Product Variety and Asset Pricing

Abstract

We build a general-equilibrium asset pricing model of a production economy with endogenous product variety. We analytically characterize the unique equilibrium, and calibrate the model to match asset pricing and product market moments. The equity premium and risk-free rate can be reconciled for relative risk aversion levels below 4 and quarterly discount rates exceeding 0.99. The market risk premium decreases with the average intrasector product substitutability and the procyclicality of entry costs. We show empirical support for the novel cross-sectional prediction that industry excess returns increase with product substitutabilities. Our results demonstrate that product variety, indeed, significantly influences asset prices.