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3 November 2008
1 Product differentiation
• Our analysis so far has restricted attention to industries offering a homogenous
product. The truth is that outside agriculture, very few industries sell truly
homogeneous products.
• The last observation is nothing but just the common sense perception that in
many markets, there can exist substantial difference in tastes among consumers.
In this case, there are often profitable opportunities for firms to differentiate
their products to find their own market niches, explaining the first observation.
Nonetheless, according to the second observation, there are forces that limit
the extent of product differentiation. There are cases where firms deliberately
choose to offer similar products. Relatedly, there are apparent market niches
left not exploited by the industry incumbents and by new entrants.
1
2 Differentiated product Bertrand oligopoly
• Consider a differentiated product duopoly. There are two firms, each selling
its own brand of the good To simplify, we assume that the marginal cost to
produce either brand is equal to the same c. The (inverse) demand curves are
of the two brands are respectively:
p1 = G − gq1 − γq2 ,
(1)
p2 = G − gq2 − γq1.
• In (1), for a given good, there is the usual negative relationship between price
and quantity. The novelty is that we also assume a negative relationship be-
tween the demand price of a brand and the quantity of the competing brand.
• The parameter g may be termed the own-price effect, which measures how the
price of a brand will vary in response to the quantity sold of the given brand.
• The parameter γ may be termed the cross-price effect, which measures how the
price of a brand will vary in response to the quantity sold of the competing
brand.
• It makes sense to assume g > γ, which is to say that the effect of increasing
q1 on p1 is stronger than the effect of increasing q2 on p1 . That is, the price of
a brand is more sensitive to a change in quantity of the given brand than to a
change in quantity of the competing brand.
• Note that when γ = 0, the demand of the two brands are completely indepen-
dent. In this case, each firm is a monopoly of its own brand, and the profit
maximizing price is simply equal to the monopoly price.
• In the other extreme case of g = γ, the two brands are perfect substitutes, and
the duopoly becomes a homogeneous product duopoly. To see this, note that
at g = γ, we have from (1)
p1 = G − g (q1 + q2 ) ,
p2 = G − g (q1 + q2 ) .
This means that the demand price of a given brand depends only on the sum
of the quantities of the two brands. Furthermore, with the right hand sides of
the two demand curves identical, we must also have p1 = p2 , and the so the
demand system collapses into
p = G − gQ,
where Q = q1 + q2.
2
• In general, the degree of product differentiation may be measured by γ, with
γ = 0 denoting maximum differentiation, and γ = g minimum differentiation.
• We should next solve for the NE of the industry, assuming that firms use prices
as strategies. To begin, the profit of firm 1 is
π 1 = (p1 − c) q1 . (2)
The firm chooses a p1 to maximize profit, while holding a fixed belief on its
competitor’s price p2 .
• In (2) , q1 depends on both p1 and p2 as governed by the demand system (1) .
Solving (1) for q1 :
G (g − γ) − gp1 + γp2
q1 = .
g2 − γ 2
Substitute the above into (2) :
G (g − γ) − gp1 + γp2
π 1 = (p1 − c) . (3)
g2 − γ 2
• What is the p1 that maximizes the firm’s profit? The profit function is maxi-
mized with respect to p1 when
∂π 1
= 0 ⇒ G (g − γ) + cg − 2gp1 + γp2 = 0.
∂p1
Solving for p1 :
g (G + c) − γ (G − p2 )
p1 = . (4)
2g
This is firm 1’s best response function, i.e. its profit-maximizing price as a
function of its belief on firm 2’s price p2 .
• We may similarly derive the best response function of firm 2:
g (G + c) − γ (G − p1 )
p2 = . (5)
2g
3
Figure 1: NE
• Alternatively the NE can also be recovered by solving the system (4) and (5)
simultaneously for p1 and p2 :
g (G + c) − Gγ
p1 = p2 = . (6)
2g − γ
Substituting the above back into the profit function in (3) :
(g − γ)2 (G − c)2 g
π 1 = π2 = . (7)
(2g − γ)2 (g 2 − γ 2 )
• When the demand of the two brands are completely independent of each other,
i.e. γ = 0, the equilibrium price and profit becomes the monopoly price and
monopoly profit respectively:
G+c
p1 = p2 = ,
2
(G − c)2
π1 = π2 = .
4g
• When the two brands are perfect substitutes, i.e. γ = g, the equilibrium price
falls to the marginal cost of production, and the equilibrium profits are down
to 0.
p1 = p2 = c,
π 1 = π 2 = 0.
4
When the two brands are perfect substitutes, the market degenerates into a
homogenous product Bertrand oligopoly, the equilibrium price of which is equal
to the marginal cost of production.
• Intuitively, the more similar the brands are, the more intense the price compe-
tition would become. When the products are nearly homogeneous, firms would
have to rely on price competition to attract consumers. In equilibrium, the
price will be lowered to nearly the marginal cost of production.