Monopoly Power and Endogenous Product Variety: Distortions and Remedies

Abstract

The inefficiencies related to endogenous product creation and variety under monopolistic competition are two-fold: one static -- the misalignment between consumers and producers regarding the value of a new variety; and one dynamic -- time variation in markups. Quantitatively, the welfare costs of the former are potentially very large relative to the latter. For a calibrated version of our model with these distortions, their total cost amounts to 2 percent of consumption. Appropriate taxation schemes can implement the optimum amount of entry and variety. Elastic labor introduces a further distortion that should be corrected by subsidizing labor at a rate equal to the markup for goods, in order to preserve profit margins and hence entry incentives.

Keywords: efficiency, Entry, Monopoly power, Optimal fiscal policy, Product creation, Variety, Welfare costs

JEL Classification: D42, D50, E60, H21, H32, L16