Differentiated Products

Differentiated products are imperfect substitutes — each firm faces a downward-sloping residual demand even with rivals in the market, because consumers do not regard the goods as identical. The standard linear-demand setup is

where $g \in (0, 1)$ measures the degree of substitutability ($g = 1$ is homogeneous goods, $g = 0$ gives two independent monopolies). The smaller $g$ is, the more market power each firm retains.

When to use

Invoke product differentiation whenever the Bertrand paradox (price = MC with just two firms) is too extreme to be plausible. Differentiation is what makes Monopolistic Competition possible: each firm is a "mini-monopolist" over the customers who prefer its variety, so equilibrium prices stay strictly above marginal cost even with many firms. The same setup underlies most of empirical IO — demand for differentiated products is what BLP-style models estimate.