Dixit y Stiglitz 1977 1831401

American Economic Association
Monopolistic Competition and Optimum Product Diversity

Author(s): Avinash K. Dixit and Joseph E. Stiglitz
Source: The American Economic Review, Vol. 67, No. 3 (Jun., 1977), pp. 297-308
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1831401
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Monopolistic Competition and Optimum
Product Diversity
By AVINASH K. DIXIT AND JOSEPH E. STIGLITZ*
The basic issue concerning production in potential commodity involves some fixed
welfare economics is whether a market solu- set-up cost and has a constant marginal
tion will yield the socially optimum kinds cost. Modeling the desirability of variety
and quantities of commodities. It is well has been thought to be difficult, and several
known that problems can arise for three indirect approaches have been adopted.
broad reasons: distributive justice; external The Hotelling spatial model, Lancaster's
effects; and scale economies. This paper is product characteristics approach, and the
concerned with the last of these. mean-variance portfolio selection model
The basic principle is easily stated.' A have all been put to use.3 These lead to re-
commodity should be produced if the costs sults involving transport costs or correla-
can be covered by the sum of revenues and tions among commodities or securities, and
a properly defined measure of consumer's are hard to interpret in general terms. We
surplus. The optimum amount is then therefore take a direct route, noting that the
found by equating the demand price and the convexity of indifference surfaces of a con-
marginal cost. Such an optimum can be ventional utility function defined over the
realized in a market if perfectly discrim- quantities of all potential commodities al-
inatory pricing is possible. Otherwise we ready embodies the desirability of variety.
face conflicting problems. A competitive Thus, a consumer who is indifferent be-
market fulfilling the marginal condition tween the quantities (1,0) and (0,1) of two
would be unsustainable because total profits commodities prefers the mix (1/2,1/2) to
would be negative. An element of monopoly either extreme. The advantage of this view
would allow positive profits, but would is that the results involve the familiar own-
violate the marginal condition.2 Thus we and cross-elasticities of demand functions,
expect a market solution to be suboptimal. and are therefore easier to comprehend.
However, a much more precise structure There is one case of particular interest on
must be put on the problem if we are to which we concentrate. This is where poten-
understand the nature of the bias involved. tial commodities in a group or sector or in-
It is useful to think of the question as one dustry are good substitutes among them-
of quantity versus diversity. With scale selves, but poor substitutes for the other
economies, resources can be saved by pro- commodities in the economy. Then we are
ducing fewer goods and larger quantities of led to examining the market solution in re-
each. However, this leaves less variety, lation to an optimum, both as regards
which entails some welfare loss. It is easy biases within the group, and between the
and probably not too unrealistic to model group and the rest of the economy. We ex-
scale economies by supposing that each pect the answer to depend on the intra- and
intersector elasticities of substitution. To
demonstrate the point as simply as possible,
*Professors of economics, University of Warwick we shall aggregate the rest of the economy
and Stanford University, respectively. Stiglitz's re-
into one good labeled 0, chosen as the
search was supported in part by NSF Grant SOC74-
22182 at the Institute for Mathematical Studies in the
numeraire. The economy's endowment of it
Social Sciences, Stanford. We are indebted to Michael is normalized at unity; it can be thought of
Spence, to a referee, and the managing editor for com- as the time at the disposal of the consumers.
ments and suggestions on earlier drafts.
I See also the exposition by Michael Spence.
2A simple exposition is given by Peter Diamond and 3See the articles by Harold Hotelling, Nicholas
Daniel McFadden. Stern, Kelvin Lancaster, and Stiglitz.
297
298 THE AMERICAN ECONOMIC REVIEW JUNE 1977
The potential range of related products is varieties, or as diversification on the part

labeled 1,2,3,.... Writing the amounts of of each consumer.
the various commodities as x0 and x = (xl,
X2, X3 ..., we assume a separable utility 1. Constant-Elasticity Case
function with convex indifference surfaces:
A. Demand Functions
(1) u = U(xO, V(x1,x2,X3..)) The utility function in this section is
In Sections I and II we simplify further (2) ( {x} I/P)

by assuming that V is a symmetric function,
and that all commodities in the group have For concavity, we need p < 1. Further,
equal fixed and marginal costs. Then the since we want to allow a situation where
actual labels given to commodities are im- several of the xi are zero, we need p > 0. We
material, even though the total number n also assume U homothetic in its arguments.
being produced is relevant. We can thus The budget constraint is
label these commodities 1,2, ..., n, where n
the potential products (n + 1), (n + 2), ... (3) xO + Pi= I

are not being produced. This is a restrictive
assumption, for in such problems we often where pi are prices of the goods being pro-
have a natural asymmetry owing to grad- duced, and I is income in terms of the
uated physical differences in commodities, numeraire, i.e., the endowment which has
with a pair close together being better been set at I plus the profits of the firms
mutual substitutes than a pair farther apart. distributed to the consumers, or minus the
However, even the symmetric case yields lump sum deductions to cover the losses, as
some interesting results. In Section III, we the case may be.
consider some aspects of asymmetry. In this case, a two-stage budgeting pro-
We also assume that all commodities cedure is valid.4 Thus we define dual quan-
have unit income elasticities. This differs tity and price indices
from a similar recent formulation by
Michael Spence, who assumes U linear in
xo, so that the industry is amenable to (4) y = {?, q= p
partial equilibrium analysis. Our approach
allows a better treatment of the intersectoral where A = (I - p)/p, which is positive since
substitution, but the other results are very O < p < 1. Then it can be shown5 that in the
similar to those of Spence. first stage,
We consider two special cases of (1). In
Section I, V is given a CES form, but U is (S) y - I s(q) xo = I(1 - s(q))
allowed to be arbitrary. In Section II, U is q
taken to be Cobb-Douglas, but V has a for a function s which depends on the form
more general additive form. Thus the for- of U. Writing a(q) for the elasticity of sub-
mer allows more general intersector rela- stitution between xo and y, we define 0(q) as
tions, and the latter more general intra- the elasticity of the function s, i.e., qs'(q)/
sector substitution, highlighting different s(q). Then we find
results.
Income distribution problems are ne- (6) 0(q) = 11 - o(q)} $1 - s(q)} < 1
glected. Thus U can be regarded as repre- but 0(q) can be negative as a(q) can ex-
senting Samuelsonian social indifference ceed 1.
curves, or (assuming the appropriate aggre-
gation conditions to be fulfilled) as a mul-
4Sec p. 21 of John Green.
tiple of a representative consumer's utility. 5These details and several others are omitted to save
Product diversity can then be interpreted space, but can be found in the working paper by the
either as different consumers using different authors, cited in the references.
VOL. 67 NO. 3 DIXIT AND STIGLITZ: PRODUCT DIVERSITY 299
Turning to the second stage of the prob- downward. The conventional condition that
lem, it is easy to show that for each i, the dd curve be more elastic is seen from (9)
and (12) to be
(7) =
(13) + (q)>?
where y is defined by (4). Consider the effect
of a change in pi alone. This affects xi di- Finally, we observe that for i + j,
rectly, and also through q; thence through y
as well. Now from (4) we have the elasticity
(14) xi Pi ]
(8)dlg =(q Thus 1/(1 - p) is the elasticity of substitu-

d logpi Pi
tion between any two products within the
So long as the prices of the products in the group.
group are not of different orders of mag-
nitude, this is of the order (I/n). We shall B. Market Equilibrium
assume that n is reasonably large, and ac- It can be shown that each commodity is
cordingly neglect the effect of each Pi on produced
q; by one firm. Each firm attempts
thus the indirect effects on xi. This leavestousmaximize its profit, and entry occurs un-
with the elasticity til the marginal firm can only just break
() logx_ -I -(I + Oi) even. Thus our market equilibrium is the
(9) =- .. familiar case of Chamberlinian monopolis-
dlogpi (I -P)
tic competition, where the question of
In the Chamberlinian terminology, this is quantity versus diversity has often been
the elasticity of the dd curve, i.e., the curve raised.6 Previous analyses have failed to
relating the demand for each product type consider the desirability of variety in an ex-
to its own price with all other prices held plicit form, and have neglected various
constant. intra- and intersector interactions in de-
In our large group case, we also see that mand. As a result, much vague presumption
for i s j, the cross elasticity d log xi/d log that
p1 such an equilibrium involves excessive
is negligible. However, if all prices in the diversity has built up at the back of the
group move together, the individually small minds of many economists. Our analysis
effects add to a significant amount. This will challenge several of these ideas.
corresponds to the Chamberlinian DD The profit-maximization condition for
curve. Consider a symmetric situation each firm acting on its own is the familiar
where xi = x and pi = p for all i from I equality of marginal revenue and marginal
to n. We have cost. Writing c for the common marginal
cost, and noting that the elasticity of de-
(10) Y= xn-IP= xnI+
mand for each firm is (1 + ,B)/,B, we have
q = pn - = pn t0-P)/P for each active firm:
and then from (5) and (7),

pi (I_ d) c
(11) X Is(q)
pn
Writing Pe for the common equilibrium
The elasticity of this is easy to calculate; we price for each variety being produced, we
find have
(15) Pe = C(I + _
(12) Ig - - - l (q)] p
d logp
6See Edwin Chamberlin, Nicholas Kaldor, and
Then (6) shows that the DD curve slopes Robert Bishop.
The second condition for equilibrium is stant budget share for the monopolistically
that firms enter until the next potential competitive sector. Note that in our para-
entrant would make a loss. If n is large metric formulation, this implies a unit-
enough so that I is a small increment, we elastic DD curve, (17) holds, and so equi-
can assume that the marginal firm is exactly librium is unique.
breaking even, i.e., (pn - c)xn = a, where xn Finally, using (7), (1 1), and (16), we can
is obtained from the demand function and a calculate the equilibrium output for each
is the fixed cost. With symmetry, this im- active firm:
plies zero profit for all intramarginal firms
as well. Then I = 1, and using (I I) and (15) (18) Xe
we can write the condition so as to yield the
number ne of active firms: We can also write an expression for the
S(Penf l) a budget share of the group as a whole:

( 16) e -
Pene f3c (1 9) Se = s (qe)
where qe = Pen -0
Equilibrium is unique provided S(Penf-)/
Pen is a monotonic function of n. This re- These will be useful for subsequent com-
lates to our carlier discussion about the two parisons.
demand curves. From (11) we see that the
behavior of s(pn -)/pn as n increases tells
us how the demand curve DD for each firm C. Constrained Optimum
shifts as the number of firms increases. It is The next task is to compare the equi-
natural to assume that it shifts to the left, librium with a social optimum. With
i.e., the function above decreases as n in- economies of scale, the first best or uncon-
creases for each fixed p. The condition for strained (really constrained only by tech-
this in elasticity form is easily seen to be nology and resource availability) optimum
requires pricing below average cost, and
(17) 1 + f3(q) > 0
therefore lump sum transfers to firms to
This is exactly the same as (13), the condi- cover losses. The conceptual and practical
tion for the dd curve to be more elastic than difficulties of doing so are clearly formid-
the DD curve, and we shall assume that it able. It would therefore appear that a more
holds. appropriate notion of optimality is a con-
The condition can be violated if c(q) is strained one, where each firm must have
sufficiently higher than one. In this case, an nonnegative profits. This may be achieved
increase in n lowers q, and shifts demand by regulation, or by excise or franchise
towards the monopolistic sector to such an taxes or subsidies. The important restriction
extent that the demand curve for each firm is that lump sum subsidies are not available.
shifts to the right. However, this is rather We begin with such a constrained opti-
implausible. mum. The aim is to choose n, Pi, and xi so
Conventional Chamberlinian analysis as- as to maximize utility, satisfying the de-
sumes a fixed demand curve for the group mand functions and keeping the profit for
as a whole. This amounts to assuming that each firm nonnegative. The problem is
n * x is independent of n, i.e., that s(pn -I) is somewhat simplified by the result that all
independent of n. This will be so if , = 0, or active firms should have the same output
if' (q) = I for all q. The former is equiv- levels and prices, and should make exactly
alent to assuming that p = 1, when all zero profit. We omit the proof. Then we can
products in the group are perfect substi- set I = 1, and use (5) to express utility as a
tutes, i.e., diversity is not valued at all. That function of q alone. This is of course a de-
would be contrary to the intent of the whole creasing function. Thus the problem of
analysis. Thus, implicitly, conventional maximizing u becomes that of minimizing
analysis assumes o(q) = 1. This gives a con- q, i.e.,
min pn (25) -(a + cx)Uo + (1 + /3)xn4LJy = 0

n,p
From the first stage of the budgeting prob-
subject to lem, we know that q = U,,/UO. Using (24)
and (10), we find the price charged by each
(20) (p - c) s(-pn a active firm in the unconstrained optimum,
pn
PU, equal to marginal cost
To solve this, we calculate the logarithmic
(26) Pu = c
marginal rate of substitution along a level
curve of the objective, the similar rate of This, of course, is no surprise. Also from
transformation along the constraint, and the first-order conditions, we have
equate the two. This yields the condition
(27) xu= a
C + 0(q)
(21) p - c _
Finally, with (26), each active firm covers its
1 + /O(q) -
variable cost exactly. The lump sum trans-
The second-order condition can be shown fers to firms then equal an, and therefore
to hold, and (21) simplifies to yield the price I = 1 - an, and
for each commodity produced in the con-
strained optimum, pc, as ( an) ws( pn
pn
(22) pC = c(l + d)
The number of firms nu is then defined by
Comparing (15) and (22), we see that the
s(cn-) a/d
two solutions have the same price. Since (28) = l
they face the same break-even constraint, nu 1I- anu
they have the same number of firms as well, We can now compare these magnitudes
and the values for all other variables can be with the corresponding ones in the equilib-
calculated from these two. Thus we have a rium or the constrained optimum. The most
rather surprising case where the monopo- remarkable result is that the output of each
listic competition equilibrium is identical active firm is the same in the two situations.
with the optimum constrained by the lack The fact that in a Chamberlinian equilib-
of lump sum subsidies. Chamberlin once rium each firm operates to the left of the
suggested that such an equilibrium was "a point of minimum average cost has been
sort of ideal"; our analysis shows when and conventionally described by saying that
in what sense this can be true. there is excess capacity. However, when
variety is desirable, i.e., when the different
D. Unconstrained Optintunt
products are not perfect substitutes, it is not
These solutions can in turn be compared in general optimum to push the output of
to the unconstrained or first best optimum. each firm to the point where all economies
Considerations of convexity again establish of scale are exhausted.7 We have shown in
that all active firms should produce the one case that is not an extreme one, that the
same output. Thus we are to choose n firms first best optimum does not exploit econo-
each producing output x in order to maxi- mies of scale beyond the extent achieved in
mize the equilibrium. We can then easily con-
ceive of cases where the equilibrium exploits
(23) u = U(1 - n(a + cx),xn'+')
economies of scale too far from the point of
where we have used the economy's resource view of social optimality. Thus our results
balance condition and (10). The first-order undermine the validity of the folklore of ex-
conditions are cess capacity, from the point of view of the
(24) -ncUo + n'l+U Y = 0 7Scc David Starrctt.
y Using (29) we can easily compare the

budget shares. In the notation we have been
using, we find s,, e s, as 0(q) e 0, i.e., as
(1/anq)/q r(q) e 1 providinig these hold over the en-
tire relevant range of q.
It is not possible to have a general result
A concerning the relative magnitudes of x0 in
the two situations; an inspection of Figure I
shows this. However, we have a sufficient
/q condition:
Xou = (1 - anu)(l - su) < 1 - su < 1 - SC

= xocif r(q) > 1
1-anu 1 0 In this case the equilibrium or the con-

strained optimum use more of the nu-
FIGURE I
meraire resource than the unconstrained
optimum. On the other hand, if c(q) = 0 we
unconstrained optimum as well as the con- have L-shaped isoquants, and in Figure 1,
strained one. points A and B coincide giving the opposite
A direct comparison of the numbers of conclusion.
firms from (16) and (28) would be difficult, In this section we have seen that with a
but an indirect argument turns out to be constant intrasector elasticity of substitu-
simple. It is clear that the unconstrained tion, the market equilibrium coincides with
optimum has higher utility than the con- the constrained optimum. We have also
straincd optimum. Also, the level of lump shown that the unconstrained optimum has
sum income in it is less than that in the lat- a greater number of firms, each of the same
ter. It must therefore be the case that size. Finally, the resource allocation be-
tween the sectors is shown to depend on the
(29) qu < qc = qe intersector elasticity of substitution. This
Further, the difference must be large elasticity also governs conditions for
enough that the budget constraint for xo uniqueness of equilibrium and the second-
and the quantity index y in the uncon- order conditions for an optimum.
strained case must lie outside that in the Henceforth we will achieve some analytic
constrained case in the relevant region, as simplicity by making a particular assump-
shown in Figure 1. Let C be the constrained tion about intersector substitution. In re-
optimum, A the unconstrained optimum, turn, we will allow a more general form of
and let B be the point where the line joining intrasector substitution.
the origin to C meets the indifference curve
in the unconstrained case. By homotheticity II. Variable Elasticity Case
the indifference curve at B is parallel to that The utility function is now
at C, so each of the moves from C to B and
from B to A increases the value of y. Since (31) u = x0 -YjZv(xi)}Y
the value of x is the same in the two optima,
we must have with v increasing and concave, 0 < y < 1.
This is somewhat like assuming a unit inter-
(30) nu > nc = ne
sector elasticity of substitution. However,
Thus the unconstrained optimum actually this is not rigorous since the group utility
allows more variety than the constrained V(x) = Ziv(xi) is not homothetic and there-
optimum and the equilibrium; this is fore two-stage budgeting is not applicable.
another point contradicting the folklore on It can be shown that the elasticity of the
excessive diversity. dd curve in the large group case is
We wish to choose n and x to maximize u,

(32) d logx1 _ _ v'(xi) foranyi subject to (34) and the break-even condition
a logpi XiV"(Xi)
px = a + cx. Substituting, we can express u
This differs from the case of Section I in as a function of x alone:
being a function of xi. To highlight the sim-
ilarities and the differences, we define O(x)
by
(39) u =y(I - y) -()a + cx-
1 + : (x) v'(x) The first-order condition defines xc:
)(x) xv " (x)
Next, setting xi = x and pi = p for i = 1, (40)a cx- - -= 1 W(xi)xcp(x)

+ cxc 1 + 3(xc) 'yp(xc)
2, .. ., n, we can write the DD curve and the
demand for the numeraire as Comparing this with (37) and using the
second-order condition, it can be shown
(34) x = I w(x), XO - 1[1 - w(x)] that provided p'(x) is one-signed for all x,
where (41) xc Q Xe according as p'(x) 5 0
(35) w(X) = yp (x) With zero pure profit in each case, the
[,yp(x) ? (I - Y) points (Xe, Pe) and (xc, pc) lie on the same
xv ' (x) declining average cost curve, and therefore
p (x) =v(x)
(42) Pc f? Pe according as xc > Xe
We assume that 0 < p(x) < 1, and therefore
have 0 < w(x) < 1. Next we note that the dd curve is tangent to
Now consider the Chamberlinian equilib- the average cost curve at (Xe, Pe) and the
rium. The profit-maximization condition DD curve is steeper. Consider the case
for each active firm yields the common XC > Xe. Now the point (xc, pC) must lie on
equilibrium price Pe in terms of the common DD curve further to the right than (Xe, Pe),
equilibrium output xe as and therefore must correspond to a smaller
number of firms. The opposite happens if
(36) Pe = c[D + /3(Xe)]
XC < xe. Thus,
Note the analogy with (15). Substituting
(43) nc ? neaccording as xc > Xe
(36) in the zero pure profit condition, we
have xe defined by Finally, (41) shows that in both cases that
arise there, p(xc) < Pp(Xe). Then w(xc) <
(37) CXe _ 1 W(Xe), and from (34),
a + cxe I + A(Xe)
(44) XOc > XOe
Finally, the number of firms can be calcu-
lated using the DD curve and the break- A smaller degree of intersectoral substitu-
even condition, as tion could have reversed the result, as in
Section I.
(38) ne - W(Xe) An intuitive reason for these results can
be given as follows. With our large group
For uniqueness of equilibrium we once assumptions, the revenue of each firm is
again use the conditions that the dd curve is proportional to xv'(x). However, the con-
more elastic than the DD curve, and that tribution of its output to group utility is
entry shifts the DD curve to the left. How- v(x). The ratio of the two is p(x). Therefore,
ever, these conditions are rather involved if p'(x) > 0, then at the margin each firm
and opaque, so we omit them. finds it more profitable to expand than what
Let us turn to the constrained optimum. would be socially desirable, so Xe > Xc.
Given the break-even constraint, this leads This is in each case transitive with (41), and
to there being fewer firms. therefore yields similar output comparisons
Note that the relevant magnitude is the between the equilibrium and the uncon-
elasticity of utility, and not the elasticity of strained optimum.
demand. The two are related, since The price in the unconstrained optimum
is of course the lowest of the three. As to
(45)(4)
x p(x)
P' (x)1+1(3(x)
l_ -px
p(x) the number of firms, we note
- (x8) __ __
Thus, if p(x) is constant over an interval, so

C a + cx a + cx
is /3(x) and we have 1/(1 + 3) = p, which is
the case of Section I. However, if p(x) and therefore we have a one-way compari-
varies, we cannot infer a relation between son:
the signs of p'(x) and d'(x). Thus the varia-
tion in the elasticity of demand is not in
(51) Ifxu < xC,thennu > nc
general the relevant consideration. How- Similarly for the equilibrium. These leave
ever, for important families of utility func- open the possibility that the unconstrained
tions there is a relationship. For example, optimum has both bigger and more firms.
for v(x) = (k + mx)j, with m > 0 and 0 < That is not unreasonable; after all the un-
j < 1, we find that -xv"/v' and xv'/v are constrained optimum uses resources more
positively related. Now we would normally efficiently.
expect that as the number of commodities
produced increases, the elasticity of substi-
III. Asymmetric Cases
tution between any pair of them should in-
crease. In the symmetric equilibrium, this is The discussion so far imposed symmetry
just the inverse of the elasticity of marginal within the group. Thus the number of varie-
utility. Then a higher x would correspond ties being produced was relevant, but any
to a lower n, and therefore a lower elasticity group of n was just as good as any other
of substitution, higher -xv"/v' and higher group of n. The next important modifica-
xv'/v. Thus we are led to expect that p'(x) > tion is to remove this restriction. It is easy
0, i.e., that the equilibrium involves fewer to see how interrelations within the group
and bigger firms than the constrained opti- of commodities can lead to biases. Thus, if
mum. Once again the common view con- no sugar is being produced, the demand for
cerning excess capacity and excessive di- coffee may be so low as to make its produc-
versity in monopolistic competition is called tion unprofitable when there are set-up
into question. costs. However, this is open to the objection
The unconstrained optimum problem is that with complementary commodities,
to choose n and x to maximize there is an incentive for one entrant to pro-
duce both. However, problems exist even
(46) u = [nv(x)]i[l - n(a + cx)]---
when all the commodities are substitutes.
It is easy to show that the solution has We illustrate this by considering an industry
which will produce commodities from one
(47) pu= c of two groups, and examine whether the
choice of the wrong group is possible.8
(48) c u = P(xu)
a +~ cxi, Suppose there are two sets of commodi-
ties beside the numeraire, the two being per-
(49) nu
(49) = +ly
~~~a cxi, fect substitutes for each other and each hav-
ing a constant elasticity subutility function.
Then we can use the second-order condition Further, we assume a constant budget share
to show that
8For an alternative approach using partial equilib-
(50) xu S x, according as p'(x) e 0 rium methods, see Spence.
for the numeraire. Thus the utility function only if

is
(55) q2 < sc-
(52) s - a,
Now consider the optimum. Both the ob-

u n + [PI P2]I/P2}s
jective and the constraint are such as to lead
the optimum to the production of com-
We assume that each firm in group i has a modities from only one group. Thus, sup-
fixed cost ai and a constant marginal cost ci.pose ni commodities from group i are being
Consider two types of equilibria, only produced at levels xi each, and offered at
one commodity group being produced in prices pi. The utility level is given by
each. These are given by
(56) u = x -Sfxlln+Ol + X2nf+$2 Is
(53a) x = a, 1x2=O and the resource availability constraint is
c, O,
= c(l + 31) (57)

xo + n1(al + clxl) + n2(a2 + C2X2) =
a,(l + 131) Given the values of the other variables, the

level curves of u in (nl, n2) space are con-
cave to the origin, while the constraint is
q, = p1n,' I= c,(l + f3)l+/(5-) linear. We must therefore have a corner
u = ss(l 1 _) I -s Iq -s optimum. (As for the break-even con-
straint, unless the two qi = pini-,i are equal,
(53b) -2 = a2 x,5 = 0 the demand for commodities in one group
C2d2' is zero, and there is no possibility of avoid-
P2 = C2(1 + /2) ing a loss there.)
Note that we have structured our ex-
ample so that if the correct group is chosen,
a2(1 + /32)
the equilibrium will not introduce any
further biases in relation to the constrained
42 = p2n22 = c2(1 + 2)
optimum. Therefore, to find the constrained
optimum, we only have to look at the
U2 = s(l - ) 2
values of ui in (53a) and (53b) and see which
Equation (53a) is a Nash equilibrium if is the greater. In other words, we have to
and only if it does not pay a firm to produce
see which 4i is the smaller, and choose the
a commodity of the second group. The de- situation (which may or may not be a Nash
mand for such a commodity is equilibrium) defined in (53a) and (53b) cor-
responding to it.
[ 0 for P2 >q1 Figure 2 is drawn to depict the possible
X2 S1P2 for P2 < equilibria and optima. Given all the rele-
vant parameters, we calculate (41, 12) from
Hence we require (53a) and (53b). Then (54) and (55) tell us
whether either or both of the situations are
max(P2 - C2)X2 = 5(I - 4) < a2 possible equilibria, while a simple compari-

son of the magnitudes of q1 and 42 tells us
which is the constrained optimum. In the
or figure, the nonnegative quadrant is split
into regions in each of which we have one
(54) S< C2 combination of equilibria and optima. We
s - a2
only have to locate the point (41, 72) in this
Similarly, (53b) is a Nash equilibrium if and space to know the result for the given
equilibria, and it is therefore possible that

C E the high elasticity group is produced in equi-
librium when the low elasticity one should
I eqm No eqm F
I opt I opt No eqm
have been. If the difference in elasticities is
large enough, the point moves into region
s I 11 opt C, where (53b) is no longer a Nash equilib-
s-aa G
rium. But, owing to the existence of a fixed
A 11 eqm cost, a significant difference in elasticities is
i11 eqm I opt
necessary before entry from group 1 com-
I opt
modities threatens to destroy the "wrong"
D equilibrium. Similar remarks apply to re-
I I eqm gions B and D.
11 opt Next, begin with symmetry once again,
/B
111 eqm
and consider a higher cl or a,. This in-
II opt creases q1 and moves the point into region
B, making it optimal to produce the low-
sc2/(s-a2) 1 cost group alone while leaving both (53a)
and (53b) as possible equilibria, until the
FIGURE 2. SOLUTIONS LABELED I REFER TO
EQUATION (53a); SOLUTIONS LABELEI) 11
difference in costs is large enough to take
REFER TO EQUATION (53b) the point to region D. The change also
moves the boundary between A and C up-
ward, opening up a larger region G, but
parameter values. Moreover, we can com- that is not of significance here.
pare the location of the points correspond- If both q1 and q2 are large, each group is
ing to different parameter values and thus threatened by profitable entry from the
do some comparative statics. other, and no Nash equilibrium exists, as in
To understand the results, we must ex- regions E and F. However, the criterion of
amine how qi depends on the relevant constrained optimality remains as before.
parameters. It is easy to see that each is an Thus we have a case where it may be neces-
increasing function of ai and ci. We also sary to prohibit entry in order to sustain the
find constrained optimum.
If we combine a case where c1 > c2 (or
a, > a2) and /3, > 02, i.e., where commodi-
(58) da Iog0 = -log ni ties in group 2 are more elastic and have
lower costs, we face a still worse possibility.
and we expect this to be large and negative. For the point (4q, 42) may then lie in region
Further, we see from (9) that a higher j3i G, where only (53b) is a possible equilib-
corresponds to a lower own-price elasticity rium and only (53a) is constrained opti-
of demand for each commodity in that mum, i.e., the market can produce only a
group. Thus qi is an increasing functionlow
of cost, high demand elasticity group of
this elasticity. commodities when a high cost, low demand
Consider initially a symmetric situation, elasticity group should have been produced.
with scl/(s - a,) = SC2/(S - a2), I, = /2 Very roughly, the point is that although
(the region G vanishes then), and suppose commodities in inelastic demand have the
the point (q-I 42) is on the boundary be- potential for earning revenues in excess of
tween regions A and B. Now consider a variable costs, they also have significant
change in one parameter, say, a higher own- consumers' surpluses associated with them.
elasticity for commodities in group 2. This Thus it is not immediately obvious whether
raises q2, moving the point into region A, the market will be biased in favor of them
and it becomes optimal to produce com- or against them as compared with an opti-
modities from group 1 alone. However, mum. Here we find the latter, and inde-
both (53a) and (53b) are possible Nash pendent findings of Michael Spence in other
contexts confirm this. Similar remarks D

apply to differences in marginal costs.
In the interpretation of the model with
heterogenous consumers and social indif-
ference curves, inelastically demanded com-
modities will be the ones which are inten-
sively desired by a few consumers. Thus we
have an "economic" reason why the market
will lead to a bias against opera relative to
football matches, and a justification for
subsidization of the former and a tax on the ACA
latter, provided the distribution of income MCA
is optimum.
Even when cross elasticities are zero, D A ACB
there may be an incorrect choice of com- McB
modities to be produced (relative either to

an unconstrained or constrained optimum) output
as Figure 3 illustrates. Figure 3 illustrates
FIGURE 4
a case where commodity A has a more
elastic demand curve than commodity B; A
is produced in monopolistically competitive sumer surplus from A (at its equilibrium
equilibrium, while B is not. But clearly, it level of output) is less than that from B
is socially desirable to produce B, since ig- (i.e., the cross hatched area exceeds the
noring consumer's surplus it is just mar- striped area), then constrained Pareto opti-
ginal. Thus, the commodities that are not mality entails restricting the production of
produced but ought to be are those with in- the commodity with the more elastic
elastic demands. Indeed, if, as in the usual demand.
analysis of monopolistic competition, elimi- A similar analysis applies to commodities
nating one firm shifts the demand curve for with the same demand curves but different
the other firms to the right (i.e., increases cost structures. Commodity A is assumed to
the demand for other firms), if the con- have the lower fixed cost but the higher
marginal cost. Thus, the average cost curves
cross but once, as in Figure 4. Commodity
A is produced in monopolistically com-
petitive equilibrium, commodity B is not
(although it is just at the margin of being
B
produced). But again, observe that B should
be produced, since there is a large con-
sumer's surplus; indeed, since were it to be
A produced, B would produce at a much
higher level than A, there is a much larger
consumer's surplus. Thus if the government
were to forbid the production of A, B
would be viable, and social welfare would
AC
B AC: increase.
In the comparison between constrained
Mc
Pareto optimality and the monopolistically
MRA competitive equilibrium, we have observed
that in the former, we replace some low
fixed cost-high marginal cost commodities
output
with high fixed cost-low marginal cost com-
FIGURE 3 modities, and we replace some commodities
with elastic demands with commodities with presented here, in conjunction with other
inelastic demands. studies cited, offer some useful and new
insights.
IV. Concluding Remarks
We have constructed in this paper some

REFERENCES
models to study various aspects of the rela-
tionship between market and optimal re- R. L. Bishop, "Monopolistic Competition
source allocation in the presence of some and Welfare Economics," in Robert
nonconvexities. The following general con- Kuenne, ed., Monopolistic Competition
clusions seem worth pointing out. Theory, New York 1967.
The monopoly power, which is a neces- E. Chamberlin, "Product Heterogeneity and
sary ingredient of markets with noncon- Public Policy," Amer. Econ. Rev. Proc.,
vexities, is usually considered to distort May 1950, 40, 85-92.
resources away from the sector concerned. P. A. Diamond and D. L. McFadden, "Some
However, in our analysis monopoly power Uses of the Expenditure Function In
enables firms to pay fixed costs, and entry Public Finance," J. Publ. Econ., Feb.
cannot be prevented, so the relationship be- 1974, 82, 1-23.
tween monopoly power and the direction of A. K. Dixit and J. E. Stiglitz, "Monopolistic
market distortion is no longer obvious. Competition and Optimum Product Di-
In the central case of a constant elasticity versity," econ. res. pap. no. 64, Univ.
utility function, the market solution was Warwick, England 1975.
constrained Pareto optimal, regardless of H. A. John Green, Aggregation in Economic
the value of that elasticity (and thus the Analysis, Princeton 1964.
implied elasticity of the demand functions). H. Hotelling, "Stability in Competition,"
With variable elasticities, the bias could go Econ. J., Mar. 1929, 39, 41-57.
either way, and the direction of the bias de- N. Kaldor, "Market Imperfection and Excess
pended not on how the elasticity of demand Capacity," Economnica, Feb. 1934, 2,
changed, but on how the elasticity of utility 33-50.
changed. We suggested that there was some K. Lancaster, "Socially Optimal Product Dif-
presumption that the market solution ferentiation," Amer. Econ. Rev., Sept.
would be characterized by too few firms in 1975, 65, 567-85.
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With asymmetric demand and cost condi- Costs, and Monopolistic Competition,"
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costs. tion in a Large Homogeneous Area,"
The general principle behind these results J. Econ. Theory, Dec. 1974, 9, 418-48.
is that a market solution considers profit at N. H. Stern, "The Optimal Size of Market
the appropriate margin, while a social opti- Areas," J. Econ. Theory, Apr. 1972, 4,
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mand functions. We hope that the cases IMSS, Stanford Univ., Feb. 1975.

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American Economic Association

Monopolistic Competition and Optimum Product Diversity

By AVINASH K. DIXIT AND JOSEPH E. STIGLITZ*

The potential range of related products is varieties, or as diversification on the part

(1) u = U(xO, V(x1,x2,X3..)) The utility function in this section is

In Sections I and II we simplify further (2) ( {x} I/P)

the potential products (n + 1), (n + 2), ... (3) xO + Pi= I

(8)dlg =(q Thus 1/(1 - p) is the elasticity of substitu-

and then from (5) and (7),

S(Penf l) a budget share of the group as a whole:

min pn (25) -(a + cx)Uo + (1 + /3)xn4LJy = 0

(24) -ncUo + n'l+U Y = 0 7Scc David Starrctt.

y Using (29) we can easily compare the

Xou = (1 - anu)(l - su) < 1 - su < 1 - SC

1-anu 1 0 In this case the equilibrium or the con-

We wish to choose n and x to maximize u,

Next, setting xi = x and pi = p for i = 1, (40)a cx- - -= 1 W(xi)xcp(x)

where (41) xc Q Xe according as p'(x) 5 0

Thus, if p(x) is constant over an interval, so

for the numeraire. Thus the utility function only if

Now consider the optimum. Both the ob-

= c(l + 31) (57)

a,(l + 131) Given the values of the other variables, the

max(P2 - C2)X2 = 5(I - 4) < a2 possible equilibria, while a simple compari-

equilibria, and it is therefore possible that

contexts confirm this. Similar remarks D

modities to be produced (relative either to

We have constructed in this paper some

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