DP11294 | Monopoly Power and Endogenous Product Variety: Distortions and Remedies

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The inefficiencies related to endogenous product creation and variety under monopolistic competition are two-fold: one static---the misalignment between consumers and producers regarding the value of a new variety; and one dynamic---time variation in markups. Quantitatively, the welfare costs of the former are potentially very large relative to the latter. For a calibrated version of our model with these distortions, their total cost amounts to 2 percent of consumption. Appropriate taxation schemes can implement the optimum amount of entry and variety. Elastic labor introduces a further distortion that should be corrected by subsidizing labor at a rate equal to the markup for goods, in order to preserve profit margins and hence entry incentives.