Optimal policy against distortions caused by monopolistic competition and variable markup pricing

Abstract

This study investigates the optimal policy design against distortions under monopolistic competition with firm heterogeneity and variable markups. In this framework, distortions arise from differences in markups across firms, necessitating sophisticated policy interventions to eliminate all markup differences. This study shows that simultaneous implementation of ad valorem tax and per-unit subsidy works effectively in eliminating the markup differences, enabling efficient resource allocation without resorting to firm-specific taxes/subsidies, whose implementation would require each firm’s private information.