On the market failure in a dixit-stiglitz setup with two trading cities

This study discusses the reasons for market failure and its bias in an economy with two cities and two final goods: tradeable differentiated products and non-tradeable housing. It is shown that inside the city, as in Dixit and Stiglitz (1977), diversity (number of firms) is too small. With regard to the population partition between the cities, the paper distinguishes between a marginal and a global market bias against agglomeration or dispersion (in a second-best context). The reasons for a marginal bias are twofold: a gap between marginal and average labor productivity and the (excessive) labor employed in housing production which vary between the large and the small cities. The source of the global bias is multiple stable equilibria. The marginal bias may be in an opposite direction to the global bias, such that more agglomeration may be marginally desirable, whereas full dispersion is (second-best) optimal. Simulations demonstrate that the same market structure and potential source of market failure may imply bias in different directions, depending on the aggregate population size.