Working Paper 95-9
by Joanna Stavins

Revised article published in Journal of Economics and Business (July/August 1997).

Supply and demand functions are typically estimated using uniform prices and quantities 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.

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