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Suggested reading
Tirole J (1988) The Theory of Industrial Organization, MIT Press, ch 7, and section 2.1 of chapter 2
Church & Ware (2000) Industrial Organization: a Strategic Approach, McGraw-Hill, ch. 11
Other sources:
Martin S (2001), Advanced Industrial Economics, Blackwell, Oxford, chapter 4
Beath J & Katsoulacos (1991), The Economic Theory of Product Differentiation, Cambridge
University Press
Cabral L (2000), Introduction to Industrial Organization, MIT, chapter 12
1
Part A Preliminaries
I
To introduce greater realism: in the real world, most products are not
homogeneous, theyre differentiated (variety of brands offered by firms).
Consider: beer, breakfast cereals, PCs, cars, supermarkets, newspapers; but, on
the other hand, sugar, salt, petrol, cement.
Within the academic literature, introducing differentiation into our models:
helps resolve the Bertrand paradox
helps our understanding of the sources of market power: are high prices due to
monopoly power & collusion, or due to very differentiated brands (with
considerable brand loyalty), or both?
provides underpinnings for econometric estimation of demand systems
provides insights for understanding determinants and evolution of market
structure
is essential for understanding the likely impact of mergers between firms selling
substitute brands
II
(i) terminology: for Tirole, the industry or market is the aggregate concept, with
individual firms selling different products. I prefer to refer to individual firms selling
different brands of the same product, e.g. Stella Artois or Guiness are brands of beer
substitutes for all others, or do they merely compete with those brands which are
close to them? Consider beer, cigarettes, newspapers, restaurants, TV
III
It can be argued that the characteristics approach is a generalisation: brands differ vertically in
their provision of any one characteristic, but horizontally in their combination of characteristics.
Consumers vary in weights they attach to different characteristics. So an encompassing approach.
1
q1 = D1(p1, p2)
q2 = D2(p1, p2)
p1 = P1(q1, q2)
p2 = P2(q1, q2)
and
p2= - q2 - q1
and
and
C1 (q1) = k q1
Objective functions:
C2 (q2) = k q2
Firm 2:
a bK cP2
2b
a bK cP1
P2
2b
P1
P1
R2 (P1)
R1 (P2)
P*1
a bK
2b
a bK
2b
P*2
P2
6
p1= - q1 - q2
and
Cost functions:
Ci (qi) = k qi ;
I=1,2
Objective functions:
p2= - q2 - q1
q2 = ( -q1 k)/2
Quantity is a negative function of the rivals quantity. If firm 1 increases its quantity,
firm 2 reacts by reducing its output. Quantities are thus strategic substitutes.
The effect is lower with respect to the traditional Cournot model since <:
differentiation reduces rivality
q1*= q2* = q * = (-k) / (2+)
p* = [+k(+)]/(2 + )= k + (-k)/(2+)
= Cournot and =0 Monopoly
q1
K
2
Y1C
Y2C
K
2
q2
Issue that has not been addressed: how firm choose the degree of differentiation ?
I.
where x = distance to shop (or departure of the brands characteristics from the
consumers ideal) and t = transport cost per unit of length (or psychic costs of having
to consumer a brand which is not ideal.)3
If the consumer enjoys a surplus of S when he consumes, then his utility is
S (p+tx)
(ii) There are two brands on offer: A and B (separate firms).
(iii) They are located at opposite ends of the city.
Define the distance between them as 1, and now think of x as the consumers distance
from brand A (and therefore 1-x from B). The consumer buys the brand which
generates the larger utility.
(b) Basic model, with fixed location
Assume that, in equilibrium, all consumers buy, and that both firms sell 4, then there is
a marginal consumer who is indifferent between the two brands. This is shown in
figure 1, from which we can derive:
the demand curves for each brand
the best response functions (from the first order conditions)
the equilibrium
Demand:
marginal consumer, located at x
so pA + tx = pB + t(1-x)
Utility
Figure 1
S-pA
S-pB
S-pA-tx
S-pB-t(1-x)
Tirole, on pp. 279/80 goes straight to quadratic transport costs. Initially, I set the model up with linear transport costs.
But see the diagrams on p.98 for where this is not true.
Best responses
A = (pA cA). DA
A = (pA cA). {(pB - pA)/2t + },
f.o.c =>
pA = (pB +c +t)/2
therefore upward sloping best response functions: the brands are strategic complements.
Equilibrium pA = pB = c +t
INSIGHT 2
(c) More general location (i.e. not necessarily at the end of the line)
Now assume that transport costs are quadratic, rather than linear. The results are
similar, but this proves to be a more convenient way of modelling location of brands.
(What do quadratic costs imply?)
Suppose that firm A is located at point a, and that firm B is at point (1-b).
Special cases:
if a=b=0, we have maximum differentiation (as before)
if a+b=1, there is minimal differentiation (both firms locate at the same point)
Again, we can proceed to derive the demand curves, best response functions and
equilibrium price:
10
Figure 2
Demand: marginal consumer defined by:
Utility
2
pA + t(x-a) = pB + t(1-b-x)
S-pA-t(x-a)2
S-pB-t(1-b-x)2
S-pB
1-b
pA = c + t(1-a-b). {1+(a-b)/3}
Conclusion: the two basic insights still hold: the equilibrium expression confirms that
price increases with t, and the best responses show that pA is positively related to pB.
HINT: Doing Tiroles exercise 7.1 is a useful test of whether youve understood this!
(d) Endogenous location
But now lets make things even more interesting (realistic), by allowing firms to
choose their locations, so as to optimise.
This now becomes a 2 stage game, in which firms choose location in stage 1 and then
price in stage 2. (Is this sequence reasonable?) It highlights a key point: brand
positioning is often a strategic variable.
Tirole provides the algebra for you to work through (sub-section 7.1.1.2).
Summarizing (new simbols: a and b are x1 and x2, z is x, pA and pB are P1 and P2):
D1 Z a
1a b
P2 P1
2
2t(1 a b )
D2 1 Z b
1a b
P1 P2
2
2t(1 a b )
1-a-b
0
X1
Z
Which variety will be chosen by the two firms?
11
X2
1a b
P2 P1
MAX P1 a
P1
2
2t (1 a b )
Firm 2s profit
1a b
P1 P2
MAX P2 b
P2
2
2t(1 a b )
From the first order conditions (first derivatives w.r.t prices), one can get the best
response functions:
P1
P2
t 1 a b 1 a b P2
2
2
t 1 b a 1 a b P1
2
2
P *1 t 1 a b 1
ba
P* 2 t 1 a b 1
Intuition:
Firms try to locate at the extremes so as to reduce price competition.
First stage: choice of the variety (locations a, b)
1a b
P * 2 P *1
*
MAX
P
a
1
Firm 1:
a
2
2t(1 a b )
P 2 b
Firm 2: MAX
b
1ab
P *1 P * 2
2
2t (1 a b )
1
t
ab
1
1 3a b 0
a
6
3
2
t
ba
1
1 3b a 0
b
6
3
12
Maximal differentiation
a
x1
x2
I want to emphasise the distinction between the demand effect and the strategic
effect. This comes about because where the firm chooses to locate (i.e. the value of a
chosen by firm 1) has two effects on its profits:
A direct (demand) effect the closer you are to your rival, the more of his
demand you can steal.
A strategic effect: the closer you get, the tougher is price competition between
the two firms.
Algebraically, this is:
d1/da = (p1* - c) { D1/a + D1/pB*. pB*/a }
direct
strategic effect
effect (+)
(-)
So theres a trade-off: the former effect makes firm 1 want to move closer to the
centre (this minimises the costs to consumers). But this will increase competition
with firm 2, and provoke a price reduction by firm 2, which thereby reduces demand
for firm 1. To avoid this latter (strategic) effect, firm 1 will want to move to the left.
Since it can be shown that the strategic effect dominates, we have:
INSIGHT 3
The two firms will locate at opposite ends of the line: MAXIMUM
DIFFERENTIATION
13
0
ii)
1-b
x1
a
x2
x1
1
1-b
x2
Which variety?
a
x1 = x2
0,5
1
14
x2
x1
0,5
1a
Firm 1 demand is: b
b 1
In the same vein, if a = 1 b > 0,5 both firms have an incentive to move leftwards.
Thus, in equilibrium:
a
x1 = x2 = 0,5
This allows us to analyse the possibility of entry and n>2. For this purpose, a circle
is better than a straight line5.
Because product space is now homogeneous no location is a priori better than any other.
15
Assumptions
Mostly similar to the linear city (in terms of transport costs, distribution of consumers
etc). Crucially, however, we now assume that:
1. there are fixed costs (of say product development and marketing)
2. free entry as many firms are allowed into the market as are profitable
1/(2N)
P1
1/(2N)
1
Stage I p =potential
entrants simultaneously choose
whether or not to enter (they
p
p2 = p
N
will be arranged equidistantly around the circle)
Stage II
1/N
XN
X2
Solution
Because firms are located symmetrically, we can look for an equilibrium where they
all charge the same price p.
n firms decide to enter, but each firm has only two competitors. If we define the
circumference of the circle as 1, then firms will be arrayed at intervals of 1/n.
Define the marginal consumer for firm i as located at distance x away. If he is to be
indifferent between firm is brand and the brand of its immediate competitor, it
follows that: pi + tx = p + t{(1/n)-x}
16
As before, this enables us to derive the demand curve for i: since demand for is
brand is 2x, solving for x from the above gives:
Di = 2x = {p + (t/n) pi}/t
Inserting this, in turn, into is profit function gives:
i = (pi c){p + (t/n) pi}/t - F
Maximising with respect to price gives:
p = c + t/n
Notice the similarity with the linear model, except that:
INSIGHT 5:
The number of firms (i.e. brands) will be higher the larger is t, and
the smaller are fixed costs
INSIGHT 7
Price will be higher the larger is t (as before), and the larger are
fixed costs. Discuss?
17
Or
Office products. Supermarket chain Staples (USA) in the 90 was trying to build a
critical mass of stores in the Northeast to shut out competitors
By Building these networks of stores in the big markets like New York and Boston
we have kept competitors out for a very, very long time, Staples CEO, 1996.
Banking sector: The main banks open too many branches.
Restaurants: Too many fast foods in town centres.
Model: Incumbent moves first and potential entrant afterwards. There is no price
competition (only choice of location). There are fixed (and sunk) costs equal to F.
A) If the incumbent manufactures one variety only it locates at the centre, to leave
to entrant the lowest possible market share (50%):
B)
|______________|_____________|
0
1
If the incumbent manufactures two varieties he chooses the following locations:
|_________|__________________|_________|
0
1
to leave the potential entrant with the lowest market share: .
Profits
In case a) i = p - F
and
e = p F
In case b) i = p - 2F and
e = p F
Without the entry menace, the incumbent would not introduce 2 varieties:
p F > p-2F
19
2)
Without the presence of sunk costs, the incumbent would not credibly threathen
to impede entry (Judd, 1985)
i (one variety) = p-F > i (two varieties) = p 2F
if p < F F > p
Exercise.
Market of size M=1; Price is exogenous and equal to 1; Fixed cost F=3/8
Two stage game: in the first stage the incumbent chooses how many and which
variety to introduce; in the second stage the entrant observes the incumbents
decisions and decides to enter or not.
1)
Chamberlin each firm faces a downward sloping demand curve (as in monopoly),
but there is free entry (as in perfect competition). No strategic effects, in that a price
change by any one firm has equal (negligible) effects on the demands for all other
firms. (Global competition, as opposed to the above local competition)
SEE APPENDIX FOR QUICK RESUME OF BASIC MODEL
Tiroles main-text comments (p.288) are addressed almost exclusively to questioning
the famous excess capacity result. This leads on to the question of whether or not the
20
market generates socially too few or too many firms (brands). In principle, there are
two opposing effects:
Non-appropriability of social surplus because each firm faces a downward
sloping demand curve, it sets p>MC and so the sum of consumer and producer
surplus is not maximised. In turn, this implies that some brands will not be
produced (because the firm cant cover its fixed cost) even although it should
be (because consumers would have received sufficient surplus to more than
offset that fixed cost, i.e. they could pay the firm to produce and still receive a
net surplus.)
Business stealing effects: each new brand steals custom away from existing
brands this loss of income for rivals is not taken into account by the entrant,
so the social cost > private cost.
In general, we cant say which effect will dominate.
22
23
markets where firms compete (via R&D and advertising) to increase consumers
willingness to pay.
Model 2 (Based on Shaked & Sutton)
There exist n firms each with a product of quality u k (labelled so that
u1>u2>>un) and a price pk
There exists a continuum of consumers with identical tastes but
different incomes t. t is uniformly distributed with density S (S=size
of the market) on a support [a,b], with a>0.
Consumers buy one unit of the good (the market is covered), and
have utility
U(t,k)=uk (t-pk)
The game
1. Firms decide on entry (fixed cost >0)
2. They decide on quality of the good
3. They decide prices and sell (zero marginal costs)
Proposition: If b<2a, only one firm will enter the industry at
equilibrium (whatever S)
(As income becomes less concentrated, more firms can enter; e.g.,
if 2a<b<4a, two firms will enter at equilibrium. Generally, the
number of firms which coexist
at equilibrium is finite even as S goes to infinity)
Proof of the proposition
We show that two firms cannot co-exist at equilibrium. Firms
demand is derived by finding the consumer indifferent between the
two qualities:
From: u1 (t-p1) u2 (t-p2), we obtain:
t t12 ( p1 , p 2 , u1 , u 2 )
u1 p1 u 2 p 2
u1 u 2
All consumers with income t t12 will buy 1, all others will buy 2.
Therefore:
q1 = b-t12 ; q2 = t12-a
24
u p u 2 p2
1 b 1 1
u1 u 2
p1
u1 p1 u 2 p2
a p2
u1 u 2
b(u1 u 2 ) u 2 p2
2u1
R2 : p1
a(u1 u 2 ) 2u 2 p2
u1
( 2b a )(u1 u 2 )
3u1
p2
(b 2a)(u1 u 2 )
3u 2
25
26
Generalisation
The finiteness property holds if the cost of producing a higher
quality does not fall upon variable costs. It holds across a number of
different specifications (see e.g., Shaked-Sutton, 1987)
Sutton
(1991):
Endogenous
Sunk
costs
and
market
structure: Advertising
Sutton (1991) puts the result to an empirical test. It shows that in
advertisingintensive industries as S increases the industry does not become
fragmented.
Advertising is an endogenous sunk cost:
- endogenous because, differently from set-up costs, is a
variable that can be chosen by the firm
- sunk, because, after having undertaken the investment, it
cannot be recovered
1/N
1/N
(i)
(ii)
(iii)
size
Endogenous sunk costs
size
Exogenous sunk costs
28
Perfect competition
one seller
many sellers
many buyers
many buyers
homogeneous product
price setter
price takers
no entry
free entry
Outcome
Price is higher, and quantity is lower under monopoly than under perfect competition
monopoly
perfect
competition
MR
Demand
Quantity
In common with monopoly, each firm produces its own differentiated product. Other firms
products are similar, but not identical. The individual firm therefore has its own downward
sloping demand curve.
In common with perfect competition, there are a large number of firms in the market as a
whole. There is also free exit and entry.
Outcomes:
The individual firm sets MR = MC (as in monopoly). In the short-run, this may imply
P>AC, in which case the firm makes a profit (as in monopoly).
However, this profit signal will attract the entry of new firms into the market. This
will impact negatively on the firms demand curve (the entrants will capture some of
the firms existing customers.) Diagrammatically, this shifts the demand curve (&
MR) inwards until the profits are dissipated. At that point, no further entry occurs 7.
The long-run zero profit outcome has been attained (as in perfect competition).
One big difference from perfect competition is that, in long-run equilibrium, firms are
not operating at the bottom of their AC curves. They are producing sub-optimally.
The famous excess capacity result.
In terms of welfare, there is a trade-off. Since P>MC, there is allocative inefficiency consumers pay more than the social costs of production. On the other hand, this
market structure provides the variety which is lacking under perfect competition.
30
Modern research in this area has looked at whether monopolistic competition provides
too much or too little product variety (compared to what would be provided by a
social planner who takes into account the utility that consumers derive from variety
per se.)
How does this match with real world industries in which products are differentiated?
31
MC
AC
profits
(short-run)
MR
Demand
Quantity
MC
AC
demand curve shifted
inwards by new entry.
Quantity
Squeezes
profits out
MR
32