The efficiency of entry, monopoly, and market deregulation

Florin Bilbiie, Fabio Ghironi, Marc Melitz

Structural reform and deregulation are often promoted as ways to lower barriers to market entry. The Dixit-Stiglitz model provides an important benchmark – given specific preferences, there is a constrained-optimal amount of producer entry and product variety. This column reconsiders optimality of product creation, differentiating between consumer-producer and intertemporal inefficiencies and quantifying the welfare costs of inefficient entry. Monopoly profits should be preserved when product variety is endogenously determined by firm entry, as they play a crucial role in generating the welfare-maximising level of product variety in equilibrium.

Structural reforms and deregulation as a means of lowering entry barriers and promoting entry are perennial topics for macroeconomic policy around the world (e.g. Draghi 2015, IMF 2015, 2016, OECD 2016). The history of economic ideas pertaining to entry, monopoly, and deregulation is long and humbling indeed – Robinson (1933) was already arguing in favour of the benefits of marginal cost pricing. Lerner (1934), on the other hand, noticed that monopoly power is not a distortion in itself, insofar as markups are equalised across sectors. This argument was further developed and formalised by Samuelson (1947) in the book that changed the landscape of economic science, Foundations of Economic Analysis.

In their seminal study, Dixit and Stiglitz (1977) derive an important benchmark neutrality result – when preferences for variety take a specific form (the eponymous form of CES preferences), the market allocation leads to the constrained-optimal amount of producer entry and product variety.1 This optimality condition was further developed by Grossman and Helpmann (1991) and others when studying the efficiency of product innovation in an endogenous-growth setting.

In a recent paper, we revisit these classic issues in a dynamic general equilibrium setting in order to answer several questions (Bilbiie et al. 2016). When is product creation by a market ‘optimal’? When it is not, what are the distortions and how large are they, measured in terms of welfare? Is deregulation always a good idea? When is markup reduction (or outright elimination) a good idea?

We start by extending the CES Dixit-Stiglitz efficiency result to a dynamic, general equilibrium, in a stochastic setting. However, this is a knife-edge result that does not hold when preferences for variety take a general (homothetic) form. In such a suboptimal equilibrium, distortions can go in either direction, generating either too much or too little entry. The first distortion, which we label ‘static’, pertains to the within-period misalignment between the benefit of an extra variety to the consumer, and the profit incentive for an entrant to produce that extra variety. The second distortion, which we label ‘dynamic’, is associated with the intertemporal variation of markups.2

One immediate policy implication is that the welfare impact of deregulation or ‘more competition’ fluctuates over the business cycle – along with the consumer’s taste for variety and the firms’ profit incentive for entry. Thus, any policy measure (such as deregulation) that affects the amount of entry in a given period needs to take into account the intertemporal dimension – more entry today is counterproductive if it generates low markups tomorrow and thus leads to an inefficient intertemporal allocation of resources.

We quantify the welfare costs of inefficient entry and variety in a calibrated version of our model that we have shown elsewhere reproduces business cycle facts of the US economy. In that baseline calibration, the total cost is very large at around 2% of consumption. An important determinant of the welfare cost is the degree of market regulation (market entry costs). Long-run deregulation leads to more substitutability among products, lower markups, and a lower static distortion (a lower gap between markup and the benefit of variety). Evidence on entry costs (e.g. Ebell and Haefke 2009) points to large heterogeneity across countries – while it ‘costs’ 8.6 days, or 1% of annual per capita GDP, to start a firm in the US (with similar numbers for Australia, the UK, and Scandinavian countries), the costs are an order of magnitude higher in most continental European countries (at the extreme, a whopping 84.5 days in Spain, and 48% of annual per capita GDP for Greece). According to our model, this heterogeneity in the degree of entry regulation is a key determinant of the cross-country variation in the inefficiencies pertaining to entry and product creation.

Policies can restore the socially optimal amount of product variety by resorting to fiscal instruments – we give one example consisting of a combination of appropriately designed ‘VAT and dividend (or profit) taxes’. The latter aligns firms' entry incentives with consumers' love for variety, while the former corrects for the inefficient intertemporal allocation of resources that is due to the dynamic misalignment of markups. However, the lump-sum instruments needed to finance such optimal policies are seldom available. This raises the need to study policy in a ‘second-best’ environment to address topics such as the implications of entry and variety for monetary, fiscal, and trade policy.3 Analyses of the efficiency of monopolistic-competition equilibria are an essential ingredient in optimal policy exercises, in particular concerning monetary policy in the New Keynesian framework. Indeed, it would be hard to find one study that does not include a prescription about ‘monopolistic distortion’ and the need to eliminate it—along the lines pioneered by Robinson (1933). This is another common policy prescription that our framework challenges – the elimination (or reduction) of markups as a way to increase efficiency. Our results show that monopoly profits should in fact be preserved whenever product variety is endogenously determined by firm entry, for they play a crucial role in generating the welfare-maximising level of product variety in equilibrium.

Policy debates on structural reforms like the ones we referenced at the beginning of this column will undoubtedly continue. Our efficiency results provide some basic elements for rigorous normative analyses of structural reforms. We believe these analyses provide some key insights into those policy debates.4

References

Bergin, P R, and G Corsetti (2008), “The Extensive Margin and Monetary Policy", Journal of Monetary Economics, 55, 1222-1237

Bergin, P R, and G Corsetti (2014), “International Competitiveness and Monetary Policy”, mimeo, Cambridge University and University of California, Davis

Bertoletti, P, and F Etro (2015), “Preferences, Entry and Market Structure”, forthcoming RAND, Journal of Economics

Bertoletti, P, and F Etro (2016), "Monopolistic Competition when Income Matters", The Economic Journal, forthcoming

Bilbiie, F O, F Ghironi, and M J Melitz (2008a), “Monetary Policy and Business Cycles with Endogenous Entry and Product Variety," in D Acemoğlu, K S Rogoff, and M Woodford (eds.), NBER Macroeconomics Annual 2007, University of Chicago Press, 299-353

Bilbiie, F O, F Ghironi, and M J Melitz (2012), “Endogenous Entry, Product Variety, and Business Cycles”, Journal of Political Economy.

Bilbiie, F O, I Fujiwara, and F Ghironi (2014), “Optimal Monetary Policy with Endogenous Entry and Product Variety”, Journal of Monetary Economics, 64, 1-20.

Bilbiie, F, F Ghironi and M Melitz (2016), "Monopoly Power and Endogenous Product Variety: Distortions and Remedies", CEPR DP11294.

Cacciatore, M, G Fiori, and F Ghironi (2016), "Market Deregulation and Optimal Monetary Policy in a Monetary Union", Journal of International Economics 99, 120-137

Cacciatore, M, and F Ghironi (2012), "Trade, Unemployment, and Monetary Policy", mimeo, HEC Montréal and University of Washington

Chugh, S K, and F Ghironi (2015), "Optimal Fiscal Policy with Endogenous Product Variety", CEPR Discussion Paper 10674

Colciago, A, and F Etro (2010), "Endogenous Market Structures and Business Cycles", The Economic Journal

Colciago, A (2015), "Endogenous Market Structures and Optimal Taxation", The Economic Journal

Cooke, D (2015), "Optimal Monetary Policy with Endogenous Export Participation", Review of Economic Dynamics

Dixit, A K, and J E Stiglitz (1977), "Monopolistic Competition and Optimum Product Diversity”, American Economic Review, 67, 297-308

Dhingra, S, and J Morrow (2013), "Monopolistic Competition and Optimum Product Diversity under Firm Heterogeneity", mimeo, London School of Economics

Draghi, M (2015), “Monetary Policy and Structural Reforms in the Euro Area” speech, Prometeia 40, Bologna, 14th December

Ebell, M, and C Haefke (2009), “Product Market Deregulation and the US Employment Miracle”, Review of Economic Dynamics, 12 (3), 479-504

Epifani, P, and G Gancia (2011), "Trade, Markup Heterogeneity and Misallocations", Journal of International Economics

Grossman, G M, and E Helpman (1991), Innovation and Growth in the Global Economy, MIT Press, Cambridge, MA

International Monetary Fund (2015), “Where Are We Headed? Perspectives on Potential Output”, World Economic Outlook, Chapter 3

International Monetary Fund (2016), “Time for a Supply-Side Boost? Macroeconomic Effects of Labor and Product Market Reforms in Advanced Economies”, World Economic Outlook, Chapter 3

Lerner, A (1934), "The Concept Monopoly and the Measurement of Monopoly Power", Review of Economic Studies, 2, 157-175

Lewis, V (2013), "Optimal Monetary Policy and Firm Entry", Macroeconomic Dynamics, 17, 1687-1710

Lewis, V, and R Winkler (2015), "Product Diversity, Market Structure, and Optimal Taxation", Economic Inquiry, 53, 979-1003

OECD (2016), Economic Policy Reforms: Going for Growth, Paris

Robinson, J (1933), The Economics of Imperfect Competition, Cambridge University Press, Cambridge, UK

Samuelson, P (1947), Foundations of Economic Analysis, Harvard University Press, Cambridge, MA

Endnotes

[1] The “Dixit-Stiglitz” label is often used for CES preferences defined over a fixed set of goods in business cycle models with monopolistic competition. We view this as a misnomer as those models shut down the key endogenous product variety channel at the heart of the Dixit-Stiglitz contribution.

[2] This last distortion – markup heterogeneity – can also have a static component when producers with heterogeneous productivity face variable elasticities of substitutions. Dhingra and Morrow (2013) focus on the normative implications of this type of distortion in a static framework.

[3] We studied optimal monetary policy and the choice of an optimal inflation target in a first-best environment in Bilbiie et al. (2008) and in a second-best, Ramsey scenario in Bilbiie et al. (2014). See also Bergin and Corsetti (2008, 2014), Cacciatore et al. (2016), Cacciatore and Ghironi (2012), Cooke (2015), Etro and Rossi (2015), Faia (2012), and Lewis (2013). Several of these studies use extensions of our model. Other contributions focused on Ramsey-optimal fiscal policy (Chugh and Ghironi 2015, Colciago 2015, and Lewis and Winkler 2015). Lastly, Epifani and Gancia (2011) and Bertoletti and Etro (2015, 2016) analyse product innovation and their implications for trade policy.

[4] Indeed, an extension of our framework has been used in a widely reported IMF World Economic Outlook chapter (IMF 2016).