An Extended Ethier Model with the Tradeoff between Economies of Scale and Transaction Costs

Abstract

The Dixit-Stiglitz model (1977, hereafter D-S model) formalizes a tradeoff between economies of scale and consumption diversity. Since an increase in the size of an economy in the D-S model enlarges agents’ scope for trading off economies of scale for consumption diversity, per capita real income, the number of goods and productivity increase with the size of an economy if there is a fixed cost in production.¹ This implies that international trade will increase per capita real income and productivity because the size of the pooling economy in the integrated world market is larger than that of any individual country. Ethier (1982) formalizes a tradeoff between economies of scale and economies of complementarity between different producer goods by introducing producer goods and the CES production function into the D-S model. An increase in the size of an economy (or opening up of international trade) in Ethier’s model will enlarge agents’ scope for trading off economies of scale against economies of complementarity and therefore raise per capita real income, the number of producer goods and productivity. Many pieces of work use this basic idea to explore the implications of the tradeoff for growth theory (see, for instance, Romer, 1986, and Grossman and Helpman, 1990); for trade theory (see, for instance, Krugman, 1979, 1980); and for macroeconomics (see, for instance, Blanchard and Kiyotaki, 1987, and Rotemberg, 1987).

We thank Anne Krueger for comments and criticisms.