Product Choice and Oligopoly Market Structure

Abstract

Ip ropose an empirical model to analyze product differentiation and oligopoly market structure. The model endogenizes firms’ product-type decisions, measures how effects of competitors differ depending on their product types, and can incorporate alternative specifications for the product choice game. I estimate using data from oligopoly motel markets along U.S. interstate highways; motel establishments are characterized by their quality choice. The results demonstrate a strong incentive for firms to differentiate. The effects of demand characteristics on product choice are also significant. Game specification is of minor importance, although differences in the games analyzed do affect equilibrium market structure predictions in some cases. Understanding the causes and consequences of concentrated industry structure continues to pose a formidable challenge for industrial organization economists. Markets in which firms can differentiate their products are especially complex, as each individual firm’s product choice affects its own profitability, and the extent of product differentiation influences the intensity of competition for all market participants. This article addresses one particularly difficult question: What drives the product-type decisions of firms in oligopoly markets? The empirical model estimated here endogenizes firm product choice and can be used to evaluate competing explanations for the patterns of product differentiation observed in markets. Numerous game-theoretic models have addressed firms’ product-type choices and made equilibrium predictions about the extent of product differentiation in markets. The framework introduced in Hotelling’s (1929) classic article sets up the underlying tradeoff firms face: competition among firms may be less intense if they offer products that consumers find less substitutable, but firms may have an opposing incentive to select an undifferentiated product for which demand is strong. Subsequent models have experimented with various factors that can influence this tradeoff and the resulting array of product types offered by firms in equilibrium. For example, players may choose their product types simultaneously or in some sequence. They may be committed to their choice or have the option to change in response to the decisions of other firms. In each