- Consumer Heterogeneity And Market Imperfections

With differentiated goods and heterogenous consumers, firms set prices above marginal costs when product choice is endogenous. When consumer tastes are identical and all consumers prefer one possible variant to all other possible variants at the marginal costs of production, then all firms provide the same variant in (subgame perfect) equilibrium and equilibrium prices in the subgame which follows, are equal to marginal costs. Intuition suggest that as the consumer density becomes more concentrated, firms will provide (weakly) closer substitutes in order to compete for the consumers in the high-density part of the distribution and prices are closer to marginal costs of production. Consequently, if the intuition is correct, price equal marginal costs can be seen as a good approximation when most consumers are rather the same. I give results specifying when prices do not approach marginal costs as consumers become more similar in taste. A small heterogeneity can give rise to large market imperfections.