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Product Line Adjustments and Price Markups

In a static multimarket spatial allocation model with multiproduct firms, I study the implications of product line extensions on firms’ optimal pricing policy in business cycle frequencies. Firms adjust their product lines in response to fluctuations in market demand, by offering more products during economic booms and fewer products during economic recessions. Overall, it is shown that aggregate product variety is procyclical, which results in procyclical changes in the degree of market competition, leading to countercyclical price markups, a real rigidity in nominal price setting. Based on data coming from a sample of five US manufacturing industries, a 10% increase in the growth rate of market demand results in a 0.6% increase in the level of product line extensions. Also, a 10% increase in the level of product line extensions causes price markups to drop by approximately 1.1%. Finally, product line extensions intensify the countercyclical behavior of price markups.