Boundaries of Differentiated Product Markets and Retailer Pricing
37 Pages Posted: 7 Sep 2021
Date Written: September 3, 2021
This paper studies the effects of misspecified boundaries of competition on optimal retail pricing using store-level supermarket scanner data. We focus on two types of misspecification: (i) misspecification of the demand estimation problem, which can arise from either defining the product market to be too narrow or specifying an overly restrictive model of demand; (ii) misspecification of the retailer's decision problem, which can arise from the retailer separately optimizing prices in each category but failing to account for, and thus internalize, cross-category effects. Both sources of misspecification are relevant in differentiated product markets where goods are broadly related but in ways that may not be immediately obvious a priori. Quantifying the costs associated with either form of misspecification is challenging because it requires a flexible yet valid demand system. To this end, we take a nonparametric approach to estimating a multi-category demand system that imposes minimal restrictions on the sign/magnitude of cross-price effects and also satisfies key properties required by economic theory. Our first set of empirical results is descriptive. We use data across nine diverse product groups to show that cross-category effects exists and are often nuanced in their sign and magnitude. That is, many categories are neither "obvious substitutes'" nor "obvious complements." We then zoom in on refrigerated juices and estimate demand nonparametrically across five juice categories where we find empirical support for a flexible model that can accommodate both substitutes and complements. We solve for optimal prices under both sources of misspecification and estimate profit losses to be in the 5-15% range.
Keywords: nonparametric demand estimation, demand spillovers, multi-category demand, model misspecification, omitted variable bias
JEL Classification: C10, C14, D12, D40, L11, M31
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