Increasing Returns to Specialization, Business Stealing, and Optimal Government Spending

By using Benassy's (1996) model setting to separate increasing returns from imperfect competition, we show there are two opposite effects, the external effects of increasing returns to specialization and of business stealing, in terms of governing the relative levels of variety in a competitive steady state and optimal steady state. By shedding light on the business-stealing effect which is absent in the analysis by Devereux et al. (2000), we show that the steady-state levels of capital, consumption, and output in the social optimum can be lower, rather than higher, than those in a monopolistically competitive equilibrium. Further, we also find that the required extent of increasing returns to specialization for a positive level of optimal wasteful government spending seems to be too high to be empirically plausible. This implies that government spending is no longer welfare improving.