It is usually suggested that a higher degree of substitutability among several commodities has a decreasing impact on prices in oligopolistic markets. The argument supporting this intuition is that with easier substitution between any pair of commodities, it is easier for each firm to attract customers from a rival firm by decreasing its price. This increases the competitive pressure on prices and thereby decreases the resulting price level. Norbert Schulz questions the generality of this argument in Discussion Paper No 1268 by stressing the importance substitutability.

Variants of a differentiated inspection good are considered. Inspection goods are characterized by the fact that consumers cannot know the exact characteristics of goods before inspecting them. Usually, such an act of inspection is not without cost. As consumers cannot know whether they will obtain an acceptable variant in the market for such goods, they may not be willing to bear the inspection costs. Equilibrium prices of the variants of a differentiated commodity are shown to increase if the variants become closer substitutes, under a set of circumstances, which is by no means pathological. Rather, the underlying argument has a bearing on market prices, whenever a potential buyer does not know with certainty the characteristics of the variants for sale before inspecting them, and therefore must incur some information costs before the final purchase decision.

Are Markets More Competitive if Commodities are Closer Substitutes?
Norbert Schulz

Discussion Paper No. 1268, November 1995 (IT)