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Unformatted text preview: Chapter 26 Product Differentiation and Innovation in Markets In all our discussions of different market structures, we have so far assumed that there is such a thing as the market for the good that is being discussed. 1 This has made markets appear to be quite static in the sense that something in the past has led up to the existence of certain markets for certain well-defined goods, but nothing is currently happening to change this. All that is happening is that different market structures satisfy existing consumer demand in one way or another dividing total potential surplus between consumers, producers and possibly dead weight loss. In this static world, firms are relegated to simply producing goods that someone else invented at some point, making sure to not waste any resources in the process while looking for some strategic pricing advantage from which to profit. But the real world appears to be constantly changing, with firms attempting to get an edge by finding new and better technologies for production, by changing features of existing products and inventing new ones, and by changing the image of products through aggressive marketing and advertising. The real world does not have the static flavor of our models from the previous chapters rather, it is dynamic , constantly changing and adapting to new circumstances. Firms often do not take as given that their choice is to produce or not produce some combination of existing goods they try to differentiate what they do and innovate toward creating new markets in which they can meet consumer demand more effectively while also establishing just a bit of market power from which to profit. It is to this process of product differentiation and innovation that we now turn. 2 From the outset, however, we should acknowledge that modeling innovation is not something that comes naturally in models that aim to characterize equilibrium behavior. As soon as we focus on the notion of an equilibrium in a typical model, we are in fact focused on describing a state of the world in which everyone is doing the best they can given what everyone else is doing. Still, by introducing product differentiation within a market into our models, we can begin to talk about the incentives firms have to innovate and set themselves apart from the pack. 1 This chapter builds on Chapters 23 through 25 but no use of part B of Chapter 24 is made. 2 The underlying structure of the material developed in this chapter follows in many ways the development of Chapter 7 in Tirole, J. (1992), The Theory of Industrial Organization , Cambridge, MA: The MIT Press. 1005 1006 Chapter 26. Product Differentiation and Innovation in Markets 26A Differentiated Products and Innovation In this section, we will proceed in several steps. We will first look at the implications of moving away from the assumption that oligopolists are producing identical products and instead assume that oligopoly firms produce differentiated products in an attempt to lessen price competition. We beginoligopoly firms produce differentiated products in an attempt to lessen price competition....
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- Fall '09