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Research proposal
Heterogeneous consumers and market structure in the monopolistically competitive setting
Objectives
The leading contemporary concept to imitate the economic reality is the representative agent approach (Kirman, 1992; Hartley, 1996; Acemoglu, 2009). It assumes that the choices of the diverse agents can be considered as the choices of one utility maximizing individual whose behavior coincides with the aggregate behavior of the heterogeneous individuals. To imitate the demand side of the economy, the representative agent approach typically postulates the identical and homothetic preferences for all consumers (Markusen, 2010). Such an assumption allows one to greatly simplify the analysis and obtain transparent analytical results. Nevertheless its justification has never been rigorously proven and still to be the hot area of discussions (Kirman, In the present project an attempt is made to get rid of both the identity and homotheticity of the consumer’s preferences. Using modified CES utility function depending on consumer’s income, we investigate the impact of the personal income distribution on the market structure and trade in the monopolistically competitive setting. The proposed approach extends the traditional Dixit-Stiglitz and Dixit-Stiglitz-Krugman models and allows revealing the collective effects of the consumer’s behavior both in the case of a closed and an open economy. Our model does not appeal to the representative agent concept and has a wider range of applications The present model does not assume all the firms to be identical. The firm heterogeneity is also a natural and important element of our model. Practical contribution of research
The endogenization of the market structure has always been a key topic of economic research. Our project contributes to this issue, suggesting a major role of per-capita income inequality. As it is well known, the personal income distribution sufficiently influences growth performance, effects the imperfect capital markets and aggregate demand (Aghion et al, 1999; Zweimueller, 2000). Besides, the significant increase in earning inequality (Caminada and Goudswaard, 2001; Santos-Paulino, 2012) may serve as an alternative explanation of the rising market concentration, which is traditionally explained by increased competition due to trade liberalization. The idea of using income polarization as an alternative phenomenon explaining increased market concentration is not new; it was put forward and studied earlier, but it was made on the basis of a simpler model (Benassi et al, 2002a). Taking into account the nonidentity and non-homotheticity of consumer’s preferences caused by personal income inequality and its influence on the market demand functions, one can investigate distributional effects in the optimal behavior of firms and market equilibrium. In the case of open economy our approach explains observed phenomena, concerning variations in bilateral trade due to difference in income per capita between different countries, sufficiently improving predictions of standard gravity models, which completely ignore the way of how total income is distributed among Literature review
The question of consumer’s preferences impact on market structure and international trade is one of the urgent and widely discussed in the contemporary literature (Caron et al, 2011; Choi et al, 2009; Dalgin et al, 2008; Fieler, 2011; Hsieh and Klenow, 2007; Hummels and Lugovskyy, 2009; Markusen,2010; Simonovska, 2010). Its urgency can be attributed to both the success of the theoretical analysis and accumulation of the empirical facts, which cannot be satisfactorily explained by the traditional models. The rising interest towards this problem was also promoted by historical reasons. Until recently the most of trade theory tended to focus on the supply side determinants of trade. So far as the demand side is concerned, it was analyzed using crude approximation. It was typically assumed that consumers have identical and homothetic preferences within and across countries (Markusen, 2010; Brakman and Heijdra, 2004). Besides, aggregate demand was supposed to depend only upon commodity prices and aggregate income and not dependent on the distribution of income. Such an assumption was used due to analytical convenience and tractability. It sufficiently simplifies calculations, but have a lot of shortcomings and empirically implausible (Kirman, 1992; Hartley, 1996; Markusen, 2010). In the meantime, though, appear a lot of publications, trying to take into account the One of the most influential papers of that kind is the Melitz attempt to model heterogeneous firms (Melitz, 2003) on the basis of the Dixit-Stiglitz approach. Melitz model has well described a new transmission channel for the impact of trade on industry structure and explained how the exposure to trade induces only the more productive firms to export while simultaneously forcing the list productive ones to exit. The empirical work has confirmed the importance of revealed channel for understanding effects of trade on firm and industry So far as heterogeneity of demand is concerned there is also some progress. The leading proponents of taking specificity of consumer’s preferences into account when explaining market structure and international trade effects are Corrado Benassi (Benassi et al, 2002a; Benassi et al, 2002b; Benassi and Chirco, 2004; Benassi et al, 2005; Benassi et al, 2006) and James Markusen (Markusen, 1986; Markusen and Venables, 1988; Markusen and Wigle, 1990). The paper of Benassi et al (2002a) focuses on the effects of income polarization and presents a model, demonstrating how income inequality leads to market concentration, i.e., to a smaller number of firms able to survive in the long run. In accordance with Benassi’s idea, income polarization may well be among the reasons why market concentration has been increasing (at least in some sectors) over the last decades. In the paper of Benassi et al (2002b) the authors analyze the opposite effects caused by income heterogeneity. They show how income concentration and income dispersion may affect market demand and its elasticity. Following an increase in income concentration towards the middle (measured by variations in mean preserving spread) the increase in demand faced by firms can be associated with an increase in price elasticity. Accordingly, the positive effects of the size of the market becoming wider are amplified by a higher degree of competition. As incomes become more concentrated around the given mean, market demand and its elasticity both increase for a relevant intermediate range of prices. In this sense, the existence of a large middle class may support a more competitive market environment, conductive to lower The paper of Benassi and Chirco (2004) studies under what distributional conditions the “Robinson effect” holds – i.e. the relationship between income and elasticity at the individual level translates at the market level. The authors have shown that there is a wide range of shocks, which can be interpreted as generalized increases in income, and which preserve at the aggregate level the sign of the relationship between income and price elasticity observed at the individual level. The main property which identifies these shocks is that they increase the share of demand accruing to richer consumers. Even though, as Joan Robinson reasonably conjectured, price elasticity decreases with income at the individual level, a generalized increase in income may be associated with an increase in market demand elasticity, provided it translates itself into an increase of the demand of low-income consumers, such that their share in overall demand increases: a poor-middle class oriented increase in income could then bring about a contraction In the paper of Benassi et al (2005) the non-homothetic preferences are introduced into the Dixit-Stiglitz model of monopolistic competition to investigate the effects of change in income dispersion on the firm’s optimal decisions and market equilibrium. Income dispersion, modeled as a mean preserving spread, is shown to affect only the degree of product differentiation under the standard negligibility hypothesis on the firms’ decision making process, while it generates a positive co-movement of demand and demand elasticity, when this assumption is removed and the price index effect is taken into account. Many interesting and important results, concerning relation between the consumer’s preferences, market structure and trade, have been obtained in James Markusen’s works (Markusen, 1986; Markusen and Venables, 1988; Hunter and Markusen, 1988; Markusen and Wigle, 1990; Markusen, 2010). Using non-homotheticity of preferences assumption, Markusen proposed an alternative explanation for the number of diverse trade phenomena, such as growing wage gaps, the mystery of the missing trade, home bias in consumption, and the role of intra- country income distribution, solely from the demand side of general equilibrium. The model developed by Markusen (2010), were aiming to explain higher mark-ups and higher price levels in higher per-capita income countries. His results in some sense are similar to those found in Hammels and Lugovskyy (2009) and Simonovska (2009), which is that mark-ups and hence the price level will be higher in higher per-capita income country. Simonovska gets strong empirical support for this relationship, also found in earlier papers including Hsieh and Klenow (2007). Essentially the same result was found in Wong (2003) for pricing of identical pharmaceutical Dalgin et al (2008) paper proves that inequality is an important determinant of import demand. The authors interpret this fact with the aid of a model in which tastes are non- homothetic. Using the correlation between household budget shares in the US and income, they classify products into luxuries and necessities and show that while the imports of luxuries increase with the importing country's inequality, imports of necessities decrease with it. They also find that an increase in the level of inequality in the importing country generally leads to an increase in imports from developed countries and to a reduction in imports from low-income Similar results were obtained in the paper of Simonovska (2010), who presents evidence from a clothing manufacturer that sells identical goods online to 28 countries and charges higher prices in richer markets. The author stays that such price discrimination on the basis of income suggests that firms exploit different price elasticities of demand across countries that differ in income. In particular, if rich consumers are less responsive to price changes than poor ones, firms find it optimal to price identical products higher in more affluent markets. In order to capture this mechanism, Simonovska introduces non-homothetic preferences in a model of trade with product differentiation and heterogeneity in firm productivity a la Melitz (2003) and Methodology of research
The main body of our research is based on the theoretical model developed by the head of the project, though empirical verifications of results are also implied. The main elements of our model for the case of a closed economy are described below (extension for an open economy There is a one-sector economy, the population of which is divided into K income groups; L being the number of individuals in the group k , y is an income of the individual in such a group. The preferences of any individual in the k -th group are given by a modified CES 2 ., K , x is the quantity of variety i consumed by an individual with income σ ≡ σ (y ) is a parameter, depending on the personal income of a consumer, N is the total number of varieties available (equal to the number of firms, each producing a different variety). Maximizing the utility functions, subject to the consumer’s budget constraint, one can get the individual demand functions, which aggregation provides the market demand for individual varieties. The market demand functions are used then to derive the sufficient conditions for the firm profit maximization. These conditions differ drastically from traditional ones and have a form of N simultaneous nonlinear algebraic equations: N , m is the constant marginal cost of firm i (generally, firms are supposed to be different), A - coefficients, depending on the prices, number of firms N , number of individuals in the income groups L , personal income levels y , and parameter σ : A = A ( p ,., p ; N , L , y ,σ ) . To get the optimal price vector dependence upon the exogenous parameters of the model, this system could be solved by Assuming, for simplicity, all firms to be identical and searching for the symmetric equilibrium, one can get the analytical solution of the above system, and find equilibrium price level, output of a firm, number of firms, price elasticity coefficients both for individual and market demand curves. The key variable driving all these dependencies turns out to be the where y = ∑λ y is the average personal income, λ = L / L is the income distribution (share of the consumers with income y in the total number of consumers). Given σ = σ ( y ) and λ = λ(y ) , one can obtain σ and then find the values of all the model parameters. Formally, expressions for the optimal price level, output and number of firms in heterogeneous case turn out to be quite similar to those in the Dixit-Stiglitz model (and coincide with them in homogeneous case). Nevertheless, there is essential difference between the two models. In the heterogeneous case the model parameters depend on the income distribution of the consumers (which is obvious from expression for σ ), while in the homogeneous case they don’t. This allows to study consumer’s collective behavior effects due to income distribution transformation. For example, fixing the average income and changing income dispersion, one can find the aggregate price, output of a firm, and firm number dependence upon the level of inequality in economy. In the homogeneous case, where all consumers are supposed to be identical (and collective behavior reduces to the behavior of an individual), this couldn’t be The outlined model can be easily extended to investigate the trade effects in the open economy case. Following the logic of the model one doesn’t need to assume the income and preferences of the consumers being identical in different countries. Such an extension allows getting some new results concerning relations between consumer’s preferences, market structure and trade patterns in different countries. The analysis could be carried out both on the basis of symmetric equilibrium with identical firms and in more general setting, where firms are supposed to differ in their marginal costs. Bibliography
Acemoglu, D. (2009): “Introduction to Modern Economic Growth”, Princeton University Press. Aghion, P., E. Caroli and C.G. Penalosa (1999): “Inequality and economic growth: the perspective of the new growth theories”, Journal of Economic Literature, 37, pp. 1615–60. Benassi, С., A. Chirco and R. Cellini (2002a): “Personal Income Distribution and Market Structure”, German Economic Review, vol. 3, No.3, pp. 327-338. Benassi, С., A. Chirco and M. Scrimitore (2002b): “Income Concentration and Market Demand”, Oxford Economic Papers, vol.54, No.4, pp. 584-596. Benassi, С. and A. Chirco (2004): “Income Distribution, Price Elasticity and the Robinson Effect”, Manchester School, vol.72, No.5, pp. 591-600. Benassi, С. and A. Chirco (2006): “Income Share Elasticity and Stochastic Dominance”, Social Choice and Welfare, vol. 26, No.3, pp.511-525. Benassi, С., A. Chirco and C. Colombo (2006): “A Model of Monopolistic Competition with Personal Income Dispersion”, Metroeconomica, 2005, vol.56, No.3, pp. 305-317. Bernard, A.B. and Jensen, J.B. (2004): “Why Some Firms Export”. Review of Economics and Statistics, Vol. 86, No. 2, pp. 561-569. Brakman, S. and B.J. Heijdra (2004): “The Monopolistic Competition Revolution in Retrospect”, Caminada, K. and K. Goudswaard (2001): “International trends in income inequality and social policy”, International Tax and Public Finance. vol. 8. No. 4. pp. 395–415. Caron, J.J, T. Fally and J.R. Markusen (2011): “Skill premium and trade puzzles: a solution linking production and preferences”, NBER Working Paper No. 18131. Chaney, T. (2008): “Distorted Gravity: The Intensive and Extensive Margins of International Trade,” American Economic Review, vol. 98, No.4, 1707–1721. Choi, Y.C., D. Hummels and C. Xiang (2009): “Explaining Import Quality: The Role of Income Distribution”, Journal of International Economics, 77, pp. 265-275. Dalgin, M., V. Trindade and D. Mitra (2008): “Inequality, Non-homothetic Preferences and Trade: A Gravity Approach”, Southern Economic Journal, 74, pp.747-774. Fieler, A.C. (2011): “Non-homotheticity and bilateral trade: evidence and a quantitative explanation”, Econometrica, Vol. 79, No. 4, pp. 1069–1101. Hartley, J.E. (1996): “The Origins of the Representative Agent”, Journal of Economic Perspectives, Vol. 10, No. 2, pp. 169-177. Hsieh, C. and P. Klenow (2007): “Relative prices and relative prosperity,” American Economic Hummels, D. and V. Lugovskyy (2009): “International Pricing in a Generalized Model of Ideal Varieties”, Journal of Money, Credit and Banking, 41, pp. 3-33. Hunter, L. and J.R. Markusen (1988): “Per-Capita Income as a Determinant of Trade”, in Robert Feenstra (editor), Empirical Methods for International Economics, Cambridge: MIT Press, pp. Kirman, A.P. (1992): “Whom or What Does the Representative Individual Represent?”, The Journal of Economic Perspectives, Vol. 6, No. 2, pp. 117-136. Markusen, J.R. (1986): "Explaining the Volume of Trade: An Eclectic Approach." American Economic Review, 76, pp. 1002-1011. Markusen, J.R. and A. Venables (1988): "Trade Policy with Increasing Returns and Imperfect Competition: Contradictory Results from Competing Assumptions," Journal of International Markusen, J.R. and R. Wigle (1990): “Explaining the Volume of North-South Trade”, Economic Markusen, J.R. (2010): “Putting per-capita income back into trade theory”, NBER Working Melitz, M. (2003): “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity”, Econometrica, Vol. 71, pp. 1695-1725. Santos-Paulino, A.U. (2012): “Trade, income distribution and poverty in developing countries: a survey”, United Nations Conference on Trade and Development (UNCTAD), Didcussion papers, Simonovska, I. (2010): “Income Differences and Prices of Tradables”, NBER Working paper Wong, E. (2003): “Pharmaceutical Drug Prices in the International Market”, PhD thesis, Zweimueller, J. (2000): “Schumpeterian enterpreneurs meet Engel’s law: the impact of inequality in innovation-driven growth”, Journal of Economic Growth, 5, pp. 186 - 206. Participants
The research team includes two participants: Osharin A.M. (the head of the project) and Verbus V.A., working with the former on the Faculty of the Economic Theory and Econometrics of the Scientific Research University «Higher School of Economics» - Nizhny Novgorod. Both participants occupy position of associate professors and have scientific degree. The basis for cooperation is their joint teaching and research activity. Alternative/additional sources of funding
The authors do not possess neither alternative, nor additional sources of financing the project, except for wages (associate professors salary). Project timetable
The project is planned to perform within 1.5 year period. At the first stage of the project (approximately half a year) it is supposed to investigate heterogeneous consumer’s demand impact on the monopolistically competitive markets in the case of a closed economy. For identical firms this will be done analytically. The case of heterogeneous firms will be investigated numerically. As an output of this stage the computer program accounting for all needful parameters will be developed. The program is supposed to calculate the aggregate price, output of a firm, optimal number of firms and price elasticity coefficients both for individual and market demand curves as functions of income level inequality. At the second phase of research (one year term) the model will be extended to an open economy case and used to study interrelations between consumer’s income heterogeneity and trade patterns. The open economy case will also be investigated both analytically (homogeneous firms) and numerically (heterogeneous firms). The purpose of investigation, which is supposed to perform for an open economy case, is in obtaining new results, concerning home market effects for consumers having non-identical and non-homothetic preferences within and across

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