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IDE 7r

IDE 7r

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Published by Arina Farihan Azhar

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Published by: Arina Farihan Azhar on Dec 08, 2011
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CHAPTER 7: PRODUCT DIFFERENTIATION AND MONOPOLISTIC COMPETITION
1.
The chapter considers models with products that are homogeneous (perfect substitutes) or withlow-degree differentiation (good substitutes).2.The market structure is monopolistic competition in which firms can freely enter and exit
3.
The case of highly differentiated products with few substitutes is more interesting.4.Markets with highly differentiated markets are not monopolistically competitive. The high degreeof differentiation creates a (temporary) barrier to entry.DEFINITIONSProduct Differentiation: Related products that have varying characteristics so that consumers do notview them as perfect substitutes. Products are differentiated if there is some identical price for eachproduct in which some consumers are willing to purchase one product over another.Horizontal Differentiation: Differences between products that increase perceived benefit for someconsumers but decrease it for others.Vertical Differentiation: Distinction of a product that makes it better than the products of competitors.Differentiation Advantage: One of the major strategies to achieve competitive advantage (positiveeconomic profits). When pursuing a differentiation advantage, firms seek to offer a higher perceivedbenefit while maintaining costs that are comparable to competitors (consumer surplus and producersurplus increase and consequently welfare [= CS + PS] will increase).Value-created= Consumer Surplus + Producer Surplus= (B P) + (P C)=B Cwhere,B = perceived benefitP = priceC = costSuccessful competitive advantage increases value (B – C), allows consumers to capture some increasedvalue (B – P), [otherwise they do not purchase the product], and increases profit for the firm (P – C)[otherwise do not seek competitive advantage].Firms may not pursue competitive advantage (and therefore society loses some welfare) if the advantagecannot be sustained for some time period. Sustainable competitive advantage requires forces that limitthe extent to which the advantage can be duplicated or neutralized. Two groups of mechanisms:1.Impediments (barriers) to imitation2.Early-mover advantagesTrade-off: Product differentiation may increase welfare by increasing value (the good part), but to makeit sustainable requires some barriers to entry and worsens market structure (the bad part).
 
MODEL 1: Representative Consumer ModelIn this model the consumers are alike and view all products as equally good substitutes. Withmonopolistic competition there is free entry.Case 1: Undifferentiated ProductsEach of the n firms shares the market demand equally and gets (1/n) share of the demand. The numberof firms, n, is determined by making n just large enough to yield zero economic profits.Results:1. Lower FC increases the number of firms, increases market output and lowers market price.2.P > MC (allocative inefficiency) – too little total output. Efficiency, in a sense, improves as morefirms enter.3.Number of firms is excessive when MC are nonincreasing (natural monopoly case)4.Better result than the Cournot oligopoly model with barriers to entryCase 2: Differentiated ProductsThe essence of the model remains the same as the undifferentiated case. However, each firm faces a moresteeply downward sloping demand curve. (reflects a higher CS from the differentiation)Results:1.P > MC (allocative inefficiency) – too little total output.2.Variety (number of brands) may not be optimal.3.May be too little variety (brands)
FC are too high and firms lose money (p < AC)
Firm creates value (increases welfare) but is unable to capture sufficient CS to make aprofit – does not produce
Need impediments to imitation so that firms can charge a higher price to cover AC – orprovide a “prize” to innovators for their discoveries leading to differentiation4.May be too many brands
With free entry firms enter until profit is exhausted
Firms entering have a negative external effect on other firms profit (PS)
Welfare may decrease with too many brands
CS increases are smaller that PS decreases
Also have additional FC with each new brand5.As before price is too high (p > MC)Inference:Differentiation may require barriers to imitation to be welfare enhancing.
 
Hotelling’s Location (Spatial) ModelThis model is an example of horizontal differentiation. It can be extended to other forms of differentiation along a (linear) dimension.Consider the case of two firms deciding where to locate on a street with uniformly distributed consumers.You could think of this as a zero-sum game.Consider the Sales from two Ice Cream trucks.Other Truck Beginning Middle EndWaldmanBeginning50, 5025, 7550, 50LocationMiddle75, 2550, 5075, 25End 50, 50 25, 75 50, 501
st
number is Waldman payoff, 2
nd
number is other truck payoff Or characterized asOther Truck Beginning Middle EndWaldmanBeginning0 -25 0LocationMiddle25 0 25End 0 -25 0Number is change in Waldman share. Negative of number is change in other truck shareThis is a dominant strategy equilibrium game, with each player choosing the action that is the bestresponse against any action the other might take.Look for dominant strategies in the game above.Other Truck Beginning Middle EndWaldmanBeginning50, 5025, 7550, 50LocationMiddle75, 2550, 5075, 25End 50, 50 25, 75 50, 50The dominant strategy for each player in this zero sum game is to locate the truck in the middle.The two firms will cluster together in the middle (no spatial differentiation), when there is no cost tolocating. This is the Bertrand equilibrium with homogenous products.Alternatively, if the stores are located apart with costly relocation, we get the Bertrand equilibrium withdifferentiated products.1.P > MC2.Differentiation softens the price competition3.Differentiation gives firms market power

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