Optimal Product Variety and Economic Growth: The Trade-off between Internal and External Economies of Scale

Abstract

We develop a model to analyze the social optimality of growth and product variety. The model contains two sectors, one assembly sector producing a homogeneous consumption good, and one intermediate goods sector producing differentiated inputs. Both growth which results from R & D performed in the intermediate goods sector and the variety of differentiated intermediate goods are determined endogenously. We disentangle three effects of changes in variety: (i) a productivity effect, (ii) a business stealing effect, and (iii) a growth effect. The market provides too little variety and sub-optimally high growth if the productivity effect of variety is large relative to the market power of intermediate goods producers. If varieties are not very productive, the market provides a too low rate of growth, whereas variety may either be too low as well as too high. Decentralization of both the first-best and a second-best is considered. The model is calibrated to US data to assess the magnitude of required policy interventions and the degree of sub-optimality of growth and product variety. We show that in this framework growth in the market can indeed be sub-optimally high for plausible parameter values.