6.2.4Product Differentiation and Monopolistic Competition

Studying the economics of agglomeration and increasing returns supposes some knowledge of the theory of the firm and its market. Mills (1967) was an early contributor to the agglomeration literature. Assuming that all goods are produced by monopolists, he demonstrated that, in equilibrium, disamenities from agglomeration on the side of households may offset the productivity advantages on the side of the firm. Recent papers have used a monopolistically competitive market structure to study agglomeration with increasing internal returns to scale. Abdel-Rahman (1988) and Rivera-Batiz (1988) used a monopolistic competition framework to demonstrate that nontransportable intermediate inputs produced with increasing returns imply agglomeration.

Traditionally, urban agglomeration has been explained as either a production or a demand phenomenon. The production explanation relies on internal scale economies, localization economies, or urbanization economies while demand explanation involves the consumption of public goods. Depending on which force dominates, different types of cities will emerge. Abdel-Rahman’s (1988) innovation was the integration of the demand and supply side explanations. On one hand, suppliers of differentiated services face higher demand, with an increase in the number of producers at low cost. On the other hand, households enjoy a higher utility from these numerous differentiated services because of their taste for product differentiation. Product differentiation and monopolistic competition becomes a more appropriate framework.

As seen in Figure 6.2, firms make no profit in the monopolistic competition framework because the long run average cost curve is tangent to the demand curve. This is due to free entry in the market. Therefore, firms produce at more than the minimum cost with excess capacity. The firm will choose its production level where its marginal revenue equals its marginal cost. At the equilibrium, the same quantity of all services is produced, and all firms have the same cost and face the same demand function. Firms will enter the market until there is zero profit. On the demand side, it is assumed that all households maximize an identical utility function with respect to a transport cost function. Rivera-Batiz (1988) used a similar approach to model agglomeration economies endogenously. The emphasis is on how product variety is determined and how it generates agglomeration economies. The key element is the local service sector. On the production side, local services include maintenance, repair, transportation and communication, engineering, advertising, banking, security. On the demand side, local services could be restaurants, theatres, taxicabs, barbershops and other personal services. The presence of this local service sector could generate agglomeration economies in two ways. First through localization economies, because an expansion of the market will lead to specialization, which will in turn lead to gain in productivity. Secondly, a large populated area generates a variety of consumer services valued positively by individuals.