Increasing Returns, Monopolistic Competition, and Optimal Unemployment

I generalize the canonical Dixit and Stiglitz (1977) model of monopolistic competition and non-CES preferences to include a labor market characterized by matching frictions and directed search. First, I demonstrate that the directed search does no longer imply an optimal unemployment level if the labor market is embedded in a general equilibrium framework with monopolistic competition. The reason is the incomplete appropriability distortion, present even under CES preferences, which propagates from the product market and creates a wedge between social and private benefits of employment.