Optimal Product Variety, Scale Effects and Growth

We analyze the social optimality of growth and product variety in a model of endogenous growth. The model contains two sectors, one assembly sector producing a homogenous consumption good, and one intermediate goods sector producing a differentiated input used in the assembly sector. Growth results from R&D performed by firms in the intermediate goods sector aimed at quality improvement. We disentangle three effects associated with increased variety, namely (i) a productivity effect, (ii) a business stealing effect, and (iii) a growth effect. The market provides too little variety and suboptimally high growth if the productivity effect of variety is large relative to the market power of intermediate goods producers. If varieties are not productive, the market provides too low a rate of growth, whereas variety may be too low as well.