Abstract
AbstractHow do product variety and quality affect the aggregate price bias? We develop a general equilibrium model that accounts for the joint interaction of product quality and variety. Our findings show that the aggregate price bias is procyclical and the contribution of product variety is persistent whereas the contribution of product quality becomes countercyclical in the medium to long run. We show that accounting for product quality and variety has critical implications on the measure of cyclical fluctuations. Measurements of cyclical fluctuations derived using the consumption deflator, which abstracts from changes in product quality and variety, underestimate the variables' true volatility.
Highlights
How do product variety and quality affect the aggregate price bias? We develop a general equilibrium model that accounts for the joint interaction of product quality and variety
Our findings show that the aggregate price bias is procyclical and the contribution of product variety is persistent whereas the contribution of product quality becomes countercyclical in the medium to long run
This paper develops a general equilibrium model that embeds endogenous product quality and variety and assesses the impact on the aggregate price bias
Summary
The economy is populated by one unit mass of atomistic households that consume products of different varieties and quality. The same type of negative correlation between product quality and the firm-specific productivity can be obtained by assuming that φ < 0 In this instance, for the same rise in capability, α, the competition on productivity becomes important to deliver a lower qualityadjusted price since the firm uses the increased capability to produce lower quality goods at lower costs. The firm’s real profits are the difference between the revenue and the cost of total production: dt (α) = ρt (α)yt (α) − wtlt (α), where ρt (α) = pt (α)/Pt is the real price of goods produced by the firm with capability level α. Equation (7) shows that changes in unit real price and unit marginal cost depend on the quality ladder, φ, since z(α) = α1−φ, for any given capability level. Using equations (6) and (7), if production materializes, the firm’s real profits are dt (α)
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