Product diversity and product selection: market equilibria and social optima

Abstract

Introduction and some preliminary results It is well-known that, in the presence of scale economies, one cannot rely on the market mechanism to produce the socially optimal quantities of goods. Optimality requires that the demand price is equal to marginal cost. Such an optimum cannot be sustained as the equilibrium of a perfectly competitive market as each firm would have negative profits. An imperfectly competitive market equilibrium, on the other hand, while it would allow firms to make positive profits, would violate the condition. What is less well-known, but at least as important a market failure in terms of its welfare implications, is that the market equilibrium may not sustain the optimal number of commodities. In other words, the amount of product diversity is not ideal. Thus Spence, writing in 1976, noted: In the past, some of the costs of imperfect competition have been measured by the cost of the nonmarginal cost pricing of the existing set of products. Using some numerical examples, I have tried to show that a significant fraction of the cost of imperfect competition may be due to the currently unmeasured cost of having too many, too few, or the wrong products. This analysis is far from decisive empirically, since it is based on numerical examples. It is however suggestive, that over a range of assumptions about the structures of demand and costs, product selection failures may be significant components of welfare costs.