# Elasticity of substitution of goods in canonical New Keynesian Model

In the context of a New Keynesian Model (NKM) with imperfect competition, the aggregate demand for good can be represented using Dixit-Stiglitz aggregator $$C_t=\Bigg(\sum^1_0C_t(i)^{\varepsilon-1\over \varepsilon}\;di\Bigg)^{\varepsilon\over\varepsilon-1}$$ where $$\varepsilon$$ is the substitutability of intermediate goods and which determines the "market power" of monopolistically competitive firms. Theoretically speaking, if $$\varepsilon \to \infty$$, the price markup in the product market, i.e. $$\mathcal{M}={\varepsilon\over \varepsilon-1}$$, approaches unity and the market is perfectly competitive while goods are perfect substitutes. From Gali (2008), and other articles on NKM that uses calibration techniques, $$\varepsilon$$ is usually within range 6 to 10 which translates to an average markup of 1.2 to 1.1 or a 20-10% markup over marginal costs.

However, it is a bit unclear to me as to how the value of $$\varepsilon$$ is chosen, which leads to my question: what is a "sensible" value of $$\varepsilon$$ for a highly competitive market? And what about imperfectly competitive market with few major firms?

• Hi. Welcome to Econ Stack Exchange. Try not to use abbreviations (like NKM) unless you first define them. This helps with discoverability with search engines, not to mention the average reader. – jmbejara Apr 6 at 15:44
• Thank you, I'll keep that in mind and modify it – Rei Apr 6 at 18:35