Product Variety, Across Market Demand Heterogeneity, and the Value of Online Retail

This paper quantifies the effect of increased product variety in online markets on consumer welfare and firm profitability. We show the gains may be small if consumer tastes vary geographically and brick-and-mortar stores cater to the local demand. We use an original data set from a large online retailer containing millions of transactions. However, the large choice set leads to many products having zero local market shares. We propose a modification to Berry (1994) and Berry, Levinsohn, Pakes (1995), where both national and local market shares are used to recover geographically varying mean utilities. Our two step approach is easy to implement and fits our data well. Our results indicate that products face substantial heterogeneity in demand across markets, with more niche products facing greater heterogeneity. Failing to account for across-market demand heterogeneity grossly overstates the consumer welfare gain of increased online product variety, and on the supply side we find traditional retail chains can generate a substantial increase in revenue by localizing assortments.

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