Product Variety and Imperfectly Competitive Free-Entry Industries : Policy Design, Conjectural Equilibria and Consumption Externalities

This paper analyses the properties of a model of imperfect competition in conjunction with a preference for product variety. When the consumer treats product variety as parametric, a tax scheme is described that generates a socially optimal equilibrium from market behaviour. Welfare-improving and optimal commodity taxes are also discussed. An alternative, conjectural, definition of equilibrium is introduced ; for a single consumer model this is argued to result in greater variety and utility. If further consumers are introduced, variety causes externalities in consumption ; their effects are analysed and policies to overcome them are discussed. When production involves a fixed cost, and consumers possess a preference for variety, there will always be a conflict between the exploitation of economies of scale and the provision of numerous product variants. A body of literature has developed that seeks to determine the efficiency of the free-market in resolving this conflict ; the focus being placed on whether too 'much' or too 'little' variety is produced, see Spence (1976), Dixit and Stiglitz (1977) and Hart (1985). However, the implications of these results for policy design have received little attention. Perry (1984) provides a characterisation of when policy should aim to expand or contract the industry in question, but without describing how this should be achieved. Two modelling issues also arise in this context : with the exception of Hart (1985) the models represent the demand side by a single, aggregate, consumer and this consumer is assumed to act in an entirely passive manner, treating available product variety as parametric. This paper aims to make progress on each of these issues. The central theme is the policy treatment of industries of the form described above. Optimal taxation is discussed in the context of a standard, single aggregate consumer, model of free-entry Cournot oligopoly. A distinction is drawn between policy design when a lump-sum subsidy to fixed costs is an available policy instrument and policy choice when it is not. With the lump-sum subsidy available I demonstrate that with the correct choice of policy, the market equilibrium achieves socially optimal levels of product variety. Without the subsidy, policy design requires the extension of recent results on optimal commodity taxation with imperfect competition (Myles (1987)a, b) to encompass the importance of variety. Following this, an alternative definition of equilibrium is discussed ; this involves the consumer forming a conjecture regarding the functional relationship between the level of his demand and the resulting number of active firms. It is argued that if these conjectures are rational, or 'correct' the conjectural equilibrium will have greater product variety than the standard equilibrium. Finally, when further consumers are introduced into the model, variety has the nature of a public good with externalities linking consumers. As each consumer will ignore the externality effect of their demand choice upon their peers, it is proved that the market equilibrium has less variety, and utility, than the welfare-maximising equilibrium with optimally chosen demands. A number of policy schemes are described that generate this social optimum from market behaviour.