Estimating Demand Elasticities in a Differentiated Product Industry: The Personal Computer Market

Supply and demand functions are typically estimated using uniform prices and quantifies across products, but where .products are heterogeneous, it is important tO Consider quality differences explicitly. This paper demonstrates a new approach to doing this by employing hedonic coefficients to estimate price elasticities for differentiated products in the market for personal computers. Differences among products are modeled as distances in a linear quality space_ derived from a multi-dimensional attribute space. Heterogeneous quality allows for the estimation of varying demand elasticities among models, using models’ relative positions as measures of market power. Instead of restricting market competition to the two nearest models, as is .typically done in the differentiated-product literature, cross-elasticities of substitution are allowed to decline continuously with distance between models in quality space. Using data on prices, technical attributes, and shipments of personal computers sold in the United States from 1977 to 1988, two-stage least squares estimates of demand elasticities are obtained. The estimated elasticities vary across models and over time, and are consistent with observed changes in market structure. Entrant firms, as well as new models, are found to face more elastic demand. The estimated elasticities are used to calculate price-cost markups and industry profit-revenue ratios. Both measures decline significantly, indicating a decrease in industry profitability over time, as the market became more competitive. I. Estimating Demand Elasticities in a Differentiated Product Industry: The Personal Computer Market Joanna Stavins Introduction Supply and demand functions are typically estimated using uniform prices and quantities across products, yielding a single industry-wide demand elasticity estimate. However, most industries are characterized by multiproduct firms producing differentiated rather than uniform goods. Each product is likely to face a different demand elasticity. It would be misleading, for example, to use a single estimate of demand elasticity for a Mercedes and a Ford Escort. Instead, individual products’ attributes and their market position should be used in demand elasticity estimation. Beginning with Rosen (1974), economists have employed various means of estimating demand and supply for differentiated products or individual attributes, There is still no agreement as to the best way to estimate demand elasticities for products differentiated in several attributes. Recent studies include Bresnahan (1981), Levinsohn (1988), Trajtenberg (1990), Berry (1992), Feenstra and Levinsohn (1995), and Berry, Levinsohn, and Pakes (1995). A large number of products forces the analysts to place strong restrictions on demand to avoid estimating thousands of elasticities. In most of the studies, models are assumed to compete only with their two nearest competitors. However, a sufficient drop in price could presumably make consumers move to a different market segment, making the assumption too stringent. Cross-elasticities are often estimated only after the market is aggregated to two general types of products (see Bresnahan (1989) for review). This paper provides a new application of hedonic coefficients in the estimation of price -2elasticities for differentiated products. In the context of the market for personal computers (PCs), differences among products are modeled as distances in a linear quality space derived from a multi-dimensional attribute space using hedonic coefficients as weights. I design a supply and demand model that allows for variation in demand elasticities among differentiated products and over time. The relative positions of models in the quality space measure their market power. Instead of restricting market competition to the two nearest models, a new method allows crosselasticities of substitution to decline continuously with distance in the quality spectrum. Two-stage least squares estimates of demand elasticities vary across models and over time, and are consistent with observed changes in market structure. Entrants are found to face more elastic demand than incumbents, although the difference is not statistically significant. Similarly, new models were found to face more elastic demand than models which had been on the market for one or two years. Using the estimates of demand elasticities, I compute two measures of industry-level profitability: the annual price-cost markups and the total profit-revenue ratio. Both measures indicate a significant decline in profitability with the increase in market competition over hme. The paper proceeds as follows. Sections II and III describe the theoretical models of demand and supply, respectively, leading to two estimable equations. Section IV describes the data, while section V provides estimation results. Section VI discusses industry profitability changes. Section VII concludes.