Chapter 4 : Product Differentiation ∗

While homogenous goods is a convenient assumption for many models, it is frequently violated in practice. Many markets feature goods that are not identical, they vary in quality, features, reliability, reputation and/or geographic location. Indeed, markets of literally identical goods seem to be relatively rare, especially once differences in seller’s locations and reputations are taken into account. Markets with differentiated products raise a number of important issues. Demand analysis obviously becomes much more complicated, as we can no longer think of a single market demand curve, but one rather must think of a demand system that yields the demands for each product in the market. It becomes even more plausible to think of the market as an oligopoly, rather than perfectly competitive, as the producers of each product will typically face downward sloping demand curves even in the presence of competition from other firms. Also, at some point (a topic considered in later chapters), we would like to know how it is that products come to be differentiation – what economic process generates new products with differing characteristics? We begin this chapter with a review of simple theoretical models, leaving details to other sources, especially to Tirole.