Introduction to Modern Economic Growth 12.4 The Dixit-Stiglitz Model and “Aggregate Demand Externalities” The analysis in the previous section focused on the private and the social values of innovations in a partial equilibrium setting In growth theory, most of our interest will be in general equilibrium models of innovation This requires us to have a tractable model of industry equilibrium, which can then be embedded in a general equilibrium framework The most widely-used model of industry equilibrium is the model developed by Dixit and Stiglitz (1977) and Spence (1976), which captures many of the key features of Chamberlin’s (1933) discussion of monopolistic competition Chamberlin (1933) suggested that a good approximation to the market structure of many industries is one in which each firm faces a downward sloping demand curve (thus has some degree of monopoly power), but there is also free entry into the industry, so that each firm (or at the very least, the marginal firm) makes zero profits The distinguishing feature of the Dixit-Stiglitz model (or of the Dixit-StiglitzSpence model) is that it allows us to specify a structure of preferences that leads to constant monopoly markups This turns out to be a very convenient feature in many growth models, though it also implies that this model may not be particularly well suited to situations in which market structure and competition affect monopoly markups In this section, we present a number of variants of the Dixit Stiglitz model, and emphasize its advantages and shortcomings 12.4.1 The Dixit-Stiglitz Model with a Finite Number of Products Consider a static economy that admits a representative household with preferences given by (12.6) U (c1 , , cN , y) = ÃN X i=1 ε−1 ε ci ε ! ε−1 + v (y) , where c1 , , cN are N differentiated “varieties” of a particular good, and y stands for a generic goods, representing all other consumption The function v (·) is strictly increasing, continuously differentiable and strictly concave The parameter ε represents the elasticity of substitution between the differentiated products and we assume that ε > The key feature of this utility function is that it features love-for-variety, 555