Product Differentiation with Imperfect Information

Abstract

The paper employs a model of monopolistic competition and product differentiation with consumers who are not well informed about the specification of the offered brands. Welfare analysis of the degree of product differentiation in such a market concludes that the socially desirable product variety is limited due to consumers' imperfect information. Consequently, when the number of consumers is sufficiently large or economies to scale in production are sufficiently weak, the market would offer excessive variety. The literature on product differentiation is motivated by the observation that only some of the potential brands of a differentiated product are produced and sold. It studies issues such as the role of the market structure in the determination of product diversity and the welfare performance of alternative markets in making this product selection. For example, see Lancaster (1979) and Salop (1979) in the spatial models tradition; Spence (1976) and Dixit and Stiglitz (1977) in the diversifying representative consumer tradition. These studies model product selection as an equilibrium outcome of monopolistic competition. The welfare analysis focuses on the tradeoff between consumer benefits which, naturally, increase with variety and production efficiency which, owing to economies to scale, decreases with variety. They find no natural relation between the socially optimal variety and the market outcome: the latter can be smaller or larger than the former, depending on the parameters of the model. Although it is natural to expect that, in some markets for differentiated products, consumers are imperfectly informed about the available brands, all these studies assume that consumers possess perfect information. The present paper assumes that consumers are imperfectly informed and indeed obtains qualitatively different results. First, regardless of how significant are the production economies of scale, the optimal variety is below a predetermined level that depends on the parameters of consumer utility and information. Second, when consumer population is sufficiently large or economies to scale in production are sufficiently weak, the market would offer excessive variety. The explanation is that consumers' imperfect information limits the extent to which they can exploit the variety offered in the market. It is, therefore, a social waste to increase variety to a level that consumers cannot benefit from.