Product Differentiation and Equilibrium Price with Partial Product Search

According to earlier economics literature, an increase in product differentiation increases firms' prices. Anderson and Renault (1999), however, show that when search cost is needed to evaluate any product, a U-shaped relationship exists between firms' equilibrium prices and product differentiation. Such a relationship emerges because an increase in product differentiation brings in a positive direct effect on price through increasing market power and a negative indirect effect through encouraging search across firms. In this paper, we revisit this important issue with the recent development of partial-depth search, which allows consumers to evaluate a subset of product attributes. We use a simultaneous search model, and our results show that a U-shaped relationship still emerges in equilibrium when search depth is fixed and dictated by the search environment but vanishes when depth is chosen by consumers. Specifically, in the latter eventuality with endogenous depth, an increase in product differentiation creates a second indirect effect which is positive on price through a greater search depth: a higher differentiation increases the expected search benefit and thus induces consumers to search products at a greater depth, which allows them to better differentiate products and thus softens competition. This new positive indirect effect combined with the conventional positive direct effect leads firms' equilibrium prices to increase with product differentiation.