Question

Evaluate and critically discuss the limitations of the Dixit-Stiglitz model.

Answer 1

The Dixit-Stiglitz monopolistic competition model makes an assumption that a representative consumer who gains directly from items variety and always prefers to consume a strictly positive level of all items produced in the country. However this assumption is unrealistic; price taking assumption which is main ingredient for a closed form solution in the model is inconsistent fundamentally with derived equilibrium behaviour in a market for a big economy.

DS model will works only if 'n' large; however in the increasing returns to scale monopolistic competition will result to a higher degree of product differentiation than it is optimal socially. When the only motivation for trade is a desire for the product diversification, then the gains from trade converge to zero as economies get big, and ultimately trade completely disappears in the presence of iceberg costs. Moreover the model does not represent a reasonable limit on a huge finite economy unless being built of heterogeneous agents on a micro-foundation.