A Theory of Monopolistic Competition with Horizontally Heterogeneous Consumers

Abstract

Our novel approach to modeling monopolistic competition with heterogeneous consumers involves a space of characteristics of a differentiated good (consumers' ideal points), alike Hotelling (1929). Firms have heterogeneous costs à  la Melitz (2003). In addition to price setting, each firm also chooses its optimal location/niche in this space. We formulate conditions for positive sorting: more efficient firms serve larger market segments and face tougher competition in the equilibrium. Our framework entails rich equilibrium patterns displaying non-monotonic markups, high in the most and least populated niches, and the unequal gains from trade across different consumers.

Keywords: firm heterogeneity, product space, positive sorting, product niches

JEL Classification: F100, L110, L130