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The Interactive Effect of Product Differentiation and Cost Variability on Profit

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  • Myong‐Hun Chang
  • Joseph E. Harrington

Abstract

It is generally believed that industries with greater product differentiation have higher rates of return. This paper shows that this effect breaks down in the presence of firm‐specific cost shocks. Greater substitutability in products generates two opposing effects: (1) it allows a larger increase in demand when a firm has a favorable cost shock, which more than compensates for the reduction in demand when it has an unfavorable cost shock, and (2) it results in more intense price competition. These two countervailing forces result in industry profit being highest in markets with a moderate degree of product differentiation.

Suggested Citation

  • Myong‐Hun Chang & Joseph E. Harrington, 1996. "The Interactive Effect of Product Differentiation and Cost Variability on Profit," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 5(2), pages 175-193, June.
    • Handle: RePEc:bla:jemstr:v:5:y:1996:i:2:p:175-193
    DOI: 10.1111/j.1430-9134.1996.00175.x
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    References listed on IDEAS

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    1. Klemperer, Paul, 1992. "Equilibrium Product Lines: Competing Head-to-Head May Be Less Competitive," American Economic Review, American Economic Association, vol. 82(4), pages 740-755, September.
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