu
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
lt (j)
(79)
ult
1
=
uct
yt
yt (j)
) 1
(1 )
yt (j)
.
lt (j)
(80)
2.2
2.2.1
yt+1
yt+1 (j)
)
yt+1 (j)
+ 1 uct+1
kt+1 (j)
(81)
11
) 1
E0
t u(ct , lt ).
(82)
t=0
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6. Monopolistic competition
ISHISE, Hirokazu
(83)
(84)
(85)
) 1
( 1
1
yt =
yt (j) dj
.
(86)
(87)
2.2.2
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)
uct = t ,
(89)
( 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)
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6. Monopolistic competition
ISHISE, Hirokazu
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 ,
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)
1
1 + .
(96)
2.4
2.4.1
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6. Monopolistic competition
2.4.2
ISHISE, Hirokazu
Log-linearization
(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
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ISHISE, Hirokazu
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
10
20
30
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6. Monopolistic competition
ISHISE, Hirokazu
Exercise
3.1
) 1
cj
(105)
j=1
pj cj = M.
(106)
i=1
(107)
Question 1
) 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
) 1
1
cj = pj cj .
cj
(110)
j=1
(111)
Since pc = M , = 1/p.
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6. Monopolistic competition
ISHISE, Hirokazu
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
1
) 1
+1
= 1
cj
( n
)
p1
j
(114)
j=1
j=1
or
(
1
=
1
) 1
p1
j
(115)
(116)
j=1
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)
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3.2
ISHISE, Hirokazu
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)
(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)
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
{p(j),y(j)}
18
(125)
(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)
and hence
0 = p(j) (j)
p(j)
,
(131)
or
p(j) =
3.3
(j).
1
(132)
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)
Question 1
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6. Monopolistic competition
ISHISE, Hirokazu
((
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
p(j) =
3.3.3
w
1 z
(137)
Question 3
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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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)
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
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)
(145)
Question 1
p(j)c(j)dj = w.
(146)
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3.4.2
ISHISE, Hirokazu
Question 2
(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.
(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)
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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ISHISE, Hirokazu
(152)
(153)
or
or
c = zL 1 f 1 1 ( 1).
1
3.4.7
(154)
Question 7
3.4.8
y(j) = ( 1) p yw z
= ( 1) p Lp c+1 w w z
=( 1)zf.
(155)
(156)
Question 8
n
0
f dj = nf ).
L=
(l(j) + f ) dj = nf.
0
Hence,
n = L/f.
3.4.9
(157)
Question 8
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n L
= 1.
L n
(158)
(159)
3.5
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)
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
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