Product Differentiation and Economic Progress

In neoclassical theory, product differentiation provides consumers with a variety of different products within a particular industry, rather than a homogeneous product that characterizes purely competitive markets. The welfare-enhancing benefit of product differentiation is the greater variety of products available to consumers, which comes at the cost of a higher average total cost of production. In reality, firms do not differentiate their products to make them different, or to give consumers variety, but to make them better, so consumers would rather buy that firm’s product rather than the product of a competitor. When product differentiation is seen as a strategy to improve products rather than just to make them different, product differentiation emerges as the engine of economic progress. In contrast to the neoclassical framework, where product differentiation imposes a cost on the economy in exchange for more product variety, in reality product differentiation lowers costs, creates better products for consumers, and generates economic progress. In the neoclassical theory of the firm, product differentiation enhances consumer welfare by offering consumers greater variety, but that benefit is offset by the higher average cost of production for monopolistically competitive firms. In the neoclassical framework, the only benefit of product differentiation is the greater variety of products available, but the reason firms differentiate their products is not just to make them different from the products of other firms, but to make them better. By improving product quality and bringing new THE QUARTERLY JOURNAL OF AUSTRIAN ECONOMICS 12, NO. 1 (2009): 17–35