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Demand Diversification Under Uncertainty and Market Power

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This paper justifies theoretically and empirically the diversification behaviour of an importing firm when it chooses the mixture of potentially differentiated products of its major input under price uncertainty. The paper investigates an equilibrium relationship among three key explanatory variables, which are the expected price, the systematic risk of price, and monopolistic market power of the suppliers in the market. The theoretical section shows that there exists a conflict between the risk–diversification effect and the agent's preference over certain products when the importer chooses the vector of optimal quantity shares. The latter effect may disturb or even dominate the former, which can be represented in an equilibrium relationship similar to the framework of the CAPM. As an empirical application, the Chinese wheat import market is examined and analysed to answer the questions raised by the basic statistics.

JEL classification: F12; F14; L22
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Keywords: CAPM; demand diversification; market power

Document Type: Research Article

Affiliations: Reserve Bank of Chicago and University of Illinois

Publication date: December 1, 2001

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