Evidence suggests that differences in initial conditions cannot fully account for the large disparities in income levels and growth rates across countries. In Discussion Paper No. 751, Research Affiliate Jordi Galí develops a model in which imperfect competition generates multiple equilibria for economies with identical initial conditions. Optimizing firms base investment on the marginal return to capital, which reflects the price reduction customers require to absorb the extra output and diverges from the marginal product of capital if firms are monopolistic competitors. With highly elastic demand, increased output is easily absorbed, but inelastic demand requires a much larger price fall, and the return to investment will be lower.

Galí then relaxes the assumption that the effective elasticity of demand is constant. If inputs are more substitutable than consumption goods, the demand elasticity is positively related to the savings rate, and multiple stationary equilibria emerge. For a given initial capital stock, a range of marginal returns on investment are consistent with equilibrium, depending on the initial values of consumption and savings. Per capita income and consumption levels of economies with identical capital stocks, preferences and technology therefore need not converge in the long run, which contrasts with predictions of neoclassical growth models, although the marginal returns on their capital will remain equal even in the absence of capital mobility. This equalization of capital returns coexists with different stationary levels of capital (and thus savings rates), so the potential for persistent cross-country divergences in per capita income may also account for the apparent failure of capital to flow from rich to poor countries.

Multiple Equilibria in a Growth Model with Monopolistic Competition
Jordi Galí

Discussion Paper No. 751, December 1992 (IM)