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Chapter21 - Chapter 21 A Macroeconomic Model of...

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© Sanjay K. Chugh 261 Summer 2008 Chapter 21 A Macroeconomic Model of Monopolistic Competition: The Dixit-Stiglitz Model The RBC view of the macroeconomy is premised on perfect competition in all three macro markets (goods markets, labor markets, and financial markets). For the seminal issue of the degree of (goods) price stickiness, it is goods markets on which we need to focus, so we limit our attention to goods markets from here on. In perfect competition, there is a sense in which no supplier makes any purposeful, meaningful decision regarding the price that it sets. Rather, because of perfect substitutability between all products (recall the assumption of homogenous goods in a perfectly-competitive market), firms are all price-takers . A view of firms as price-takers is incompatible with the notion that we would now like to entertain, that of firms only infrequently setting their prices . Thus, the most basic step we must take in order to even begin to conceptually understand the idea of (possibly sticky) price-setting is to assert that firms are indeed price- setters , rather than pure price- takers. As you should recall from basic microeconomics, the market structure of monopoly offers a relatively easy analytical framework in which firms are indeed price- setters . However, from the point of view of macroeconomics, pure monopoly seems an untenable view to adopt. After all, it is implausible, at the aggregate level, to asset that there is one producer of all of the goods that are produced and sold in the economy. A more realistic view should admit the simple fact that there are many producers of goods as well as the fact that these goods are not all identical to each other. That is, there is some imperfect substitutability between the many goods an economy produces. The concept of monopolistic competition offers an intermediate theoretical ground between pure monopoly and perfect competition. Indeed, the terminology itself suggests that the concept is an intermediate one between pure monopoly and perfect competition. Modern New Keynesian models are based on a monopolistically-competitive view of goods markets, in contrast to the RBC framework’s perfectly-competitive view. The basic economic idea underlying a monopolistically-competitive view of goods markets is that there are many goods that consumers purchase and that they all are, to some degree, imperfect substitutes for each other. In what follows, we will lay out the basic theoretical structure of macroeconomic models based on monopolistic competition. Before beginning, though, we define an important concept for the analysis of models employing or based on monopolistic competition.
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© Sanjay K. Chugh 262 Summer 2008 Markup We will often want to speak of by how much a firm’s (presumably, optimally-chosen) chosen price, on a per-unit basis, exceeds the cost of production of a given unit of the good. As you should recall from basic microeconomics, a firm’s cost of producing a given (i.e., the marginal) unit of output is measured by its marginal cost.
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