In the previous chapter, we discussed how to estimate a market-level model in which all firms sell a homogeneous product. In this chapter, we generalize this one-sector structural model to include many firms (or markets) that may sell differentiated products. The emphasis in most of these generalized models is on the role of factors that affect demand in determining market power.
There are at least three reasons for generalizing the model of market power to allow for multiple firms and products. First, we can better examine the role of product differentiation in determining market power. A firm differentiates its product to affect its demand curve – presumably causing it to shift out and to become relatively less elastic – which increases the firm's market power.
Second, we can use such models to examine how factors other than differentiation that vary across markets affect market power. Typically, structure–conduct–performance studies compare market power or its causes across industries, whereas most early structural models focused on a single industry. By extending the structural approach to allow estimation of the market power that exists for many industries, we can model the markups as a function of entry costs or other factors that affect these markups.
Third, we can test more complicated hypotheses than with the one-sector model. In the one-sector model, we usually assume that all firms produce homogeneous output, have identical cost functions, and behave identically.