Professional Documents
Culture Documents
4.2.hotelling Model PDF
4.2.hotelling Model PDF
Hotelling Model
Matilde Machado
1
4.2. Hotelling Model
Graphically
Mass of
consumers =
1
1dz = z = 1 0 = 1
1
1 0
0
0 x 1
Location of firm B
Location of firm A
2
4.2. 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.
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.
3
4.2. Hotelling Model
s
Ui
Total cost to
consumer x: pA+tx2
pB+t(1-x)2
pA
pB
0 x 1
i
A B
s pA t B 0
2t
This condition is equivalent to say that s has to be
high enough
4
4.2. Hotelling Model
Once we know the indifferent consumer, we may
define the demand functions of A and B.
pB p A + t p B p A 1
x
DA ( p A , pB ) = 1dz = z 0 = x = = +
x
0
2t 2t 2
p p A 1 p A pB 1
1
DB ( p A , pB ) = 1dz = z x = 1 x = 1 B + = +
1
x 2t 2 2t 2
5
4.2. Hotelling Model
Once the equilibrium prices are determined, we may
determine the other equilibrium quantities:
1
x* = (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
= = ( p c ) DA* = ( t + c c ) x* =
A* B* * t
2
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
Industrial Organization- Matilde Machado The Hotelling Model 11
6
4.2. Hotelling Model
s
Ui
pA+tx2
pB+t(1-x)2
pA=t+c pB=t+c
0 1
i
A x B
7
4.2. Hotelling Model
General Case Endogenous locations:
2 periods:
In the first period, firms choose location
8
4.2. Hotelling Model
1. The indifferent consumer: U x ( A) = U x ( B )
p A + t ( x a )2 = pB + t ( x (1 b))2
p A + tx2 + ta 2 2txa
= pB + tx2 + t (1 b) 2 2tx(1 b)
2tx (1 b a ) = pB p A + t (1 b)2 ta 2
pB p A + t (1 b) 2 ta 2 pB p A + t ( (1 b) a )
2 2
x = =
2t (1 b a ) 2t (1 b a )
x =
pB p A
+
(1 b a )(1 b + a )
2t (1 b a ) 2 (1 b a )
x =
pB p A
+
(1 b + a ) = pB p A + (1 b a ) + a
2t (1 b a ) 2 2t (1 b a ) 2
DA ( p A , pB ) = x =
pB p A
+
(1 b a ) + a
2t (1 b a ) 2
DB ( p A , pB ) = 1 x = 1
pB p A
(1 b a ) a
2t (1 b a ) 2
p A pB 1 b a
= + +b
2t (1 b a ) 2
a (1-b-a)/2
0 a 1-b 1
Industrial Organization- Matilde Machado The Hotelling Model 18
9
4.2. Hotelling Model
Interpretation of the demand functions:
if p A = pB
DA ( p A , p B ) = a +
(1 b a )
captive consumers 2
to the left (own half of the consumers
backyard) between a and 1-b
1 b a
DB ( p A , pB ) = + b
2
captive consumers
half of the consumers to the right (own
between a and 1-b backyard)
if p A pB
DA ( p A , p B ) = a +
(1 b a ) + pB p A
2 2t (1 b a )
sensitivity of the demand
to price difference
pA+t(x-a)2
pA pB
0 a x 1-b 1
Firm As Firm Bs
captive market captive market
Industrial Organization- Matilde Machado The Hotelling Model 20
10
4.2. Hotelling Model
2. Finding the reaction functions
Max A = ( p A c ) DA ( p A , pB ) = ( p A c ) a +
(1 b a ) + pB p A
p A
2 2t (1 b a)
A
(1 b a ) + pB p A + p c 1
FOC: =0 a+ ( A ) =0
p A 2 2t (1 b a ) 2t (1 b a )
2 pA
=a+
(1 b a ) + pB + c
2t (1 b a) 2 2t (1 b a )
pA
=a+
(1 b a ) + pB + c
t (1 b a ) 2 2t (1 b a)
t (1 b a )
2
p +c Firm As reaction
p A = at (1 b a ) + + B function
2 2
Max B = ( pB c ) DB ( p A , pB ) = ( pB c ) b +
(1 b a ) + pA pB
pB
2 2t (1 b a )
B
FOC: =0
pB
b+
(1 b a ) + p A pB
+ ( pB c )
1
=0
2 2t (1 b a ) 2t (1 b a)
b+
(1 b a ) + p A 2 pB + c
=0
2 2t (1 b a)
Industrial Organization- Matilde Machado The Hotelling Model 22
11
4.2. Hotelling Model
2. 2. Finding the reaction functions
b+
(1 b a ) + 2 pB + c 1
+ a +
1 b a
+
pB + c
=0
2 2t (1 b a ) 2 2 2t (1 b a )
3 pB + 3c
+b+
(1 b a ) + 1 a + 1 b a = 0
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 )
pB = c +
3
ba ab
= c + t (1 b a ) 1 + y p A = c + t (1 b a ) 1 +
3 3
12
4.2. Hotelling Model
3. 1st period, simultaneous choice of a and b
Profits are functions of (a, b) alone:
a b pB p A 1 b 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 )
2
a b b a 1 b + a
A ( a, b) = t (1 a b ) 1 + + = t (1 a b )
3 3 2 18
3 b + a
3+ a b
=
3 6
13
4.2. Hotelling Model
3. 1st period, simultaneous choice of a and b
(3 b + a )
2
Max (a, b) = t (1 a b )
A
a 18
(3 b + a ) + t 1 a b 2 (3 b + a )
2
A ( a, b)
FOC: = t ( )
a 18 18
t
= ( 3 b + a )(1 + b + 3a ) < 0 a* = 0
18
(3 + b a )
2
Max ( a, b) = t (1 a b )
B
b 18
(3 + b a ) + t 1 a b 2 (3 + b a )
2
( a, b)
B
FOC: = t ( )
b 18 18
t
= ( 3 + b a )(1 + 3b + a ) < 0 b* = 0 1 b* = 1
18
14
4.2. Hotelling Model
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.
15
4.2. Hotelling Model
The social planners problem is:
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
(1 b a )(1 b + a ) (1 b + a )
x = = = half the distance bweteen a and 1-b
2 (1 b a ) 2
16
4.2. Hotelling Model
The planner has to max total surplus which is
the same as minimize transportation costs
1 b + a
x =
a 2 1 b 1
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
x=1b2+ a 1 b
buy from A
buy from B
0 a x 1-b 1
a 3 1 1 b a 3 1 1 b a 3 b 3
Min + + +
a ,b
3 3 2 3 2 3
17
4.2. Hotelling Model
a 3 1 1 b a 3 1 1 b a 3 b3
Min + + +
3 3 2 3 2 3
a ,b
The FOC:
a = 0 4a (1 b a ) = 0 (A)
2 2
= 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
4a 2 (1 a a ) = 0 a* = ;(1 b* ) =
2
4 4
Industrial Organization- Matilde Machado The Hotelling Model 35
18