Optimum product variety in urban areas

Abstract A monopolistically competitive industry in which firms produce differentiated products subject to increasing returns to scale technology is superimposed on a monocentric residential land-use model. The main result is the demonstration that, given an isoelastic demand structure, the market equilibrium will correspond to a first-best optimum if firms own shares in land rents and population is set optimally. This result contrasts with existing literature on monopolistic competition and product diversity in which it is contended that the market equilibrium is a second-best optimum. If firms do not own shares in land rents, a corrective subsidy paid to firms and financed out of a tax on differential land rents will result in replication of the planning solution.