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# Outline

Salop Circle

## Hotelling and Salop Models

Zhenyu Lai
Ec1642 (Adv. Industrial Organization) - Section 3

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Outline

Salop Circle

Section Outline

## Today we will solve the following two problems:

1. Hotelling Model with Entry Decision
2. Salop Circle with Endogenous Entry
Solution Concepts to understand:
1. Demand as determined by threshold type
2. Backwards induction
Math is your friend!
Focus on how to interpret math expressions.

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Outline

Salop Circle

## Hotelling Model with Entry Decision

Reference: Tirole, The Theory of Industrial Organization, p. 279-282

## Unit mass of consumers located on linear city of unit length.

With quadratic travel costs, consumer purchase utility is

v t 2 p
Two Stage Game (how is this different from class?)
Stage 1: Two firms enter, simultaneously locate at a and b.
Stage 2: Both firms simultaneously choose prices pa and pb

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Outline

Salop Circle

## Use backwards induction, consider second period.

Given a and b, what is firm 1 and 2s demand?
Threshold type: Solve for indifferent consumer at x

Indifference condition:

v (x a)2 p1 = v (1 b x )2 p2
Solve for threshold x at which consumer is indifferent

x=

1+ab
p2 p1
+
2
2 (1 a b )
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Outline

Salop Circle

## Solving for indifferent consumer...

Details of derivation

Indifference condition:
v (x a)2 p1 = v (1 b x )2 p2
x 2 + a2 2xa + p1 = x 2 + (1 b )2 2x (1 b ) + p2


2x (1 a b ) = (1 b )2 a2 + p2 p1
p2 p1
(1 b )2 a2
Threshold x =
+
2 (1 a b )
2 (1 a b )
p2 p1
(1 a b ) (1 + a b )
=
+
2 (1 a b )
2 (1 a b )
1+ab
p2 p1
=
+
2
2 (1 a b )
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Salop Circle

## ...yields Stage 2 demand

Given locations a and b, indifference threshold yields demand

1ab
p2 p1
+
2
2 (1 a b )
p1 p2
1ab
+
D 2 ( p1 , p2 ) = 1 x = b +
2
2 (1 a b )

D 1 ( p1 , p2 ) = x = a +

## Interpreting demand equations:

D1 (p1 , p2 ) = x =

a
+
|{z}

Everything
to left

1a b
2

| {z }

between a and b

p2 p1
2 (1 a b )
|
{z
}

## Gains from price competition

Equals 0 if p1 =p2

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Outline

Salop Circle

## Solve for Stage 2 equilibrium

Recall that firms choose price in Stage 2
Firms maximize profits. Consider firm 1:

p1


1ab
p2 p1
1
a+
+
(p1 c )
=0
2
2 (1 a b )
2 (1 a b )

## Policy functions for firm 1s optimal pricing

(1 a b )2 p2 + c
+
(p2 ; a, b ) = a (1 a b ) +
2
2
By symmetry,
P1

P2 (p1 ; a, b ) = b (1 a b ) +

(1 a b )2 p1 + c
+
2
2
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Salop Circle

## Interpreting equilibrium pricing

Solving system of equations, equilibrium prices are

p1
p2


ab
= c + (1 a b ) 1 +
3


ba
= c + (1 a b ) 1 +
3


Comparative statics
1. Less price competition when products are less substitutable


p1
ab
= (1 a b ) 1 +
>0

3
2. For given location a, movement of firm 2 towards the center
will decrease the price charged by firm 1.
 




p1
= 1 + a3 b 1a3b = 43 + 2b
<0
3
b
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Salop Circle

## Solve first stage for location choice

Intermediate microeconomics refresher

## of the second stage game

Consider firm 1. Profit function (given locations a and b) is

## 1 (p1 , p2 , a, b ) = (p1 c ) D1 (p1 , p2 , a, b )

By implicit function theorem,

## 1 (a, b ) = {p1 (a, b ) c } D1 (p1 (a, b ) , p2 (a, b ) , a, b )

First order condition


d 1
D1
1
= D1 dp
+
p

(
)
1
da
a +
da

D1 dp1
p1 da

D2 dp2
p2 da

=0

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Salop Circle

## Application of the envelope theorem

Intermediate microeconomics refresher

1
Recall in stage 2, firm 1 maximizes wrt price, so
p1 = 0
By the envelope theorem,


d 1
1
= (p1 c ) D
a +
da

D2 dp2
p2 da

h
1
+ dp

D1 + (p1 c )
da
|
{z

= p 1
1

D1
p1

i
}

which is 0

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Salop Circle

## How does changing location affect profits?

A change in a has a direct effect and an indirect effect

d 1
D1
D2 dp2
)
= (p1 c ) (
+
da
a
p da
|{z}
| 2{z }
Demand
effect

Strategic
effect

D1
a

1
2

p2 p1
2 (1a b )2

35ab
6(1a b )

>0


h 
i
D2 dp2
1
4 + 2a
=

= 3(12a+ab ) < 0
3
3
p2 da
2 (1a b )

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Salop Circle

## Interpreting Stage 1 result

How will choosing location impact profits?

## Negative strategic effect dominates positive demand effect.

d 1
<0
da
What is the intuition? Does more demand more profit?
What is the difference between holding prices fixed, and

## considering the competitors strategic response for pricing?

Where will firms choose to locate?

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Salop Circle

## Interpreting Stage 1 result

How will firms choose location?

## Both firms locate at extreme pts. Max product differentiation.

a=b=0
Social planner minimizes average transport cost.

a=b=

1
4

## Thus, product differentiation inefficiently high.

1. Welfare gains from lower transport cost not captured by firm.
2. Notice any welfare gains from lower prices hurts firm, but not
captured by social planner (because consumption is fixed).

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Salop Circle

## Salop Circle with Endogenous Entry

Reference: Tirole, The Theory of Industrial Organization, p. 282-285

## Recall the Hotelling linear city model. Now, circular city.

Think of a tropical island with a mountain in the middle.

## Suppose there are n identical ice-cream stands

Unit mass of consumers distributed evenly on beach
Consumers have linear travel costs, t
Market is covered (every consumer buys ice cream)
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Salop Circle

## Salop considers a two-stage game:

Stage 1: Firms choose whether or not to enter
Stage 2: Firms compete on price given location

## choose location but are located equidistant from each other.

Q1: When will a firm enter?
Q2: What is the equilibrium price charged by entrants?

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Salop Circle

## Backwards Induction: Solve 2nd Stage First

Given firms locate symmetrically, what is equilibrium price?
Use indifference condition
Suppose neighbor chooses p, and firm i chooses pi


0, n1 from firm i is
indifferent between firm i and closest neighbor if


1
pi + tx = p + t
x
n

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Salop Circle

## What price will entrants set?

Firm i obtains demand from both sides

Di (pi , p ) = 2x =

p + t/n pi
t

## To find equilibrium, set up optimization problem

Firm i maximizes profit





p + t/n pi
max (pi c )
f
p
t
i

p=c+

t
n

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Salop Circle

## Stage 1: When will firms enter?

Firms will enter when profits are positive.
Profits for each firm is

t  1
f
n n

Thus number of firms when profits are zero (with free entry)

n=

t/f

## What happens to number of firms when fixed costs increase?

What happens to the profit margin p c when fixed costs

## increase? How about when fixed costs tend to zero?

Is this the optimal n from a Social Planners perspective?

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Salop Circle

## Social Planners take on Circular City

Social planner would want to minimize sum of the firms fixed

## costs and consumers transportation costs.

Price doesnt matter: Just a transfer from consumers to firms.

## Social Planners objective function:

min nf + t 2n
n

Z 1/2n


xdx

Integrating, we get
min (nf + t/4n )
n

## The solution here is nSP = 21 ft =

Too many firms enter in the market

1
2 n.

equilibrium. Intuition?
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