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Department of Economics, Stockholm University Research Papers in Economics, Department of Economics, Stockholm University

No 2010:26:
Endogenous Product Differentiation, Market Size and Prices

Shon Ferguson ()

Abstract: Recent empirical evidence suggests that prices for many goods and services are higher in larger markets. This paper provides an explanation for this phenomenon when firms can choose how much to differentiate their products in a monopolistically competitive environment. The model proposes that consumers’ love of variety makes them more sensitive to product differentiation efforts by firms, which leads to higher prices in larger markets. Larger markets lead to greater variety and products that are more differentiated, which provides consumers with greater welfare despite the adverse effect of product differentiation on prices. The social planner does not charge a markup, which allows it to differentiate products more than is possible in the competitive equilibrium. The model also provides an explanation for why prices do not always fall when trade is liberalized.

Keywords: Endogenous Technology; Market Size Effect; International Trade; (follow links to similar papers)

JEL-Codes: D43; F12; L13; (follow links to similar papers)

27 pages, December 9, 2010

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