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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
Contact details of provider: Postal: 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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  8. 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.
  9. Jeffrey Campbell, 2000. "Market Size Matters," Econometric Society World Congress 2000 Contributed Papers 1225, Econometric Society.
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  11. Robert C. Feenstra, 2006. "New Evidence on the Gains from Trade," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 142(4), pages 617-641, December.
  12. Gianmarco Ottaviano & Thierry Mayer, . "The happy few: the internationalisation of European firms," Blueprints, Bruegel, number 12, 3.
  13. Richard Baldwin & James Harrigan, 2011. "Zeros, Quality, and Space: Trade Theory and Trade Evidence," American Economic Journal: Microeconomics, American Economic Association, vol. 3(2), pages 60-88, May.
  14. Bresnahan, Timothy F & Reiss, Peter C, 1991. "Entry and Competition in Concentrated Markets," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 977-1009, October.
  15. Paula Bustos, 2011. "The Impact of Trade Liberalization on Skill Upgrading Evidence from Argentina," Working Papers 559, Barcelona Graduate School of Economics.
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  18. Markusen, James R & Venables, Anthony J, 1997. "The Role of Multinational Firms in the Wage-Gap Debate," Review of International Economics, Wiley Blackwell, vol. 5(4), pages 435-51, November.
  19. AMIR, Rabah & LAMBSON, Val, 1999. "On the effects of entry in Cournot markets," CORE Discussion Papers 1999059, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  20. Lorz Oliver & Wrede Matthias, 2009. "Trade and Variety in a Model of Endogenous Product Differentiation," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 9(1), pages 1-14, November.
  21. Ina Simonovska, 2009. "Income Differences and Prices of Tradables," 2009 Meeting Papers 692, Society for Economic Dynamics.
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  23. Helble, Matthias & Okubo, Toshihiro, 2008. "Heterogeneous quality firms and trade costs," Policy Research Working Paper Series 4550, The World Bank.
  24. Benassy, Jean-Pascal, 1996. "Taste for variety and optimum production patterns in monopolistic competition," Economics Letters, Elsevier, vol. 52(1), pages 41-47, July.
  25. Krugman, Paul R., 1979. "Increasing returns, monopolistic competition, and international trade," Journal of International Economics, Elsevier, vol. 9(4), pages 469-479, November.
  26. Steven Berry & Joel Waldfogel, 2010. "PRODUCT QUALITY AND MARKET SIZE -super-* ," Journal of Industrial Economics, Wiley Blackwell, vol. 58(1), pages 1-31, 03.
  27. Harald Badinger, 2007. "Has the EU’s Single Market Programme Fostered Competition? Testing for a Decrese in Markup Rations in EU Industries," Working Papers 135, Oesterreichische Nationalbank (Austrian Central Bank).
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