“Upstream Innovation and Product Variety in the U.S. Home PC Market,” A. Eizenberg (2014)

Who benefits from innovation? The trivial answer would be that everyone weakly benefits, but since innovation can change the incentives of firms to offer different varieties of a product, heterogeneous tastes among buyers may imply that some types of innovation makes large groups of people worse off. Consider computers, a rapidly evolving technology. If Lenovo introduces a laptop with a faster processor, they may wish to discontinue production of a slower laptop, because offering both types flattens the demand curve for each, and hence lowers the profit-maximizing markup that can be charged for the better machine. This effect, combined with a fixed cost of maintaining a product line, may push firms to offer too little variety in equilibrium.

As an empirical matter, however, things may well go the other direction. Spence’s famous product selection paper suggests that firms may produce too much variety, because they don’t take into account that part of the profit they earn from a new product is just cannibalization of other firm’s existing product lines. Is it possible to separate things out from data? Note that this question has two features that essentially require a structural setup: the variable of interest is “welfare”, a completely theoretical concept, and lots of the relevant numbers like product line fixed costs are unobservable to the econometrician, hence they must be backed out from other data via theory.

There are some nice IO tricks to get this done. Using a near-universe of laptop sales in the early 2000s, Eizenberg estimates heterogeneous household demand using standard BLP-style methods. Supply is tougher. He assumed that firms get a fixed cost per product line shock, then pick their product mix each quarter, then observe consumer demand, then finally play Nash-Bertrand differentiated product pricing. The problem is that the pricing game often has multiple equilibria (e.g., with two symmetric firms, one may offer a high-end product and the other a low-end one, or vice versa). Since the pricing game equilibria are going to be used to back out fixed costs, we are in a bit of a bind. Rather than select equilibria using some ad hoc approach (how would you even do so in the symmetric case just mentioned?), Eizenberg cleverly just partially identifies fixed costs as backed out from any possible pricing game equilibrium, using bounds in the style of Pakes, Porter, Ho and Ishii. This means that welfare effects are also only partially identified.

Throwing this model at the PC data shows that the mean consumer in the early 2000s wasn’t willing to pay any extra for a laptop, but there was a ton of heterogeneity in willingness to pay both for laptops and for faster speed on those laptops. Every year, the willingness to pay for a given computer fell $257 – technology was rapidly evolving and lots of substitute computers were constantly coming onto the market.

Eizenberg uses these estimates to investigate a particularly interesting counterfactual: what was the effect of the introduction of the lighter Pentium M mobile processor? As Pentium M was introduced, older Pentium III based laptops were, over time, no longer offered by the major notebook makers. The M raised predicted notebook sales by 5.8 to 23.8%, raised mean notebook price by $43 to $86, and lowered Pentium III share in the notebook market from 16-23% down to 7.7%. Here’s what’s especially interesting, though: total consumer surplus is higher with the M available, but all of the extra consumer surplus accrues to the 20% least price-sensitive buyers (as should be intuitive, since only those with high willingness-to-pay are buying cutting edge notebooks). What if a social planner had forced firms to keep offering the Pentium III models after the M was introduced? Net consumer plus producer surplus may have actually been positive, and the benefits would have especially accrued to those at the bottom end of the market!

Now, as a policy matter, we are (of course) not going to force firms to offer money-losing legacy products. But this result is worth keeping in mind anyway: because firms are concerned about pricing pressure, they may not be offering a socially optimal variety of products, and this may limit the “trickle-down” benefits of high tech products.

2011 working paper (No IDEAS version). Final version in ReStud 2014 (gated).

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