<p>In the context of a New Keynesian Model (NKM) with imperfect competition, the aggregate demand for good can be represented using Dixit-Stiglitz aggregator
<span class="math-container">$$C_t=\Bigg(\sum^1_0C_t(i)^{\varepsilon-1\over \varepsilon}\;di\Bigg)^{\varepsilon\over\varepsilon-1}$$</span>
where <span class="math-container">$\varepsilon$</span> is the substitutability of intermediate goods and which determines the &quot;market power&quot; of monopolistically competitive firms. Theoretically speaking, if <span class="math-container">$\varepsilon \to \infty$</span>, the price markup in the product market, i.e. <span class="math-container">$\mathcal{M}={\varepsilon\over \varepsilon-1}$</span>, approaches unity and the market is perfectly competitive while goods are perfect substitutes. From <a href="https://press.princeton.edu/books/hardcover/9780691164786/monetary-policy-inflation-and-the-business-cycle" rel="nofollow noreferrer">Gali (2008)</a>, and other articles on NKM that uses calibration techniques, <span class="math-container">$\varepsilon$</span> is usually within range 6 to 10 which translates to an average markup of 1.2 to 1.1 or a 20-10% markup over marginal costs.</p>
<p>However, it is a bit unclear to me as to how the value of <span class="math-container">$\varepsilon$</span> is chosen, which leads to my question: <strong>what is a &quot;sensible&quot; value of <span class="math-container">$\varepsilon$</span> for a highly competitive market? And what about imperfectly competitive market with few major firms?</strong></p>

CC BY-SA 4.0
2021-04-06T15:44:19.613Z
Hi. Welcome to Econ Stack Exchange. Try not to use abbreviations (like NKM) unless you first define them. This helps with discoverability with search engines, not to mention the average reader.
jmbejara
CC BY-SA 4.0
2021-04-06T18:35:21.857Z
Thank you, I'll keep that in mind and modify it
Rei
<new-keynesian-economics><empirical-evidence><monopolistic-competition>
Elasticity of substitution of goods in canonical New Keynesian Model
Rei
# Elasticity of substitution of goods in canonical New Keynesian Model

(Asked by: username_0 on 2021-04-06)

In the context of a New Keynesian Model (NKM) with imperfect competition, the aggregate demand for good can be represented using Dixit-Stiglitz aggregator
$$C\_t=\Bigg(\sum^1\_0C\_t(i)^{\varepsilon-1\over \varepsilon}\;di\Bigg)^{\varepsilon\over\varepsilon-1}$$
where $\varepsilon$ is the substitutability of intermediate goods and which determines the "market power" of monopolistically competitive firms. Theoretically speaking, if $\varepsilon \to \infty$, the price markup in the product market, i.e. $\mathcal{M}={\varepsilon\over \varepsilon-1}$, approaches unity and the market is perfectly competitive while goods are perfect substitutes. From [Gali (2008)](https://press.princeton.edu/books/hardcover/9780691164786/monetary-policy-inflation-and-the-business-cycle), and other articles on NKM that uses calibration techniques, $\varepsilon$ is usually within range 6 to 10 which translates to an average markup of 1.2 to 1.1 or a 20-10% markup over marginal costs.

However, it is a bit unclear to me as to how the value of $\varepsilon$ is chosen, which leads to my question: **what is a "sensible" value of $\varepsilon$ for a highly competitive market? And what about imperfectly competitive market with few major firms?**

**Tags:** new-keynesian-economics, empirical-evidence, monopolistic-competition

> **Comments:**
> **username_1**: Hi. Welcome to Econ Stack Exchange. Try not to use abbreviations (like NKM) unless you first define them. This helps with discoverability with search engines, not to mention the average reader.  
> **username_0**: Thank you, I'll keep that in mind and modify it  

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## 0 answers

