Frictions and Welfare in Monopolistic Competition

Joint work with Francesco Del Prato. Under review.

Abstract. In a heterogeneous firm economy with monopolistic competition, could informational asymmetries between entrepreneurs and financial intermediaries sometimes improve welfare? We study this question by introducing informational financial frictions into a Melitz economy where banks finance entrepreneurs under asymmetric information. While aggregate productivity monotonically decreases with these frictions, welfare can be maximized at intermediate levels of information asymmetry due to a trade-off between productivity and product variety. We show that the decentralized equilibrium is generically inefficient, as banks do not internalize the variety benefits of entry. Additionally, input cost distortions can improve welfare when financial frictions are severe by tightening firm selection.