microeconomicsI’ve been reading the book, “Perception, Opportunity and Profit”, written by Israel M. Kirzner.
It says that prosperity rises due to differentiation of labor and that differentiation of product may also improve prosperity even more.
The first, I can understand. How would the second (differentiation of product) work?
Firms engage in product differentiation as a competitive strategy. In a world of product differentiation the equilibrium state no longer collapses to zero profits. Indeed, firms can price above marginal cost and make a profit. The higher the degree of product differentiation, the more firms can charge and the higher firm profits.
To answer your question it is not obvious that product differentiation improves prosperity.
In fact in Bertrand competition, without product competition a greater sum of producer surplus and consumer surplus would be generated. One way to realize is this is that to consider that a manufacturer of a differentiated product faces a downward sloping demand curve just as a monopolist does. The issue with the monopolist is not so much that higher prices are charged (that would be a producer surplus offsetting the loss of the consumer surplus), but that the optimal social quantity of product is not produced (i.e. the sum of producer and consumer surplus is less than optimal).
So Kirzner needs to formalize his argument in terms of another model. Intuitively, it is intuitively appealing to link product differentiation to prosperity and consumer innovation of the past several decades. However, Kirzner’s economic model that connects this to prosperity or social welfare needs to be formalized (maybe a linkage between product differentiation and funding for R&D or innovation, for example, or a linkage between firm profits and entrepreneurial activity).
If all your country’s factories are producing is widgets then your country is going to be competing with itself. So as your businesses compete with each other cutting prices they both become less profitable reducing the income for your nation. In addition if China decides they are going to get into the widget business then as they steal sales and drive down the price it impacts your countries bottom line.
But if you make several hundred different products then an incursion into one product does not has as much of an impact. In addition each of these products can grow its market and provide innovation that can be leveraged with other products. Making all of the industries more competitive and increasing the strength of your nations economy.
Differentiation of products first leads to an increase in UTILITY (“different strokes for different folks.”) This gain in utility then leads to an increase in prosperity (people feel better, so they produce and spend more).
The most persuasive answer to this question was provided, in my view, by Joseph Schumpeter’s theory of creative destruction. His broad argument is that the biggest benefit of the market system is not that it lowers prices, but that it forces firms to constantly innovate in order to acquire market power, or to hold on any existing market power. Product differentiation can therefore be thought of as the outcome of creative destruction. Once you accept that, one could argue that product differentiation increases prosperity by forcing further creative destruction and innovation.
For example, if there was no possibility of claiming a chunk of the market share by designing cool new phones and iPods, we would still be listening to walkmans.
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