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10 November 2008

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Number of brands

• Our previous analysis on product diﬀerentiation is based on the assumption that the number of brands is ﬁxed at two. Then we ask how what forces would drive ﬁrms to locate their brands close together, and what forces would drive ﬁrms to locate their brands apart from each other along the product characteristic spectrum. • The analysis misses an important dimension to product diﬀerentiation, namely, how the number of brands get determined in the ﬁrst place. • When there are more brands available, there will be more product varieties, other things equal. The number of brands that get introduced is an equally important determinant of the extent of product diﬀerentiation as how ﬁrms choose to diﬀerentiate their brands from each others’

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**The basic theory of monopolistic competition
**

• The issue is best analyzed with the model of monopolistic competition developed by Avinsh Dixit of Princeton University and Nobel Prize winner Joseph Stiglitz of Columbia University. • There are n ﬁrms, each producing a distinct brand, which we index by i = 1, 2, 3, ..., n. • Previously in the locational models, we assume consumers’ tastes are heterogeneous, and that each consumer will only purchase one brand among possibly many. The Dixit-Stiglitz model, on the other hand, assumes that consumers’ tastes are homogeneous, and that each consumer will purchase all possible brands available for sale.

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Figure 1: A love—for—variety preference • The reason that they do demand all possible brands is that the preference of the consumer is assumed to exhibit a love for variety. That is, a given consumer would prefer to allocate her budget between two brands over allocating the budget over just one brand, and then prefer three brands over two brands, so on and so forth. For example, she would choose spending her clothing budget on a red T-shirt, a pink dress, a blue jean, and a purple shirt over spending the entire budget on four purple shirts. • The assumption is arguably not too far oﬀ from actual observed behaviours. After all, variety is the spice of life. Indeed, the love—for—variety assumption is basic in the indiﬀerence curve analysis we were taught in microeconomic theory class. • In ﬁgure 1, the consumer always attains a higher level of utility by spreading her budget over both X1 and X2 than spending the entire budget on either X1 or X2 . It is easy to see that the conclusion follows so long as the indiﬀerence curves are convex, as is customarily assumed. • Speciﬁcally, Dixit and Stiglitz assume that the utility function of the consumer is given by u (x1 , x2 , ..., xn ) , where xi is the quantity of brand i the consumer purchases. Each consumer has an income equal to y to allocate among the consumption of the n brands. The budget constraint is p1 x1 + p2 x2 + ... + pn xn = y. 2

The consumer chooses {x1 , x2 , ..., xn } to maximize utility u (x1 , x2 , ..., xn ) subject to the above budget constraint. • The utility maximization yields the usual (Marshallian) demand curves of each brand: x1 = D1 (p1 ; p2 , p3 , p4 , ..., pn , y) , x2 = D2 (p2 ; p1 , p3 , p4, ..., pn , y) , . . . xn = Dn (pn, p1 , p2 , ..., pn−1 , pn , y) • We assume that 1. The demand curves are downward sloping, i.e. as pi increases, Di declines, i = 1, ..., n. 2. The brands are substitutes, i.e. for j 6= i, as pj increases, Di goes up.1 • The market is monopolistic in the sense that each ﬁrm faces a downward sloping demand curve. That is, a ﬁrm will not lose all sales when charging a price higher than the price charged by others. The worse that can happen is that the quantity demand will go down. If the brands are not diﬀerentiated and in a world of perfect information, the demand curve facing any single ﬁrm would be perfectly elastic in that a ﬁrm will lose all sales when it attempts to charge a price above that charged by others. Now that the brands are diﬀerentiated and are only imperfect substitutes of each other, consumers will not give up on the given brand altogether even if it costs more than other brands. • The market, however, is not pure monopoly since, though imperfect, there are substitution possibilities. Each brand is supposedly competing with a large number of brands, which limits the ﬁrm’s ability to charge high prices. • We shall analyze a NE in prices. Consider the pricing decision of ﬁrm 1. Holding a ﬁxed belief on the pricing decisions of all others at some {p∗ , p∗ , ..., p∗ }, ﬁrm 2 3 n 1 chooses the price to charge to maximize proﬁt: max {p1 − c} D1 (p1 ; p∗ , p∗ , ..., p∗ , y) . 2 3 n Call the proﬁt-maximizing price p∗ . Figure 2 illustrates that p∗ is determined 1 1 in the usual procedure of setting the marginal revenue equal to the marginal cost.

1

(1)

If the brands are complements, Di declines as pj increases.

3

Figure 2: Proﬁt maximization • In equilibrium, the n prices {p∗ , p∗ , ..., p∗ } maximize the proﬁt of each ﬁrm 1 2 n i = 1, ..., n, i.e. for any other pi : (p∗ − c) Di p∗ ; p∗ , p∗ , ..., p∗ , p∗ , ..., p∗ ≥ i i 1 2 i−1 i+1 n

³ ´ ³ ´

(pi − c) Di pi ; p∗ , p∗ , ..., p∗ , p∗ , ..., p∗ . 1 2 i−1 i+1 n • In equilibrium, each ﬁrm earns a gross proﬁt π gross (n) = (p∗ − c) q ∗ .

• We write the gross proﬁt as a function of the number of brands. Why should there exist such a dependence? When there are more brands competing for the ﬁxed budget of the consumers, the consumers may then only allocate a smaller fraction of their ﬁxed budgets on the purchase of each good. Speciﬁcally, the demand curve of each brand should shift in as the number of brands goes up, resulting in lower prices, sales, and proﬁts. • If there is some ﬁxed cost of entry equal to F , the net proﬁt is π net (n) = π gross (n) − F, which will be driven down to zero in equilibrium if there is free entry. The next diagram shows that equilibrium entry ne occurs at the intersection of the ﬁrm’s gross proﬁt and the ﬁxed cost of entry. 4

Figure 3: Falling demand when n increases

Figure 4: Free—entry equilibrium

5

Figure 5: Proﬁt and surplus

3

**Eﬃcient product variety
**

• Is the equilibrium product variety, as given by ne in ﬁg.4, eﬃcient? In other words, are there too many or too few brands get introduced in the free market? To answer the question, we ask whether the private beneﬁt the ﬁrm enjoys from introducing a new brand is below, above, or just equal to the social beneﬁt — the beneﬁts that accrue to ﬁrms and consumers altogether. • In ﬁg.5, we assume that the monopolistically competitive ﬁrm’s proﬁt maximization occurs at some (pm , Qm ) pair, where the ﬁrm’s marginal revenue is equal to the constant marginal cost c. • The ﬁrm’s gross proﬁt is equal to the area B. As we argued in the previous section, when more brands get introduced, the demand curve of each shifts in due to the greater competition for the consumers’ ﬁxed budgets. The ﬁrm’s proﬁt-maximizing price, as well as the gross proﬁt, is lowered in the process. Entry would continue until the ﬁrm’s gross proﬁt is no greater than the ﬁxed cost of entry F that may be thought of as the investment necessary to introduce the new brand, as shown in ﬁg.4. In terms of ﬁg.5, we have in equilibrium: B = F. • Should the introduction of new brands stop at this point for eﬃciency? 6

Figure 6: Eﬃcient entry? • The consumer surplus that is made available due to the introduction of this brand is equal to the area A. The ﬁrm’s gross proﬁt is equal to the area B. The total gross surplus is thus the sum of A and B. The cost to society of introducing the new brand is equal to the ﬁxed cost F. Apparently, from a eﬃciency point of view, the introduction of new brands should continue until the total surplus is no greater than the ﬁxed cost of entry A+B =F (2)

Figure 6 shows how entry is determined if instead it is governed by the above criteria. • The comparison suggests that the number of brands introduced in equilibrium ne falls below the level governed by the criteria in (2) . When a ﬁrm introduces a new brand, it also confers positive beneﬁts to consumers, the size of which is equal to area A in ﬁgure 5. This externality is of course not taken into account in the ﬁrm’s decision whether to introduce the brand. The ﬁrm’s only concern is its proﬁt — area B in ﬁgure 5, notwithstanding society as a whole enjoys a surplus that is equal to area A + B. We may call this the imperfect appropriability of the returns to new product introduction. The ﬁrm is responsible for the entire cost of introducing a new brand that is equal to F but is only able to reap part of the returns, with the other part accruing to consumers. • Actually the maximum surplus that could be available due to the introduction 7

of the new brand is equal to sum of areas A, B and C if the ﬁrm can be made to price at marginal cost and produce at the Pareto optimal output level Q∗ . But then the ﬁrm may only earn a zero gross proﬁt and could not hope to recover any of the investment at all. Any regulations that restrict the monopolistically competitive ﬁrm to price at marginal cost would only suﬀocate any new product introduction. The ﬁrm earns the greatest returns to introducing a new brand when it is made the monopolist of the new brand. Even then the returns fall below the returns to society as a whole. • Should we then conclude that the free market necessarily introduces too few new brands? • The answer is no because there is yet another externality the ﬁrm imposes on others when it makes available a new brand. We have noted previously that when there are more brands competing in the monopolistically competitive market, the demand curve of each shifts in, as the ﬁxed budgets of consumers will have to be allocated among more brands. This is a negative externality a ﬁrm imposes on others when it introduces a new brand. The eﬀect is a variant of the business stealing eﬀect, which we ﬁrst saw operative in Cournot oligopoly of a homogeneous product. • It is clear from ﬁg.3 that the sum of consumer surplus and the ﬁrm’s gross proﬁt associated with each brand falls when the demand curve shifts in. When deciding whether or not to introduce a new brand, the ﬁrm will not take into account the fact that it would cause a decline in the consumer surpluses and proﬁts associated with other brands. Introducing a new brand is privately proﬁtable as along as the gross proﬁt is above the ﬁxed cost. But from for eﬃciency point of view, the reduction in the surpluses associated with all other brands should also be ﬁgured into the decision. • Now let the reduction in the surpluses associated with all other brands that is caused by the entry of the nth brand be δ (n) . For eﬃciency, a new brand should be C.S. (n) + Gross Proﬁt (n) − δ (n) = F. (3) The left hand side, which may be thought of as the social marginal beneﬁt of introducing a new brand, is the net addition to total surplus brought by the introduction of the nth brand. Eﬃcienct product variety is at where this is just equal to the social cost of entry F . • The private beneﬁt is simply the ﬁrm’s gross proﬁt which may either fall below or rise above the left hand side of (3) . Therefore, equilibrium product variety may either be greater than or less than the socially optimal product variety. The ambiguity stems from the opposite tendencies of the two externalities. 8

The imperfect appropriability tends to cause too little product variety, whereas the business stealing eﬀect tends to cause excessive product variety. • What is not ambiguous however is that the free market in general cannot be made to provide us with the socially optimal product variety. When the imperfect appropriability is stronger than the business stealing eﬀect, there is insuﬃcient new product introduction. In this case, the government may correct the ineﬃciency by subsidizing ﬁrms to introduce new brands. Whereas when the business stealing eﬀect is stronger, there is a case for the government to tax the introduction of new brands.

4

General equilibrium

• In the above analysis, we have taken as given the budgets of consumers that may be spent on the various brands. The very ﬁrst lesson in macroeconomics however is that aggregate income is equal to aggregate output. The introduction of a new brand raises aggregate output and should result in a corresponding increase in aggregate income. Then the consumers’ budgets that may be spent on the various brands could rise by as much as the output of the new brand. • In this case, the budget to be allocated on the existing brands can stay constant despite the fact that there are now more brands to be purchased. Speciﬁcally, there may not be any leftward shifts in the demand curves of the brands given rise by the business stealing eﬀect. In large part, the business stealing eﬀect is an artifact of our assumption that income is ﬁxed in advance, which may not be a good assumption in the present context. • There is a well-known proposition in 19th century classical economics called Say’s law, which states that supply creates its own demand. Indeed, the Say’s Law is the historical percussor of the aggregate income—aggregate output identity in modern marcroeconomics. Applying Say’s law to the present analysis, the business stealing eﬀect may well vanish entirely. In that case, we will be left with the imperfect inappropriability , which tends to cause insuﬃcient equilibrium product variety. • The policy implication is that the free market should fail to deliver suﬃcient product variety in most cases, and the appropriate public policy is that the introduction of new brands should be subsidized.

9

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