Theme Four

Imperfect Competition
 Introduction
The role of perfect competition is viewed as
a benchmark against which other
markets can be measured using the
concept of monopoly power.
The move away from the Marshallian firm in
Economic theory is in two waves:
1. E. Chamberlin and J. Robinson (1930s);
2. A. Dixit and J. Stiglitz (1970s).
 Monopolistic Competition
In Chamberlin’s original model (1933) each
firm produces one differentiated good.
1. Downward-sloping demand curve;
2. Firms are profit-maximising: MR = MC;
3. Free entry and exit;
4. Zero profit and p = AC;
5. AC is not minimised that is AC > MC.
 Implications of Chamberlin
The main consequences of Chamberlin is
that the firm is no longer no longer U-form.
There is no cross-price effects and there is
another implication that the firm has no
direct neighbours.
Also, consumers value variety and hence
other business functions emerge such as
advertising, branding and R&D.
 Dixit and Stiglitz

In recent times there has been the model of

Monopolistic Competition developed by
Dixit and Stiglitz (1977).
This is a hugely influential paper that was
published at a time of high inflation and
productivity slowdown in the global
economy.
 Limitations of Perfect Competition
The work by Dixit and Stiglitz really does
highlight the limitations of the paradigm
of Perfect Competition. The influences in
this work include:
1. Returns to scale;
2. Risk and uncertainty;
3. Asymmetric information;
4. Strategic behaviour.
 The Model
The Dixit and Stiglitz model of Monopolistic
Competition has the number of brands
determined endogenously: i = 1…,
The representative consumer likes variety in
consumption. The utility from consuming
q1, q2 is given by the constant elasticity of
substitution (CES) utility function.
 Constant Elasticity of Substitution
The CES is as follows:

u (q1, q 2,...)   qi
i 1

Following-on from the analysis:

u'(qi) → ∞ as qi→ 0: desire for variety
The indifference curves are convex to the origin.
 The Firms
The firms in this model each produce a single
brand. There are identical technologies (i.e. cost
functions) and the cost function has increasing
returns to scale. Namely;
TC (qi) = F + cqi
Where F is fixed costs and c is variable costs
The firms choose whether to enter and what
quantity to produce if and when there is entry to
the market.
 Solving the Model
The representative consumer maximises the
utility given by the budget constraint (i.e.
labour supply) and yields a system of
demand functions.
The firm’s production decisions is based on
choosing qi to max πi given the downward
sloping demand curve. There is free entry
(πi = 0) and this determines finite number
of products and producers.
 The results
Equilibrium outcomes:
Price: Pmc = 2c
Output: Qmc = F/c
There is a smaller number of brands which
are produced and each is consumed in
greater quantities.
The static Dixit-Stiglitz framework has a
taste for variety as part of the analysis.
 The Variety
The optimal number is determined by the
balance between two factors:
1. Duplication of fixed cost (F) is wasteful;
2. Consumer desire for variety is beneficial.
This outcome is rather ambiguous and
depends on functional form such that the
market outcome that are determined by
two opposing effects.
 Market Outcome
Non-appropriability of social surplus:
1. Firms cannot capture whole consumer
surplus (CS) by introducing a product;
2. Positive externality where n is too low.
Business Stealing:
1. Product introduction steals profit from
other firms;
2. Negative externality where n is too high.
 Summary
The firm in Monopolistic Competition has the
following to contend with:
1. A downward-sloping demand curve
reflecting different point elasticities.
2. Cross-elasticities of demand for any pair
of firms which are low.
3. Free entry that is there are NO barriers
to entry.
 Applications
There are many areas of applications for the
Dixit-Stiglitz model, including:
1. International Trade Theory;
2. Macroeconomics;
3. Growth Theory;
4. Economic Geography.
This is because the model is determinate
and gives simple, clean answers.