Microfoundations for the Linear Demand Product Differentiation Model, with Applications

This paper shows (1) that the Spence-Dixit-Vives model of linear demand for differentiated varieties is implied if supplies of substitutes reduce individual consumers' reservation prices as indicated in the paper, (2) that for the micro-foundation-based version SDV demand and endogenous sunk costs, the equilibrium number of varieties is independent of the number of consumers in the market and the marginal cost of a variety of unit quality, and (3) that with endogenous sunk cost, if demand does not expand with the number of varieties (as in the SDV model), the equilibrium number of varieties is unchanged, but equilibrium qualities and quantities purchased are less, all else equal.