On the Effects of Income Heterogeneity in Monopolistically Competitive Markets

Abstract

This paper studies the e¤ects of consumer income heterogeneity on monopolistically competitive product markets and individual welfare in the context of non-homothetic preferences. When expenditure of richer individuals is less sensitive to price change compared to poorer ones, a mean-preserving contraction of income distribution makes firm revenue less sensitive to price changes. This entices firms to charge higher prices. As a result, new firms enter the market, broadening product diversity. General equilibrium effects have a negative impact on poorer individuals and, in specific circumstances, on richer individuals. Furthermore, reduced income inequality may shift the market equilibrium further away from optimal product diversity. In open economies, lower income inequality in a country creates a price divergence between countries and decreases trade volumes and values. Those general equilibrium effects are shown to be quantitatively non negligible.

Keywords: Monopolistic competition, nonhomothetic preferences, income inequality, pricing, welfare, optimal product diversity, trade.

JEL Classification: D43, L16, F12, F14, R13.