Monopolistic Competition: CES Redux?

We investigate competitive, selection and reallocation effects in monopolistic competition trade models. We argue that departing from CES preferences in an otherwise standard Dixit-Stiglitz setup with additive preferences seems to involve implausible assumptions about consumer behavior and inconsistent competitive effects. In the presence of trade costs, selection effects à la Melitz (2003) are instead generally robust to the assumptions about preferences. However, they are unambiguously associated to aggregate productivity gains only when preferences are CES. We also study competitive effects in alternative monopolistic competition settings featuring non-additive preferences, strategic interaction and consumers’ preference for an ideal variety. We find that none of the these setups delivers a compelling pro-competitive mechanism. Overall, our results suggest that in monopolistic competition, consistent with CES preferences, larger markets select more aggressively on productivity rather than forcing firms to move down their average cost curves.