Introduction

The Dixit–Stiglitz (1977) framework has become a powerful tool to analyse monopolistic competition and market structure in general equilibrium models, in particular in (international) macroeconomics and trade theory. While the Dixit–Stiglitz model was originally phrased in a static context, its importance is at least as large in a dynamic context. In R&D-based models of economic growth, aggregate economic growth is explained from the incentives private firms have to invest in research and development (R&D) (seminal contributions are Romer, 1990; Grossman and Helpman, 1991; Aghion and Howitt, 1992). R&D generates blueprints for new product varieties, new production processes, or improved product quality. Firms are willing to invest in R&D only if they can reap some profits. The Dixit–Stiglitz framework has proved to be a most appealing and elegant way of modelling the conditions under which firms can realise profits, which provide both the incentives to innovate as well as the means to pay for the cost of innovation. The key assumption in the Dixit–Stiglitz framework is that each firm produces a good that is differentiated from other goods in the market. The elasticity of substitution in utility between product varieties from different producers captures the degree of product differentiation. This parameter determines the firm's price elasticity and hence the degree of market power it can exert. Because of this link between market conditions and investment incentives, international differences in market conditions determine international differences in growth.