Product Differentiation and Systematic Risk: Theory and Empirical Evidence
21 Pages Posted: 14 Dec 2011
Date Written: November 13, 2011
Firms producing differentiated products have high margins and therefore low risk. As a result firms invest more into developing differentiated products when they perceive risk is high. Higher risk also implies higher product skewness towards more differentiated products and therefore higher average markups. The model predicts endogenous systematic and idiosyncratic riskiness as well as endogenous intensity of competition: firms in high risk industries reduce their riskiness by competing less than firms in low risk industries. Empirical evidence on product differentiation, R\&D expenses, B/M ratios, and market beta is consistent with the model.
Keywords: Stock Returns, Price Differentiation, Product Market Competition, Product Development, Idiosyncratic Volatility, Research and Development, Counter-Cyclical Markups, Price of Risk, Price-Cost Margin, Investment, Innovation
JEL Classification: E32, E22, G12, G32, L11, L16, L25, O31
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