Habit Formation, Demand and Growth through Product Innovation

Growth theory has mainly focused on process innovation, either through an increase in quality of the product or a reduction on the cost. The main contributions in growth theory that includes product innovation has been done in the Dixit and Stiglitz framework. This framework works with oversimplifying restrictions on the demand side: Preferences of consumers are assumed to be constant and equal for all goods. This paper introduces vertical and horizontal differentiation in final goods. Goods are different in their habit formation parameters. Innovation is not the normal reduction in costs but an increase in the capacity to satisfy consumers’ needs. Growth in this model is defined as the growth of the final value added.