Micro-Uncertainty and Growth

Abstract

In this paper idiosyncratic uncertainty is introduced in a model of economic growth with an increasing variety of intermediate products. Both the costs of producing intermediate products and their quality are uncertain for all producers at all times. Using the property of the model that the number of intermediate firms is infinite, uncertainty cancels out in the aggregate. Furthermore, the magnitude of uncertainty has several deterministic effects on long-term economic growth. First, uncertainty causes growth in the heterogeneity of intermediate firms. As heterogeneity grows, the number of very efficient intermediate firms increases. Depending on the degree of competition and the returns to intermediate products, these firms can attract an increasing share of demand by the final sector. This makes final production become more efficient over time. Second, uncertainty changes the rate at which new intermediates are introduced by its effect on the efficiency of final production and by a real-option effect.

Keywords: Increasing variety, idiosyncratic uncertainty

JEL Classification: O41, D81, L11