Price-increasing Monopolistic Competition? The Case of IES Preferences

by P. Bertoletti, E. Fumagalli, C. Poletti

We introduce a new class of increasing elasticity of substitution (IES) preferences to model product differentiation. In a monopolistic competition setting à la Dixit Stiglitz (1977) we find that, even under constant returns to scale and complete information, a rise in the number of firms can be price-increasing. This result extends to Cournotian competition. Despite the price increase, consumers benefit from a rise in the number of monopolistic competitors because of higher product diversity. Higher prices are therefore associated with higher consumer welfare. Our results suggest a possible explanation to the empirical puzzle posed by the countercyclical movements of price-cost margins following globalisation and market reforms. In addition, they should be of interest for real business cycle literature which investigates the impact of an endogenous market structure.