Introducing Monopolistic Competition into the GTAP Model

Abstract

This technical paper documents one approach to incorporating monopolistic competition into the GTAP model. In this framework, consumer preferences are heterogeneous, leading to an apparent "love of variety" in the aggregate utility function for each region. The more heterogeneous are preferences, the smaller the elasticity of substitution in the aggregate utility function, and the greater the value placed on the addition of new varieties. The same is true for firms, which experience lower unit costs for differentiated, intermediate inputs, as the number of varieties on offer increases. In order to meet the diverse needs of consumers, firms differentiate their products through research and development (R&D) as well as advertising activities. These costs are assumed to be invariant to the total volume of sales for a given variety of product. With production occurring at constant returns to scale, this gives rise to declining average total costs. A zero profits equilibrium in this model is characterized by firms marking up their price over marginal costs by an amount sufficient to cover the fixed costs associated with establishing a new variety in the marketplace. Since the optimal markup is itself determined by the elasticity of substitution among varieties, this establishes a direct relationship between fixed costs and the degree of preference heterogeneity. The main differences between the monopolistically competitive sectors and the traditional GTAP sectors may be summarized as follows: We introduce two new variables: n, the number of firms in the industry and qof, the output per firm. Minimum expenditure and unit costs are declining in n. Average total costs are declining in output per firm. Unlike the Armington specification, foreign and domestic firms compete directly in the representative consumer's utility function. We illustrate this framework with a 2 commodity/3 region example in which we eliminate US antidumping duti