Endogenous Technological Change II

The variety expansion model is complex to analyse because it includes physical capital. Grossman and Helpman (1991, Chap. 3) showed that economic growth can be achieved by expanding variety and introducing preferences for a variety of goods instead of omitting physical capital. The economy consists of households, the goods sector and the R&D sector. New varieties developed by R&D firms are purchased by entrepreneurs to enter the goods market. The monopoly profit is distributed to households that provide R&D funds as dividends. The increase in production associated with the expansion of varieties leads to economic growth. Households have a preference for variety, however, the elasticity between varieties is constant. Under a fixed expenditure, in each period, the consumption quantity that maximises utility is selected and the demand function is derived. Under intertemporal budget constraints, the expenditure that maximises lifetime utility is selected and the Euler equation is derived. In addition to the scale effect, the degree of product differentiation decreases due to a decrease in the elasticity of substitution, hence, the economy grows.