Product Variety and Quality Horizontal versus Vertical Differentiation Horizontal differentiation: various consumers rank the differentiated products differently due to differences in consumer preferences. Vertical differentiation: different qualities of the product are ranked in a common order but with differences in willingness to pay. Horizontal Differentiation The Hotelling Model- Monopoly Assumptions: There are N identical consumers that are uniformly located along a linear market. Each consumer purchases at most one unit of the product per time period. Transportation costs are paid by the consumer and are equal to t per unit distance so that the full price is P + tx where x is the distance of the consumer from the seller. The product is homogeneous except for location. Aconsumer will purchase if the reservation price V exceeds P+tx.Diagram with one location (no differentiation) (page 133) Pitty 20 The consumer located at the shop pays P1. The consumer located x1 distance from the shop pays their full reservation price V. Consumers outside of x1 distance don’t purchase. At x1, V=P14x:t. So x1 = (V- p1)/t In order to sell more of the product, the monopoly must lower its price. (What price would allow the monopoly to serve the entire market?)The monopoly can increase price, and potentially profit, by offering a differentiated product. With two locations, the price that allows the firm to serve the entire market has increased. As the monopoly offers more differentiated products (more locations), the price that allows the firm to sell a given quantity continually increases. There is, of course, a cost to the differentiation that must be balanced against the increase in revenue.But what if there are two firms producing the product? Hotelling Model- Oligopoly x1 Suppose that a firm enters first at point X1 and enjoys a profit. Where would the attracted entrant locate? By locating just next to X1 on the longer side of the market, the new firm shelters the majority of the market. Since the transportation cost would be lower, firm two can now charge a higher price. But what happens when the long run rolls around? The proposed equilibrium for this model was both firms agglomerated at the center of the market. Differentiation would be eliminated. This outcome would be socially suboptimal. Why? It was soon pointed out that central agglomeration would not be an equilibrium. Once agglomerated, each firm has an incentive to differentiate, shelter part of the market and gain control over price. There is no equilibrium.The pressing economic question concerning product differentiation is whether there is too much, too little, or the right amount. Remember that differentiation comes with a cost.Horizontal Differentiation under Monopolistic Competition Product differentiation is key to understanding Monopolistic Competition, where the source of the firm’s market power is product differentiation... Review of the characteristics of Monopolistic Competition: Many small firms Each firm has some market power because its product is differentiated Independent behavior Easy entry and exit Typical firm with short-run economic profit:The picture looks just like monopoly EXCEPT that the demand curve is not the market demand curve. How does it compare? There is easy entry in the long run. So new firms will enter, drawn in by the profit. As new firms enter, Consumer Surplus will increase. Why? There is more differentiation and price is lower. So consumer surplus increases with the number of firms in the market. cs Number of firmsHow does producer surplus, or profit, respond to the entry of new firms? Demand decreases with entry and the firm’s demand curve may become more elastic as well, so profit for the typical firm decreases. profit per firm Neg Number of firms Profit per firm But total profit, (number of firms x profit per firm) first increases and later decreases.Total (or social) surplus is the sum of consumer and producer surplus. The optimal amount of differentiation (the optimal number of firms) maximizes social surplus, So the socially optimal number of firms is N*. But the long-run equilibrium number of firms is Neq, Why? As drawn, there is too much differentiation. But depending on the exact shapes of the CS curve and the per firm profit function, there could be too little or even the right amount. Dollar$ Number of Firms