Introduction

The Dixit–Stiglitz (1977) model of monopolistic competition has been the essential building block for the new generation of growth models that was developed by Romer (1990) and others. It is a well-known property of neoclassical theory that exogenous forces ultimately drive growth. By relying on perfect competition neoclassical growth theory could not model productivity growth and technical change as endogenous variables. R&D efforts lead to increases in productivity, but typically R&D expenditures are a fixed cost, which can be recouped only if firms make profits.

Monopolistic competition can generate profits in the short run if the number of competing firms is not too large. In the Dixit–Stiglitz model entry of new firms will lead to zero profits in the long run. However, the standard assumption that new firms appear out of the blue does not seem realistic. Each new firm in the model of monopolistic competition introduces a new product variant, which may require innovative effort in the first place. The development of a new product requires an up-front R&D expenditure. Entry then takes place as long as the R&D costs do not exceed the net present value of future profits that can be reaped by bringing the new product on the market.

In the Dixit–Stiglitz model the number of firms is finite in the long run. Entry of new firms reduces profits of all firms in the industry. This result is not changed if account is taken of up-front expenditure to develop new products.