Abstract:
We consider a version of the imperfect competition model of Butters (1977), Varian (1980) and Burdett and Judd (1983) in which sellers make an ex-ante investment in the quality of their variety of the product. Equilibrium exists, is unique and is e¢ cient. In equilibrium, search frictions not only cause sellers to o§er di§erent surpluses to buyers but also cause sellers to choose di§erent qualities for their varieties. That is, equilibrium involves endogenous vertical di§erentiation. As search frictions decline, the market becomes more and more unequal as a smaller and smaller fraction of sellers produces varieties of increasing quality, o§ers 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. Under some conditions, the growth rate of gains from trade and welfare is constant.
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