4.2.hotelling Model PDF

4.2.
Hotelling Model
Matilde Machado
Industrial Organization- Matilde Machado
The Hotelling Model
4.2. Hotelling Model

The model:
1.
2.
3.
4.
5.
6.
Linear city is the interval [0,1]

Consumers are distributed uniformely along this interval.
There are 2 firms, located at each extreme who sell the
same good. The unique difference among firms is their
location.
c= cost of 1 unit of the good
t= transportation cost by unit of distance squared. This
cost is up to the consumer to pay. If a consumer is at a
distance d to one of the sellers, its transportation cost is
td2 . This cost represents the value of time, gasoline, or
adaptation to a product, etc.
Consumers have unit demands, they buy at most one
unit of the good {0,1}
The Hotelling Model

Graphically
Mass of
consumers =
1
1dz = z
1
0
= 1 0 = 1
Location of firm B
Location of firm A
The Hotelling Model

The transportation costs of consumer x:

Of buying from seller A are tx 2
2

Of buying from seller B are t (1 x )
s gross consumer surplus - (i.e. its maximum

willingness to pay for the good)
Lets assume s is sufficiently large for all
consumers to be willing to buy (this situation is
referred to as the market is covered). The
utility of each consumer is given by:
U = s-p-td2 where p is the price paid.
The Hotelling Model

We first take the locations of the sellers as given
(afterwards we are going to determine them
endogenously) and assume firms compete in
prices.
1. Derive the demand curves for each of the sellers
2. The price optimization problem given the

demands
The Hotelling Model

In order to derive the demands we need to derive
the consumer x that is just indifferent between
buying from A or from B:
x is defined as the location where U x ( A) = U x ( B)
s p A tx2 = s pB t (1 x) 2
p A + tx2 = pB + t (1 x) 2
p A + tx2 = pB + t + tx2 2tx
2tx = pB p A + t
Buy from A
p pA + t
x = B
2t
Buy from B
If (pB=pA) then the indifferent consumer is at half the distance between A and B. If
(pB-pA) the indifferent consumers moves to the right, that is the demand for firm A
increases and the demand for firm B decreases.
The Hotelling Model

s
Ui
Total cost to
consumer x: pA+tx2
pB+t(1-x)2
pA
pB
0
B
The equilibrium of the Hotelling model
The Hotelling Model

We say the market is covered if all consumers buy.
Since the consumer with the lowest utility is the
indifferent consumer (because it is the one who
is further away from any of the sellers), we may
say that the market is covered if the indifferent
consumer buys i.e. if:
p pA + t
s pA t B
0
2t
This condition is equivalent to say that s has to be

high enough
The Hotelling Model

Once we know the indifferent consumer, we may
define the demand functions of A and B.
x
DA ( p A , pB ) = 1dz = z 0 = x =
x
pB p A + t p B p A 1
=
+
2t
2t
2
1
p p A 1 p A pB 1
DB ( p A , pB ) = 1dz = z x = 1 x = 1 B
+ =
+
2 2t
2
2t
x
1
Demand of firm A depends positively on the difference (pB-pA) and

negatively on the transportation costs. If firms set the same prices
pB=pA then transportation costs do not matter as long as the
market is covered, firms split the market equally (and the indifferent
consumer is located in the middle of the interval ).
The Hotelling Model

The maximization problem of firm A is:
Max A ( p A , pB ) = ( p A c ) DA ( p A , pB ) = ( p A c )
pA
FOC:
pB p A + t
2t
A
p pA + t 1
=0 B
( pA c ) = 0
p A
2t
2t
pB 2 p A + t + c = 0 p A =
pB + t + c
2
Firm As
reaction
curve
Because the problem is symmetric pA=pB=p*

p* =
p* + t + c
p* t + c
=
p* = t + c
2
2
2
The Hotelling Model
Note that if t=0 (no

product
differentiation) we
go back to Bertrand
p*=c; *=0
10

Once the equilibrium prices are determined, we may
determine the other equilibrium quantities:
1
(the indifferent consumer is in the middle because prices are equal)
2
1
DA ( p*A , pB* ) = x* =
2
1
*
*
*
DB ( p A , pB ) = 1 x = = DA ( p*A , p*B )
2
t
*
A*
B*
= = ( p c ) DA* = ( t + c c ) x* =
2
x* =
Note: The higher is t , the more differentiated are the goods from the point of
view of the consumers, the highest is the market power (the closest consumers
are more captive since it is more expensive to turn to the competition) which
allows the firms to increase prices and therefore profits. When t=0 (no
differentiation) we go back to Bertrand
The Hotelling Model
11

Observations:
Each firm serves half the market D*A=D*B=1/2
The Bertrand paradox disapears (note that firms
compete in prices) pA=pB>c
An increase in t implies more product
differentiation. Therefore, firms compete less
vigorously (set higher prices) and obtain higher
profits.
t=0 back to Bertrand
The Hotelling Model
12

s
Ui
pA+tx2
pB+t(1-x)2
pA=t+c
pB=t+c
The equilibrium of the Hotelling model

The Hotelling Model
13

How do prices change if the locations of A and B
change?
If A=0 and B=1 there is maximum differentiation
Si A=B, there is no differentiation, all consumers
will buy from the seller with the lowest price,
back to Bertrand,
pA=pB=c y A=B=0.
The Hotelling Model
14

General Case Endogenous locations:
2 periods:
In the first period, firms choose location
In the second period firms compete in prices given their
locations
We solve the game backwards, starting from the

second period.
The Hotelling Model
15

Second period:
Denote by a [0,1] the location of A
Denote by (1-b) [0,1] the location of B
Note: Maximum differentiation is obtained with a=0;
and 1-b=1 (i.e. b=0)
Minimum differentiation (perfect substitutes)
is obtained with a=1-b a+b=1
The Hotelling Model
16

1. The indifferent consumer:
U x ( A) = U x ( B )
p A + t ( x a )2 = pB + t ( x (1 b))2
= pB + tx2 + t (1 b) 2 2tx(1 b)
p A + tx2 + ta 2 2txa
2tx (1 b a ) = pB p A + t (1 b)2 ta 2
x =
x =
x =
2
2
pB p A + t (1 b) 2 ta 2 pB p A + t ( (1 b) a )
=
2t (1 b a )
2t (1 b a )
(1 b a )(1 b + a )
pB p A
+
2t (1 b a )
2 (1 b a )
(1 b + a ) = pB p A + (1 b a ) + a
pB p A
+
2t (1 b a )
2
2t (1 b a )
2
Hence if pA=pB, As demand is a+(1-b-a)/2

17
The Hotelling Model

Demands are:
DA ( p A , pB ) = x =
(1 b a ) + a
pB p A
+
2t (1 b a )
2
DB ( p A , pB ) = 1 x = 1
=
(1 b a ) a
pB p A
2t (1 b a )
2
p A pB
1 b a
+
+b
2t (1 b a )
2
(1-b-a)/2
1-b
The Hotelling Model
1
18

Interpretation of the demand functions:
if p A = pB
DA ( p A , p B ) =
captive consumers
to the left (own
backyard)
DB ( p A , pB ) =
half of the consumers

between a and 1-b
DA ( p A , p B ) = a +
2

half of the consumers
between a and 1-b
1 b a
2

if p A pB
(1 b a )
a
b
captive consumers
to the right (own
backyard)
(1 b a ) +
2
pB p A
2t (1 b a )

sensitivity of the demand
to price difference
19
The Hotelling Model

Graphically
pA+t(x-a)2
pA
pB
Firm As
captive market
1-b
1
Firm Bs
captive market
The Hotelling Model
20
10

2. Finding the reaction functions
(1 b a ) +
Max A = ( p A c ) DA ( p A , pB ) = ( p A c ) a +
p
2
pB p A
2t (1 b a)
(1 b a ) + pB p A + p c
1
=0 a+
( A )
=0
p A
2
2t (1 b a )
2t (1 b a )
A
FOC:
2 pA
(1 b a ) + pB + c
=a+
2t (1 b a)
2
2t (1 b a )
(1 b a ) + pB + c
pA
=a+
2
2t (1 b a)
t (1 b a )
t (1 b a )
p +c
+ B
2
2
2
p A = at (1 b a ) +
Firm As reaction
function
The Hotelling Model
21

2. Finding the reaction functions
(1 b a ) + pA pB
Max B = ( pB c ) DB ( p A , pB ) = ( pB c ) b +
pB
2
2t (1 b a )
B
FOC:
=0
pB
b+
(1 b a ) +
p A pB
1
+ ( pB c )
=0
2t (1 b a )
2t (1 b a)
b+
(1 b a ) +
p A 2 pB + c
=0
2t (1 b a)
2
2
The Hotelling Model
22
11

2. 2. Finding the reaction functions
b+
(1 b a ) +
2
2 pB + c
1
1 b a
pB + c
+ a +
+
=0
2t (1 b a ) 2
2
2t (1 b a )
(1 b a ) + 1 a + 1 b a = 0
3 pB + 3c
+b+
4t (1 b a )
2
2
4
3 pB
3c
b 3 a
=
+ +
4t (1 b a ) 4t (1 b a ) 4 4 4
t ( 3 + b a ) (1 b a )
3
ba
ab
= c + t (1 b a ) 1 +
y p A = c + t (1 b a ) 1 +
3
3
pB = c +
The Hotelling Model
23

2. 2. Finding the reaction functions
ba
ab
*
p*B (a, b) = c + t (1 b a ) 1 +
and p A (a, b) = c + t (1 b a ) 1 +
3
3
Note that prices are maximum when differentiation is

maximum (a=b=0; pA=pB=c+t) and minimum
when there is no differentiation (a+b=1 (same
location) and pA=pB=c)
The Hotelling Model
24
12

3. 1st period, simultaneous choice of a and b
Profits are functions of (a, b) alone:
A ( a, b) = ( p*A (a, b) c ) DA (a, b, p*A (a, b), pB* (a, b))

B ( a, b) = ( pB* (a, b) c ) DB (a, b, p*A (a, b), pB* (a, b))
*
A
*
B
*
A
*
B
Replacep (a, b), p (a, b), D (a, b), D (a, b) and we get a function of a and b
alone. Take the FOC as always with respect to a and b.
The Hotelling Model
25

*
*
1 b a
a b pB p A
A ( a, b) = c + t (1 a b ) 1 +
c
+
+ a

3 2t (1 a b)
2
ba
but pB* p*A = 2t (1 a b)
3
which simplifies:
(3 b + a )
a b b a 1 b + a
A ( a, b) = t (1 a b ) 1 +
+
=
t
1
b
(
)
3 3
2
18

3 b + a
3+ a b
The Hotelling Model
26
13

Max (a, b) = t (1 a b )
A
(3 b + a )
18
(3 b + a ) + t 1 a b 2 (3 b + a )
A ( a, b)
= t
(
)
a
18
18
t
= ( 3 b + a )(1 + b + 3a ) < 0 a* = 0
18
2
FOC:
The Hotelling Model
27

Max ( a, b) = t (1 a b )
B
18
(3 + b a ) + t 1 a b 2 (3 + b a )
( a, b)
= t
(
)
b
18
18
t
= ( 3 + b a )(1 + 3b + a ) < 0 b* = 0 1 b* = 1
18
B
FOC:
(3 + b a )
The Hotelling Model
28
14

Conclusion: Firms choose to be in the
extremes i.e. they choose maximum
differentiation.
For firm A, for example, an increase in a (movement
to the right):
Has a positive effect because it moves towards
where the demand is (demand effect)
Has a negative effect (competition effect)
If transportation costs are quadratic, the
competition effect is stronger than the demand
effectand firms prefer maximum differentiation.
The Hotelling Model
29

The social optimum solution is the one
that minimizes costs (or maximizes
utility) and it would be a=1/4 and 1b=3/4. Therefore, from a social point
of view the market solution leads to
too much differentiation.
The Hotelling Model
30
15

The social planners problem is:
Surplus of consumer x is:

s-t(x-a)2-pA if he buys from A
s-t(x-(1-b))2-pB if he buys from B
For each consumer, the sellers profit is

pA-c firm A
pB-c firm B
Prices are therefore pure transfers between consumers and sellers

(note that here it is important the assumption that the market is
covered that is that s is sufficiently high), the total surplus
associated with a given consumer x is:
s-t(x-a)2-pA+pA-c= s-t(x-a)2-c if he buys from A
s-t(x-(1-b))2-pB+pB-c= s-t(x-(1-b))2-c if he buys from B
The Hotelling Model
31

To derive the social optimum we must first derive
the indifferent consumer :
s t ( x a ) 2 c = s t ( x (1 b))2 c
( x a )2 = ( x (1 b)) 2
x2 + a 2 2ax = x 2 + (1 b) 2 2(1 b) x
a 2 2ax = (1 b)2 2(1 b) x
2 x [1 b a ] = (1 b) 2 a 2
x =
(1 b a )(1 b + a ) (1 b + a )
=
= half the distance bweteen a and 1-b
2 (1 b a )
2
The Hotelling Model
32
16

The planner has to max total surplus which is
the same as minimize transportation costs
x =
1 b + a
2
1 b
Min t ( a z ) 2 dz + t ( z a ) 2 dz + t ((1 b) z ) 2 dz + t ( z (1 b)) 2 dz

a ,b
0
a
1 b

x=1b2+ a
buy from A

buy from B
1-b
1
33
The Hotelling Model

a
x=
1b + a
2
1 b
Min t (a z ) 2 dz + t ( z a )2 dz + t ((1 b) z )2 dz + t ( z (1 b)) 2 dz

a ,b
0
a
1 b

x=1b2+ a
buy from A

buy from B
a
( a z )3
( z a)
Min
+
a ,b
3 0
3
1 b + a
3
2
(1 b z )3
1 b
1 b + a
2
1
( z (1 b))3
+
3
1 b
a 3 1 1 b a 3 1 1 b a 3 b 3
Min +
+
+
a ,b
2 3 2
3
3 3
The Hotelling Model
34
17

a 3 1 1 b a 3 1 1 b a 3 b3
Min +
+
+
a ,b
2 3 2
3
3 3
The FOC:
2
a = 0 4a (1 b a ) = 0 (A)
= 0 4b 2 (1 b a )2 = 0 (B)
b
(A)-(B):
4a 2 4b 2 = 0 a 2 = b 2 a = b
replacing in (A) implies that:
1
3
2
4a 2 (1 a a ) = 0 a* = ;(1 b* ) =
4
4
The Hotelling Model
35

The basic conclusion of the Hotelling model is the principle
of differentiation: firms want to differentiate as much as
possible in order to soften the price competition.
It may happen that some forces will lead firms to locate in
the same location, usually the center (minimum
differentiation):
1) Firms may want to locate where demand is (i.e. in the
center)
2) In the case of no price competition (for example if prices
are regulated) firms may want to locate in the center
and split the market 50-50.
The Hotelling Model
36
18

4.2.hotelling Model PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

4.2.hotelling Model PDF

Uploaded by

Copyright:

Available Formats

4.2.

Industrial Organization- Matilde Machado

The Hotelling Model