Incorporating Theory-Consistent Endogenous Markups into Applied General-Equilibrium Models

Abstract

The incorporation of increasing returns and imperfect competition into applied general-equilibrium (AGE) models, beginning with Harris (1984), led to much larger welfare effects from changes such as trade liberalization. But the imperfect competition side of these industrial organization (IO) developments has often failed to incorporate meaningful strategic behavior, largely ruling out firm-level productivity and scale effects. I show here that the incorporation of theory-based endogenous markups into AGE models is not difficult by employing the template of non-linear complementarity. I first derive the optimal markup equations for Nash Cournot and Nash Bertrand competition in a constant elasticity of substitution (CES) environment with free entry and exit. The first model is a simple closed-economy model where three alternatives are considered: large-group monopolistic competition (LGMC), small-group Cournot (SGC) and small-group Bertrand (SGB). Growth in the economy, a parable for trade liberalization among similar economies, is the experiment used to compare these specifications. The gains to initially small economies are much larger under either small-group assumption relative to LGMC, but diminish relative to LGMC as economies grow large. I also show how the contributions of variety (entry), firm scale (productivity), and markups (distortions) to welfare changes differ substantially among the three alternatives. The second model is a two-country trade model where the experiment is a reduction in trade costs using the SGB case and compares it to LGMC. A fall in trade costs increases firm scale, lowers markups and boosts welfare in spite of a fall in variety. Under LGMC, firm scale and markups are constant, but no fall in variety.