Monopolistic competition and income dispersion

•In the CES model of monopolistic competition, income redistribution has no effect.•We develop a model where consumers are heterogeneous in both incomes and preferences.•The impact of heterogeneity on equilibrium is captured through only one parameter.•A reduction in income disparities may lead to either softer or tougher competition.•The key-factor is the sign of correlation between income and preference for variety.

We develop a model of monopolistic competition that accounts for consumers' heterogeneity in both incomes and preferences. This model makes it possible to study the implications of income redistribution on the toughness of competition. We show how the market outcome depends on the joint distribution of consumers' tastes and incomes and obtain a closed-form solution for a symmetric equilibrium. Competition toughness is measured by the weighted average elasticity of substitution. Income redistribution generically affects the market outcome, even when incomes are redistributed across consumers with different tastes in a way such that the overall income distribution remains the same.