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Endogenous Product Differentiation, Market Size and Prices

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.

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File URL: http://www2.ne.su.se/paper/wp10_26.pdf
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Paper provided by Stockholm University, Department of Economics in its series Research Papers in Economics with number 2010:26.

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Length: 27 pages
Date of creation: 09 Dec 2010
Date of revision:
Handle: RePEc:hhs:sunrpe:2010_0026
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Department of Economics, Stockholm, S-106 91 Stockholm, Sweden

Phone: +46 8 16 20 00
Fax: +46 8 16 14 25
Web page: http://www.ne.su.se/
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  19. Helble, Matthias & Okubo, Toshihiro, 2008. "Heterogeneous quality firms and trade costs," Policy Research Working Paper Series 4550, The World Bank.
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  23. Paula Bustos, 2011. "The Impact of Trade Liberalization on Skill Upgrading Evidence from Argentina," Working Papers 559, Barcelona Graduate School of Economics.
  24. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
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