Research Papers in Economics, Department of Economics, Stockholm University
Endogenous Product Differentiation, Market Size and Prices
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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