Endogenous Product Differentiation, Market Size and Prices

This paper provides a framework to understand how market size affects firms’ investments in product differentiation in a model of monopolistic competition. The theory proposes that consumers’ love of variety makes them more sensitive to product differentiation efforts by firms, which leads to more differentiated products in larger markets. The framework also predicts an inverted U-shaped effect of trade liberalization on product differentiation, with trade liberalization leading to more differentiated products when starting from autarky but then leading to less differentiated products as the countries approach free trade.