A Variety-Expansion Model of Growth with External Habit Formation

Abstract

This paper introduces external habit formation into one of the basic models of endogenous growth in which continuing expansion of product variety sustains long-term growth. We assume that households consume a range of final goods and they set a benchmark level of consumption for each good. The benchmark consumption is determined by external habit formation so that there are commodity-specific external effects. Each good is produced by a monopolistically competitive firm and the firmfs optimal pricing decision exploits the fact that consumersf demand is subject to the external habit formation. Given those settings, we show that the introduction of consumption externalities may affect the balanced-growth characterization, transitional dynamics as well as policy impacts in fundamental manners.consumption externalities, habit formation, monopolistic competition, R&Dbased growth model