Estimating Models with Product Differentiation and Endogenous Product Characteristics

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Proposal Summary In many markets, products are not homogeneous, but differentiated. Recently, there has been much progress in analyzing and estimating models of product differentiation. A complete model of a differentiated products industry would include (i) consumers' valuation of the differing characteristics of products, (ii) a description of the costs of producing different products, (iii) an examination of how, conditional on product characteristics, producers make production and pricing decisions and (iv) a model of how product characteristics are chosen over time. This proposal contains a number of projects that extend existing work to better model and estimate production costs, the product space and the endogeneity of product characteristics. The first project develops a simple model that relates plant-level cost data to the characteristics of products produced at the plant, thereby uncovering the `hedonic cost function`. The model is to be estimated on Census data for the automobile industry. We explore how, after adjusting for differences in product characteristics, production costs have changed in the face of a changing economic and regulatory environment. The project also focuses on the fundamentals of the production process, such as economies of scale and learning-by-doing. Finally, the new cost-side estimates are incorporated into existing demand-side studies. The second project focuses on the correct nature of the product space in a differentiated products model. Existing econometric models implicitly assume that the dimensionality of the product space changes with the number of products. This contrasts with many theoretical models that hold the dimension of the product space fixed. The proposed research develops methods for estimating models of product differentiation with fixed dimensional product spaces and examines the performance of these estimators. Modeling the choice of product characteristics is much more difficult. This project begins with very simple product spaces and simple models of entry into those spaces. One empirical example here is the radio industry. It has long been alleged that there is excess entry into the radio industry, because new stations often duplicate the programming of existing stations and therefore steal customers. A series of increasingly realistic models of the product space are combined with entry models as a first step toward endogenizing the set of existing products. The empirical applications examine different policy regimes toward broadcasting entry. The simplest entry models use cross-sectional data and are really one-shot `static` models of entry. The last set of projects examines fully dynamic models of entry into differentiated product markets. These dynamic models are especially important in the presence of sunk costs. There have been important recent advances in the theory and computation of dynamic models. These advances make it possible to compute and estimate the model for relatively realistic state spaces, such as a list of radio formats and different station quality levels. This research completes one of the first empirical studies using the newly possible dynamic industry frameworks;. The proposed empirical applications are, again, to a variety of industries including radio.