Economic growth and economic development 569

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 > 1. The key feature of this utility function is that it features love-for-variety,
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