Lecture 5

SPATIAL ECONOMY:
THE DIXIT-STIGLITZ MODEL

By Carlos Llano,
References for the slides:
Fujita, Krugman and Venables: Economa Espacial. Ariel Economa, 2000.
1. Introduction
2. The Dixit-Stiglitz model of monopolistic competition:
spatial implications.
3. Applications.
4. Conclusion
Outline
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3 Gobalizacin, comercio internacional and
economa geogrfica
3
Figure 1.1 Cartogram of GNP
Areas are NOT proportional to population
1. Introduction
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4 Gobalizacin, comercio internacional and
economa geogrfica
4
Figure 1.2 GDP per capita
Highland variable among countries
1. Introduction
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5 5
1. The external and internal economies of scale can act as an
engine for international trade in addition to the existence of CA or
differences in factor endowments.
2. The internal ES require to develop an imperfect competition
model. The perfect competition model is the most used since the
70s. (Dixit-Stiglitz, 1977).
3. With the ES the distinction between inter-industrial and intra-
industrial trade arises.
4. The advantages of the external economies are less clear, and
give rise to several arguments that are commonland for
protectionism in international trade.
1. Introduction
AC
p
n
AC = average cost in
the firm
= n CF/ S + c
PP = price in the industry
price = c + 1 / nb
E
N2 = n companies in equilibrium (with Profit=0)
p2 = CM2
3. Number of companies in equilibrium:
PP Curve: the more + firms in the industry + competition and - price.
CC Curve: the more + firms in the industry + average cost in each firm.
E: long run equilibrium in the industry(n2 firms producing with CM2)
1. Introduction
P
c
N: countries / variety
P = c + 1 / bn
LARGER MARKET
BECAUSE OF TRADE
C (S2) = n CF / S2 + c
CLOSED COUNTRY
C (S1) = n CF / S1 + c
p1
n1
p2
n2
1
2
1. Introduction
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1. The Dixit-Stiglitz model is the starting point for the of the
monopolistic competition models (Dixit-Stiglitz, 1977).
2. Since the 70s, its use in the field of international trade has been
fundamental. It is the starting point for the New Economic
Geography (NEG): agglomeration, economies of scale,
transportation cost.
3. Fujita, Krugman and Venables (1999) present a spatial version of
the DSM:
2 regions; 1 mobile production factor (L= labor).
2 products:
Agriculture: residual sector, perfect competitive, constant returns to scale; no
transportation costs.
Manufacturing: differentiated goods (n varieties); scale economies; monopolistic
competition; transportation costs.
2. The Dixit-Stiglitz Model
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Structure of the Dixit-Stiglitz spatial model:
1. Solution to the consumers problem
2. Multiple Locations and Transportation Costs
3. Producer Behavior
4. The Price Index Effect and the Home Market Effect
5. Equilibrium
2. The Dixit-Stiglitz Model
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1. Consumer Behavior: Utility function
Every consumer shares the same Cobb-Douglas tastes for the two type of goods (M, A).
2. The Dixit-Stiglitz Model
1
A M U

=
1
1

M
U
A

|
.
|

\
|
=
M
A
1

RMS
MA

=
1 0 di m(i) M
1/
n
0

< <
(

=
}
M= composite index of the manufactured goods.
A= consumption of the agricultural good.
Mu (): constant: expenditure share in manufactured goods.
M is a sub-utility function defined over a continuum of varieties of manufactured
goods:
m(i): consumption of each available variety (i),
n: range of varieties.
M is defined by a constant-elasticity-of-substitution (CES):
Rho (): intensity of the preference for variety (love for variety)
If =1, differentiated goods are nearly perfect substitutes (low love for variety)
If =0, the desire to consume a greater variety of manufactured goods increases.
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1. Consumers Behavior:
2. The Dixit-Stiglitz Model

1
1 ;
1
1
=

= We define sigma () as:

: elasticity of substitution between any 2 varieties
The consumers problem: maximize utility defined by the function U
subject to the budget constraint.

We solve it in 2 steps:
1. First, the consumption of varieties will be optimized:
1. The ideal consumption of each variety will be given by the
combination that ensures utility with the minimum cost (given
the relative prices of each variety).
2. Once the consumption of varieties in generic terms has been
optimized (for every M), the desired quantity of A and M will be
chosen according to the relative prices of both goods.
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1. The Consumers Behavior: the budget constraint
2. The Dixit-Stiglitz Model
}
+ =
n
0
A
p(i)m(i)di A p Y
P
A
= Price of the agricultural goods.
A= consumption of the agricultural good.
p(i)= price of each variety (i) of
manufacturing product.
m(i)= quantity of each variety (i).
To maximize the utility U subject to the budget constraint Y, there are 2
steps:
1. Whatever the value of the manufacturing composite (M), each m(i)
needs to be chosen so as to minimize the cost of attaining de M
(Phase I).
2. Afterwards, the step is to distribute the total income (Y) between
agriculture (A) and manufactures (M) in aggregate (Phase II).
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2. The Dixit-Stiglitz Model
M di ) ( . .
) ( ) (
1/

n
0
0
=
(

=
}
}
i m t s
di i m i p Min
n
1. Minimize expenditure for any given M :
P
A
= Price of the agricultural goods.
A= consumption of the agricultural good.
p(i)= price of each variety (i) of
manufacturing product.
m(i)= quantity of each variety (i).

To minimize:
1. The first-order condition establishes the equality of marginal rates
of substitution MRS to price ratios:
p(j)
p(i)
m(j)
m(i)
1
1
=

1. Consumer Behavior: Phase I:

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2. The Dixit-Stiglitz Model
p(j)
p(i)
m(j)
m(i)
1
1
=

j i
1
1
m(j)p
p(i)
p(j)
m(j) m(i) =
|
|
.
|

\
|
=

For any pair i, j that leads to:
1. Consumer behavior: Phase I:
And bringing the common term outside the integral
- 1
1
m(j)p(j)
Substituting this into the original constraint: M di m(i)
1/
n
0

=
(

}
M
di p(i)
p(j)
m(j)
1/
n
0
1

1 1/
(
(

=
}

We have that:
m(j)= this is the
compensated demand
function (Hicks demand:
compensation for the price
variation; constant utility in all
the curve;) for the jth variety
of manufactures
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M di p(i) p(j)m(j)dj
1/ -
n
0
1

n
0
(
(

=
} }

2. The Dixit-Stiglitz Model
We can also derive an expression for the minimum cost of attaining
M:
Since the expenditure on the j
th
variety is p(j)m(j), if we use the
previous equation and integrating over all j we get:
1. Consumer behavior: Phase I:
Now we want to express this term as the
manufactures price index (G)
So G*M=total expenditure in
manufactures
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2. The Dixit-Stiglitz Model
) 1 1/(
n
0
1
1)/ - (
n
0
1

di p(i) di p(i)
o
o


(

=
(
(

=
} }
G
The price index G measures the minimum cost of purchasing a unit
of the composite index M of manufacturing goods,
If M is thought as a utility function, G would be the expenditure
function.
1. Consumer behavior: Phase I:
Now we can write the demand for m(i) more compactly:
M
G
p(j)
M
G
p(j)
m(j)
) 1 /( 1 o
|
.
|

\
|
=
|
.
|

\
|
=
We substitute G [4.7] in equation
[4.5]:
M
di p(i)
p(j)
m(j)
1/
n
0
1

1 1/
(
(

=
}

[4.7]
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2. The Dixit-Stiglitz Model
Now we have to divide the total income (Y) between the two goods,
M and A. We will do it by maximizing U constrained to the optimal
expenditure derived from minimizing M.
1. Consumer behavior: Phase II:
This maximization gives: (MRS=price ratio)
{ }
Y . .
1
= + =
=

A p GM t s
A M U Max
A

P
A
= Price of the agricultural goods.
G= Manufactures Price Index
A= consumption of the agricultural good.
p(i)= price of each variety (i) of manufacturing
product.
m(i)= quantity of each variety (i).

G
Y
M =
A
p
Y
) (1 A =
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2. The Dixit-Stiglitz Model
) 1 (
p(j)
m(j)

=
o
o

G
Y
Pulling the stages together, we obtain the following uncompensated
consumer demand functions :
1. Consumer behavior: Phase I + Phase II:
If G=constant, the price elasticity of demand for every available variety is
constant and equal to ().
A
p
Y
) (1 A =
For agriculture:
For manufactured
products:
For
n] [0, je
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2. The Dixit-Stiglitz Model
We can now express maximize utility as a function of income, the
price of agricultural output, and the manufactures price index, giving
the indirect utility function:
1. Consumer behavior: Phase I + Phase II:
) (1 A 1
) (p YG ) (1 U

=
) (1 A
) (p G

Cost-of-living index in the economy
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2. The Dixit-Stiglitz Model
Now FKV introduce a variation of the DS Model:
They make that the range of manufactures on offer becomes an
endogenous variable.
Therefore it is important to understand the effects on the consumer of
changes in n the number of varieties.
If n G (manufactures price index), because consumers value
variety.
Therefore Cost of attaining a given level of utility.
1. Consumer behavior: Phase I + Phase II:
To prove it, we assume that all manufactures are available at the same
price, p
M
. Then, the price index G becomes:
( )
( )
( ) o
o
o - 1 1/
- 1 1/
n
0
- 1
di p(i) G n p
M
=
(

=
}
The relationship between G
and n depends on the elasticity
of substitution between
varieties
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2. The Dixit-Stiglitz Mode
( ) o - 1 1/
G n p
M
=
The relationship between G and n depends on the elasticity of
substitution between varieties
The lower is (the more differentiated are varieties) the greater is the
reduction in G caused by an increase in the number of varieties.

Changing the range of products available also shifts demand curves for
existing varieties.
To prove it, we look at the demand curve for a single variety:
1. Consumer behavior: Phase I + Phase II:
When n G , the demand m(j) shifts downward,
Important: it allows us to know the equilibrium n:
If n competition shifts downward the
existing products m(j) and reduce the sales of those
varieties (evolution to more firms with profit=0)
) 1 (
p(j)
m(j)

=
o
o

G
Y
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2. The Dixit-Stiglitz Model
We consider the existence of R possible discrete locations.
Each variety is produced in only one location and all varieties produced
in a particular location are symmetric in technology and price.
n
r
= number of varieties in location r.
p
m
r
= FOB price of manufacturing in location r.
Agricultural and Manufactured products can be shipped between
locations incurring in transport costs:
Iceberg costs: if a unit of a good is shipped from a location r to another location
s, only a fraction of the original unit actually arrives. The rest is lost
(melted) in the way as a transportation cost.
The constant represents the amount of the agricultural good dispatched per
unit received in s.
2. Multiple locations and transportation cost: iceberg costs
A
rs
T / 1
A
rs
T
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2. The Dixit-Stiglitz Model
2. Multiple locations and transportation cost: CIF prices
M
rs
M
r
M
rs
T p p =
If p
m
r
is the FOB price of the manufacturing product in location r, and there
are iceberg transport costs, the CIF price when delivered to location s is
given by:
Then, the manufacturing price index (G
s
) may take a different value in each
location according to the location s where it is consumed:
( ) R 1,..., s , T p n G
1
1
R
1 r
1
M
rs
M
r r s
=
(

=

=

( ) 1
s
M
rs
M
r s
G ) T (p Y

Price index in s of
manufactures produced in r
Consumption demand in location s for a
product produced in r
Ys= income for location s: this gives the consumption of the variety in s.
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2. The Dixit-Stiglitz Model
2. Multiple locations and transportation cost: CIF prices
As a consequence, summing across locations in which the product is
sold, the total sales of a single location r variety is:
M
rs
R
1 s
1
S
M
rs
M
r S
M
r
T G ) T (p Y q

=

=
Important consequences:
Sales depend on: income and the price index in each location, on the
transportation costs and the mill price.
Because the delivered prices of the same variety at all consumption locations
change proportionally to the mill price, and because each consumers demand
for a variety has a constant price elasticity sigma (), the elasticity of the
aggregate demand for each variety with respect to its mill price is also
sigma (), regardless of the spatial distribution of consumers.
I have to produce T
m
rs
in r, knowing that a
portion 1/ T
m
rs
is lost during the trip
(transportation cost)
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2. The Dixit-Stiglitz Model
3. Producer Behavior:
The agricultural goods is produced with constant returns;
Manufacturing involves economies of scale at the level of the variety (internal).
Technology is the same for all varieties and in all locations:
The only input is labor L, the production of a quantity q
M
of any variety at any
given location requires labor input l
M
, given by:
M M M
q c F l + =
With increasing returns to scale, consumers preference for variety, and the
unlimited number of potential varieties of manufactured goods, no firm will
choose to produce the same variety supplied by another firm,
Each variety is produced in only one location by a single specialized firm,
The number of manufacturing firms is the same as the number of
available varieties.
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2. The Dixit-Stiglitz Model
M
r
M M
r
w c / ( p = ) 1 1
3. Producer Behavior: Profit maximization
) q c (F w q p
M
r
M M
r
M
r
M
r r
+ =
Firms maximize profits with a given income (sales) and with
given costs (according to the wages)
Costs: F+V (given the wages w
r
) Revenues (sales)
Each firm accept the price index G as given. Thus, the
perceived elasticity of demand is therefore , and the profit
maximization (Img = CMg) implies that:

w c
elasticity
elast
CMg
p
M
r
M
M
r
=

=
1
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2. The Dixit-Stiglitz Model
3. Producer Behavior: Profit maximization
If there is entry and exit in the industry, the profits of a firm at
location r are:
Therefore, the zero-profit
condition, implies that the
equilibrium output is:
(

= F
1
c q
w
M M
r M
r r
( )
M
/c 1 - F q* =
F q* c F l*
M
= + =
F
L
* l
L
n
M
r
M
r
r
= =
Both q* and l* are constants common to every active firm in the economy.
Thus, if L
r
M
is the number of manufacturing workers at location r, and n
r
is the
number of manufacturing firms (=number of varieties) at r, then:
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3. Producer Behavior: Profit maximization
2. The Dixit-Stiglitz Model
Conclusions:
Odd results: the size of the market affects neither the markup of
price over marginal costs nor the scale at which individual goods are
produced. All scale effects work through changes in the variety of
goods available.
Caveat: this is a strange result:, since normally the larger the
markets, + competition (- mark up), and + larger production in
scale.
The Dixit-Stiglitz model says that all market-size effects work through
changes in variety.
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2. The Dixit-Stiglitz Model
3. Producer Behavior: wages
( )
1
s
1 M
rs

M
r
R
1
S
G ) (T p Y q*

=
s
( )

=

=
R
1
1
s
1 M
rs S

M
r
G ) (T Y
* q

p
s
1/
R
1 s
1
s
1 M
rs S
M
M
r
G ) (T Y
* q

c
1
w
(

|
.
|

\
|

=

=

Nominal wages in the industry:
The production q* is the demand;
We can turn this equation around and say that
active firms break even if and only if the price
they charge satisfies:
Put in P=CMg/; and clear
This is the wage equation: it gives the manufacturing wage at which firms in each location
break even, given the income levels and price indices in all locations and the costs of
shipping into these locations:
The wage increases with the income (Ys) at location s, the access to location s from location
(Tmrs), and the less competition the firm faces in location s (G decreases with n)
Using the price rule (*) we get:

w c
p
M
r
M
M
r
=
(*)
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3. Producer Behavior: wages
2. The Dixit-Stiglitz Model
) (1 A
r

r
) (p G

) (1 A
r
-
r
M
r
M
r
) (p G w

= =
This means that the real wage of manufacturing workers in location r,
denoted by
r
M
is
Real wages: real income at each location is proportional to nominal
income deflated by the cost-of-living index,
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2. The Dixit-Stiglitz Model
) (

1
C
M
=

=
M
r
M
r
w p =

F =

L
n
M
r
r
=
l* q* = =
) 1/(1
R
1 s
) (1 M
sr
M
s
M
s
) 1/(1
R
1 s
) (1 M
sr
M
s s r
) T (w L

1
) T (p n G

=

=
(

=

1/
R
1 s
1
s
1 M
rs s
1/
R
1
1
s
1 M
rs s
M
M
r
G ) (T Y G ) (T Y
* q

c
1
w
(

=
(

|
.
|

\
|

=

=

=

s
For selecting the units we have to notice the requirement so that the marginal labor satisfies the next
equation:
Now, the price index and the wage equation becomes:
IMP: with these normalizations we have shifted attention from the number of
manufacturing firms and product prices (n/G) to the number of manufacturing
workers and their wages rates. (L/W).
3. Producer Behavior: normalizations
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2.The Dixit-Stiglitz Model
5. The price index effect and the Home Market Effect
| |
2 2
) (1
1 1
- 1
2
w L ) T (w L

1
G + + =
o
We consider an economy with 2 regions, that produce 2 manufacturing varieties:
| |
) (1
2 2 1 1
- 1
1
) T (w L w L

1
G

+ =
o
1
2 2
1 1
1 1 2
1 1
2 2
1
1 1 1
G Y T G Y w
T G Y G Y w


+ =
+ =
o
o
These pairs of equations are symmetric, and so its solutions.
So, if L1=L2; Y1=Y2, then there is a solution with G1=G2 and with w1=w2.
We can explore the relationships contained in the price indices and wage equations by
linearizing them around the symmetric equilibrium:
An increase in a variable in R1 is associated with a decrease in R2 but of equal
absolute magnitude.
So letting dG=dG1=-dG2, and so on, we derive, by differentiating the price indices and
wage equations respectively, and we get:
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5. The price index effect and the Home Market Effect
2. The Dixit-Stiglitz Model
(

+
|
.
|

\
|
=

w
dw
) (1
L
dL
) T (1
w
G

L
G
dG
) (1
1
1
( )
(

+
|
.
|

\
|
=

G
dG
1
Y
dY
) T (1
w
G
w
Y
w
dw

1
1
[Eq 1]: Price Index Effect: We suppose that the supply of labor is
perfectly elastic, so that dw=0. Bearing in mind that 1- <0 and that
T>1, the equation implies that a change dL/L in manufacturing
employment has a negative effect on the price index, dG/G.
Conclusion: the location with a larger manufacturing sector also has a lower
price index for manufactured goods, simply because a smaller proportion of this
regions manufacturing consumption bears transport costs.
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2. The Dixit-Stiglitz Model
1
1
T 1
T 1
Z

( )
Y
dY
L
dL
Z
w
dw
1 Z
Z

= +
(

+
Now , let us consider how relative demand affects the location of manufacturing.
It is convenient to define a new variable, Z,
Using the definition of Z and eliminating dG/G, we have
If dw=0, supply of labor is perf. elastic: Home market effect: A 1% change in
demand for manufactures (dY/Y) causes a 1/Z % (>1) change in the employment, and
the production (dL/L).
The location with the larger home market has a more than + proportionately larger
manufacturing sector (industrial agglomeration) and therefore also tends to export
manufactured goods.
If dw>0, positive supply of labor : part of the home market advantages is higher wages
instead of exports
Locations with a larger home market (demand) tends to offer a higher nominal
wage (qualified labor agglomeration).
Z is sort of an index of trade cost, with value between 0-1:
Z=0, if trade is costless;
Z=1, if trade is impossible.
5. The price index effect and the Home Market Effect

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2. The Dixit-Stiglitz Model
We in general are not interested in economies in which increasing returns are
that strong, if only because, in such economies the forces working toward
agglomeration always prevail, and the economy tends to collapse into a point.
(Everyone to NY).
To avoid this black-hole location theory, we usually impose what we call the
assumption of no black holes:

1
> =

6. The No-Black-Hole Condition

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3. Applications
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3. Applications
n= # industries
g= # goods
c= # countries
ROW= rest of the world
Xngc= output of product g in industry
n in country c.
ROW= rest of the world
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3. Applications
= technology matrix
V= factor endowments
of country c
X
ngc
= output of product g in industry
n in country c.
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3. Applications