© Sanjay K. Chugh
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
Rather, because of perfect
substitutability between all products (recall the assumption of
perfectly-competitive market), firms are all
A view of firms as price-takers
is incompatible with the notion that we would now like to entertain, that of
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-
, rather than pure price-
As you should recall from basic microeconomics, the market structure of
a relatively easy analytical framework in which firms are indeed price-
from the point of view of macroeconomics, pure monopoly seems an untenable view to
After all, it is implausible, at the aggregate level, to asset that there is
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
between the many goods an economy produces.
The concept of
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.
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.