Outline
Hotelling Model with Entry
Salop Circle
Hotelling and Salop Models
Zhenyu Lai
Ec1642 (Adv. Industrial Organization)  Section 3
September 19, 2012
1 / 19
Outline
Hotelling Model with Entry
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.
2 / 19
Outline
Hotelling Model with Entry
Salop Circle
Hotelling Model with Entry Decision
Reference: Tirole, The Theory of Industrial Organization, p. 279282
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
Where will firms locate?
3 / 19
Outline
Hotelling Model with Entry
Salop Circle
Stage 2: Solve Consumer Demand
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 )
4 / 19
Outline
Hotelling Model with Entry
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 )
5 / 19
Outline
Hotelling Model with Entry
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 }
Half the distance
between a and b
p2 p1
2 (1 a b )

{z
}
Gains from price competition
Equals 0 if p1 =p2
Higher consumers more sensitive to differentiated product
take less demand from other firm by lowering price
6 / 19
Outline
Hotelling Model with Entry
Salop Circle
Solve for Stage 2 equilibrium
Recall that firms choose price in Stage 2
Firms maximize profits. Consider firm 1:
max (p1 c ) D1 (p1 , p2 )
p1
First order condition:
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
7 / 19
Outline
Hotelling Model with Entry
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
8 / 19
Outline
Hotelling Model with Entry
Salop Circle
Solve first stage for location choice
Intermediate microeconomics refresher
In Stage 1, firms choose location a and b knowing the result
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
9 / 19
Outline
Hotelling Model with Entry
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
10 / 19
Outline
Hotelling Model with Entry
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
1. Direct effect (+ if a, b 12 ): moving a closer to b steals business
D1
a
1
2
p2 p1
2 (1a b )2
35ab
6(1a b )
>0
2. Strategic effect (): but causes firm 2 to price more aggressively
h
i
D2 dp2
1
4 + 2a
=
= 3(12a+ab ) < 0
3
3
p2 da
2 (1a b )
11 / 19
Outline
Hotelling Model with Entry
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?
12 / 19
Outline
Hotelling Model with Entry
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).
13 / 19
Outline
Hotelling Model with Entry
Salop Circle
Salop Circle with Endogenous Entry
Reference: Tirole, The Theory of Industrial Organization, p. 282285
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 icecream stands
Unit mass of consumers distributed evenly on beach
Consumers have linear travel costs, t
Market is covered (every consumer buys ice cream)
14 / 19
Outline
Hotelling Model with Entry
Salop Circle
Solving equilibrium for Circular City
Salop considers a twostage game:
Stage 1: Firms choose whether or not to enter
Stage 2: Firms compete on price given location
Note: Salop assumes that when firms enter, they do not
choose location but are located equidistant from each other.
Q1: When will a firm enter?
Q2: What is the equilibrium price charged by entrants?
15 / 19
Outline
Hotelling Model with Entry
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
Consumer located at distance x
This is the indifference condition.
16 / 19
Outline
Hotelling Model with Entry
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
First order condition: Differentiate wrt pi , and set pi = p
(since firms are symmetric)
p=c+
t
n
Note that profit margin (p c ) decreases with n
17 / 19
Outline
Hotelling Model with Entry
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?
18 / 19
Outline
Hotelling Model with Entry
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?
19 / 19