Vertical Differentiation in Frictional Product Markets

Abstract

We study a search-theoretic model of imperfect competition in product markets where sellers make an ex ante investment in the quality of their product variety. Equilibrium exists and is unique. In equilibrium, search frictions not only cause sellers to offer different surpluses to buyers but also cause sellers to choose different qualities for their varieties. Equilibrium is efficient. As search frictions decline, the market becomes increasingly unbalanced, as a vanishing fraction of sellers produces varieties of increasing quality, offers increasing surplus to their customers, and captures an increasing share of the market, while a growing fraction of sellers produces varieties of decreasing quality. Gains from trade and welfare grow at constant rates.