Abstract
We study the role of exchange rate variability in the firm's choice of whether to offer one or two varieties. The firm sells in both the Home market and the Foreign market. It is shown that variability in the exchange rate induces the firm to vertically segment markets (i.e., offer two varieties). This happens because variability in the exchange rate affects income dispersion and hence the firm's incentives to extract consumer surplus. To better extract surplus, the firm offers two price-quality menus, high quality variant (priced high) for top-end surplus extraction and a low quality variety (priced low) to address market coverage concerns. We extend the model to allow for horizontal segmentation. We find that the profitability of second degree price discrimination increases as markets become horizontally segmented. Hence, when the costs of segmenting markets are not too high, variability in the exchange rate will lead to both greater variety and international market segmentation.