Reconsidering the Microeconomic Foundations of Price-Setting Behavior

Although the Dixit-Stiglitz aggregator is the workhorse specification of monopolistic competition, this framework and related variants are fundamentally inconsistent with a key stylized fact from empirical studies of consumer behavior and product marketing, namely, that the price elasticity of demand for a given brand is primarily determined by the extensive margin (i.e., changes in the number of customers purchasing that product) rather than the intensive margin (i.e., changes in the specific quantity purchased by each individual customer). In this paper, we analyze household scanner data to confirm the salient empirical results, and we then proceed to formulate a new dynamic general equilibrium framework that captures both the intensive and extensive margins of demand. Our theoretical framework involves a two-dimensional product space and incomplete household information, giving rise to an equilibrium price distribution with customer search. Assuming uniform distributions for the individual-specific search costs and for the firm-specific productivity shocks, we obtain analytical expressions for the equilibrium price distribution and the optimal price-setting behavior of each producer, and we show that the implications of the model are consistent with the key stylized facts. Finally, we discuss how this new approach holds substantial promise for future research on price-setting behavior, not only in enhancing the linkages between micro data and macro models but in building stronger connections to ongoing research in marketing and consumer behavior. JEL classification: E30; E31; E32