Industrial Organization

CLEF-Unibo

Product differentiation

Giacomo Calzolari
Industrial Organization CLEF 1 Introduction 2
Compe
ting
shops

Industrial Organization CLEF 1 Introduction 3

 Competing shops

Industrial Organization CLEF 1 Introduction 4

The same brand?

5
 Introduction

• Observations from the previous figure

1. Most firms sell more than one product

2. Products of the same firm and of different firms

are differentiated in different ways
– horizontally
• goods of similar quality targeted at consumers of
different types
– how is variety determined?
– is there too much variety
– vertically
• consumers agree on quality
• differ on willingness to pay for quality
– how is quality of goods being offered determined?
6
 Horizontal product differentiation
• Suppose that consumers differ in their tastes
– firm has to decide how best to serve different types of
consumer
– offer products with different characteristics but similar
qualities
• This is horizontal product differentiation
– firm designs products that appeal to different types of
consumer
– products are of (roughly) similar quality
• Questions:
– how many products?
– of what type?
– how do we model this problem?

7
 A spatial approach to product variety

• The spatial model (Hotelling) is useful to

consider
– pricing
– design
– variety

• Has a much richer application as a model of

product differentiation
– “location” can be thought of in
• space (geography)
• time (departure times of planes, buses, trains)
• product characteristics (design and variety)
– consumers prefer products that are “close” to their
preferred types in space, or time or characteristics

8
We begin with monopolist

9
A Spatial approach to product variety 2
• Assume N consumers living equally spaced along Main
Street – 1 km long.
• Monopolist must decide how best to supply these
consumers
• Consumers buy exactly one unit provided that price
plus transport costs is less than V.
• Consumers incur there-and-back transport costs of t
per mile
• The monopolist operates one shop
– reasonable to expect that this is located at the center of Main
Street

10
 The spatial model
Suppose that the monopolist
sets a price of p1
Price Price
p1 + tx p1 + t.x

V V

All consumers within t t

distance x1 to the left p1
What determines
and right of the shop
x1?
will by the productNotice this is x1!!

z=0 x1 1/2 x1 z=1

Shop 1

p1 + tx1 = V, so x1 = (V – p1)/t

11
 The spatial model 2
Suppose the firm
reduces the price
Price Price
p1 + t.x p +to
1 t.xp2?

V V

Then all consumers p1

within distance x2
p2
of the shop will buy
from the firm

z=0 x2 x1 1/2 x1 x2 z=1

Shop 1

12
 The spatial model 3

• Suppose that all consumers are to be served and at price p

(why? See next).
– The highest price is that charged to the consumers at the ends of
the market
– Their transport costs are t/2 : since they travel ½ km to the shop
– So they pay p + t/2 which must be no greater than V.
– So p = V – t/2.
• Suppose that marginal costs are c per unit.
• Suppose also that a shop has set-up costs of F.
• Then profit is p(N, 1) = N(V – t/2 – c) – F.

13
 The spatial model 4

• Why all consumers are to be served at price p?

• Consider the price that would maximize the profit with the
demand 2x1=2(V-p)/t
• From the FOC the optimal price is p=(V+c)/2 then we
need to check that at this price the position of the
indifferent individual (between buying or not) is larger
than zero:
½-x1=1/2-(V-p)/t with the p=(V+c)/2 we get
½-x1=-1/(2t)(V-c-t)<0 hence the x1 is not “interior”

14
 Monopoly pricing in the spatial model

• What if there are two shops of the same monopolist?

– This means two varieties of the same product of the monopolist
(e.g. two different brands of the same owner)
• The monopolist will coordinate prices at the two shops
• With identical costs and symmetric locations, these prices
will be equal: p1 = p2 = p*
– Where should they be located?
– What is the optimal price p*?

15
 Location with two shops
Delivered price to
consumers at the
Suppose that the entire market is tomarket
be served
center equals
Price their reservation price Price
If there are two shops
they will be located V V
symmetrically a
distance d from the
p(d) p(d)
The end-points
maximumofpricethe
the firmmarket
can charge What determines
is determined bythe
theprice p(d)? The middle
Now raise consumer indifference
consumers at the
at each shop
center
Start
ofwith
the market
a low price
at each shop d 1/2 1-d
z=0 z=1
Shop 1 Shop 2
Suppose that The shops should be
d < 1/4 moved inwards…

16
 Location choice 1

d < 1/4

We know that p(d) satisfies the following constraint:

p(d) + t(1/2 - d) = V
This gives: p(d) = V - t/2 + td

Aggregate profit is then: p(d) = (p(d) - c)N

= (V - t/2 + td - c)N

This is increasing in d so if d < 1/4 then d should be increased.

17
 Location with two shops 2
Delivered price to
consumers at the
end-points equals
The maximum price their reservation price
the firm can charge Price Price
is now determined
by the consumers
at the end-points V V
of the market
p(d) p(d)

Now what
determines p(d)? The extreme
Now raise the price
Consumers indifference
at each shop
Start with a low price
at each shop d 1/2
z=0 1-d z=1
Shop 1 Shop 2
Now suppose that The shops should be
d > 1/4 moved outwards…

18
 Location choice 2

d > 1/4

We now know that p(d) satisfies the following constraint:

p(d) + td = V
This gives: p(d) = V - td
Aggregate profit is then: p(d) = (p(d) - c)N
= (V - td - c)N

This is decreasing in d so if d > 1/4 then d should be decreased.

19
 Location with two shops 3
It follows that
shop 1 should Price at each
be located at shop is then
Price Price
1/4 and shop 2 p* = V - t/4
at 3/4
V V

V - t/4 V - t/4
Profit at each shop
is given by the
shaded area c c

z=0 1/4 1/2 3/4 z=1

Shop 1 Shop 2

Profit is now p(N, 2) = N(V - t/4 - c) – 2F

20
 Three shops By the same argument
they should be located
What if there at 1/6, 1/2 and 5/6
are three shops?
Price Price

V V
Price at each V - t/6 V - t/6
shop is now
V - t/6

z=0 1/6 1/2 5/6 z=1

Shop 1 Shop 2 Shop 3

Profit is now p(N, 3) = N(V - t/6 - c) – 3F

21
 Optimal number of shops

• A consistent pattern is emerging.

• Assume that there are n
• shops.
They will be symmetrically located distance 1/n apart.
• We have already considered n = 2 and n = 3.How many
• When n = 2 we have p(N, 2) = V - t/4 shops should
there be?
• When n = 3 we have p(N, 3) = V - t/6
• It follows that p(N, n) = V - t/(2n)
• Aggregate profit is then p(N, n) = N(V - t/(2n) - c) – nF

22
 Optimal number of shops 2

Profit from n shops is p(N, n) = (V - t/(2n) - c)N - nF

and the profit from having n + 1 shops is:
p*(N, n+1) = (V - t/(2(n + 1))-c)N - (n + 1)F
Adding the (n +1)th shop is profitable
if p(N,n+1) - p(N,n) > 0
This requires tN/(2n) - tN/(2(n + 1)) > F
which requires that n(n + 1) < tN/(2F).

23
 An example

Suppose that F = $50,000 , N = 5 million and t = $1

Then tN/2F = 50
For an additional shop to be profitable we need n(n + 1) < 50.
This is true for n < 6
There should be no more than seven shops in this case: if
n = 6 then adding one more shop is profitable.
But if n = 7 then adding another shop is unprofitable.

24
 Some intuition
One more shop profitable if n(n + 1) < tN/(2F).

• What does the condition on n tell us?

• Simply, we should expect to find greater product variety
when:
– there are many consumers.
– set-up costs of increasing product variety are low.
– consumers have strong preferences over product characteristics
and differ in these
• consumers are unwilling to buy a product if it is not “very close”
to their most preferred product

25
 Social optimum Are there too
many shops or
What number of shops maximizes total surplus? too few?

Total surplus is consumer surplus plus profit

Consumer surplus is total willingness to pay minus total revenue
Profit is total revenue minus total cost
Total surplus is then total willingness to pay minus total costs
Total willingness to pay by consumers is N.V

Total surplus is therefore NV - Total Cost

So what is Total Cost?

26
 Social optimum 2
Assume that
there
are n shops Price Price
Transport cost for
V each shop is the area V
of these two triangles
Consider shop multiplied by
i consumer density

Total cost is t/2n t/2n

total transport
cost plus set-up z=0 1/(2n) 1/(2n) z=1
costs Shop i

This area is t/(4n2)

27
 Social optimum 3
Total cost with n shops is, therefore: C(N,n) = n(t/4n2)N + nF
= tN/4n + nF
Total cost with n + 1 shops is: C(N,n+1) = tN/(4(n+1))+ (n+1)F

Adding another shop is socially efficient if C(N,n + 1) < C(N,n)

This requires that tN/4n - tN/4(n+1) > F
which implies that n(n + 1) < tN/(4F)

The monopolist operates too many shops and, more

generally, provides too much product variety

28
 Social optimum 4
• Intuition for too much variety (recall our picture at supermarket!):
Increasing the variety the monopolist increases revenues (by increasing prices)
but this is not necessarily an increase in surplus because the larger revenue is
just a TRANSFER from the buyers to the firm
• In fact in the end maximizing profits is NOT as maximizing
surplus!
• But then why excess variety and not lower variety than social
optimum?
Because the monopolist uses the increase in variety in order to extract more
surplus from buyers
• If just one variety and you want to sell to all, you must set a
very low price because all buyers pay the same price
But if you increase the varieties you can increase the price and thus revenues
And what about if you could charge different prices to different consumers?
 VERTICAL PRODUCT
DIFFERNTIATION
Monopoly and product quality
• Firms can, and do, produce goods of different
qualities
• Quality then is an important strategic variable
• The choice of product quality determined by its
ability to generate profit; attitude of consumers to
quality
• Consider a monopolist producing a single good
– what quality should it have?
– determined by consumer attitudes to quality
• prefer high to low quality
• willing to pay more for high quality
• but this requires that the consumer recognizes quality
• 30
also some are willing to pay more than others for quality
 Demand and quality
• We might think of individual demand as being of the form
– Qi = 1 if Pi < Ri(Z) and = 0 otherwise for each consumer i
– Each consumer buys exactly one unit so long as price is less
than her reservation price Ri(Z)
– the reservation price is affected by product quality Z
• Assume that consumers vary in their reservation prices,
from low to high
• Then aggregate demand is of the form P = P(Q, Z)
• An increase in product quality increases demand

31
 Demand and quality
Derivation of aggregate demand

Order consumers by their reservation prices

Aggregate individual demand horizontally

Price

1 2 3 4 5 6 78 Quantity

32
 Demand and quality 2
Begin with a particular demand curve
for a good of quality Z1
Price
Then an increase in product
R1(Z2)
P(Q, Z2) quality
Suppose that from Z1 in
an increase to Z2 rotates
quality increases
the demand thecurve around
If the price is P1 and the product quality
willingness to pay ofaxis as follows
the quantity
is Z1 then allinframarginal
consumers with reservation
consumers more
P2
prices greater than
thanPthat
1 will
ofbuy
the the good
marginal
R1(Z1)
consumer
Quantity Q1 can now be
P1 This
These are theis the
marginal sold for the higher
inframarginal price P2
consumer
consumers
P(Q, Z1)

Q1 Quantity

33
 Demand and quality 3
Price Suppose instead that an
Then aninincrease in product
increase
qualityquality from
increases theZ1 to Z2 rotates
willingness tothe
paydemand
of marginal
curve around
consumers moreaxis as follows
the price
than that of the inframarginal
R1(Z1) consumers
P2 Once again quantity Q1
P1 can now be sold for a
higher price P2
P(Q, Z2)
P(Q, Z1)

Q1 Quantity

34
 Demand and quality 4

• The monopolist must choose both

– price (or quantity)
– quality
• Two profit-maximizing rules
– marginal revenue equals marginal cost on the last unit sold for
a given quality
– marginal revenue from increased quality equals marginal cost
of increased quality for a given quantity
• This can be illustrated with a simple example:
P = Z( - Q) where Z is an index of quality

35
 Demand and quality 5
P = Z(q - Q)
Assume that marginal cost of output is zero: MC(Q) = 0
Cost of quality is C(Z) = aZ2
Marginal cost of quality = dC(Z)/d(Z)
= 2aZ This means that quality i
The firm’s profit is: costly and becomes
increasingly costly
p(Q, Z) =PQ - C(Z) = Z(q - Q)Q - aZ2

36
 Demand and quality 6

Again, profit is:

p(Q, Z) =PQ - C(Z) = Z(q - Q)Q - aZ2
The firm chooses Q and Z to maximize profit.
Take the choice of quantity first: this is easiest.
Marginal revenue = MR = Zq - 2ZQ
MR = MC  Zq - 2ZQ = 0  Q* = q/2
 P* = Zq/2

37
 Price
Demand and quality A1
Z2 q
P(Q, Z2)
When quality is Z2
MR(Z2) price is

Z1 q WhenZ2quality
q/2 is Z
How does 1 increased quality
price is affect demand?
P2 = Z2q/2 Z1q/2

P1 = Z1q/2

MR(Z1) P(Q,Z1)

q/2 q Quantity
Q*

38
 Demand and quality 7

Total revenue = P*Q* = (Zq/2)x(q/2) = Zq2/4

So marginal revenue from increased quality is
MR(Z) = q2/4
Marginal cost of quality is
MC(Z) = 2aZ
Equating MR(Z) = MC(Z) then gives
Z* = q2/8a
Does the monopolist produce too high or too low quality?

39
 Demand and quality An example
Price So an increase in quality from
Z1 to Z2 increases surplus
by this
Social area at
surplus minus
qualitytheZ2
Z2 q
isincrease
this areainminus
qualityquality
costs
which is lower than the
An increase
costs in increased
quality from
revenue (the incentiveof thefirm)
Z1 to Z2 increases
revenue by this Thearea:increase in total
Z1 q hence the increase surplus is greater than
of quality cost
P2 = Z2q/2 Social surplus at quality
cannot be larger than this1 Z
is this area minus thequality
increase in profit.
P1 = Z1q/2
The monopolist produces
costs
too little quality

q/2 q Quantity
Q*

40
PRODUCT DIFFERENTIATION
AND
COMPETITION

41
 An example of product differentiation

Coke and Pepsi are similar but not identical. As a result, the
lower priced product does not win the entire market.
Econometric estimation gives:

QC = 63.42 - 3.98PC + 2.25PP

MCC = $4.96

QP = 49.52 - 5.48PP + 1.40PC

MCP = $3.96
There are at least two methods for solving for PC and PP
42
 Bertrand and product differentiation

Method 1: Calculus
Profit of Coke: pC = (PC - 4.96)(63.42 - 3.98PC + 2.25PP)
Profit of Pepsi: pP = (PP - 3.96)(49.52 - 5.48PP + 1.40PC)
Differentiate with respect to PC and PP respectively
Method 2: MR = MC
Reorganize the demand functions
PC = (15.93 + 0.57PP) - 0.25QC
PP = (9.04 + 0.26PC) - 0.18QP
Calculate marginal revenue, equate to marginal cost, solve for
QC and QP and substitute in the demand functions

43
 Bertrand and product differentiation 2

Both methods give the best response functions:

PC = 10.44 + 0.2826PP PP
The Bertrand
Note that these
equilibrium
are upwardis RC
PP = 6.49 + 0.1277PC
atsloping
their
These can be solved intersection
for the equilibrium $8.11 RP
prices as indicated B
The equilibrium prices $6.49
are each greater than
marginal cost
What about if the Pepsi buys PC
$10.44
$12.72
out Coca? What would they
do with the two brands? 44

What prices?
 Strategic complements and substitutes
q2
• Best response functions are
very different with Cournot
and Bertrand Firm 1
– they have opposite slopes Courno
t
– reflects very different forms of
Firm 2
competition
– firms react differently e.g. to an q1
increase in costs p2
Firm
1
Firm 2 Bertrand

p1

45
Strategic complements and substitutes
q2
– suppose firm 2’s costs increase
aggressive
– this causes Firm 2’s Cournot best response by
response function to fall Firm 1
firm 1
• at any output for firm 1 firm 2 Cournot
now wants to produce less passive
– firm 1’s output increases and response Firm 2
firm 2’s falls by firm 1
q1
– Firm 2’s Bertrand best response p2
function rises Firm 1
• at any price for firm 1 firm 2
now wants to raise its price Firm 2 Bertrand
– firm 1’s price increases as does
firm 2’s
p1

46
 Strategic complements and substitutes 2

• When best response functions are downward sloping

(e.g. Cournot) we have strategic substitutes
– passive actions induces aggressive response
– Here it can be show First Mover Advantage
• When best response functions are upward sloping (e.g.
Bertrand) we have strategic complements
– passive action induces passive response
– Here it can be show Second Mover Advantage
• Difficult to determine strategic choice variable: price or
quantity
– output in advance of sale – probably quantity
– production schedules easily changed and intense competition
for customers – probably price
47
 Bertrand competition and the spatial
model
• An alternative approach for product diferentiation:
spatial model of Hotelling
– a Main Street over which consumers are distributed
– supplied by two shops located at opposite ends of the street
– but now the shops are competitors
– each consumer buys exactly one unit of the good provided that
its full price is less than V
– a consumer buys from the shop offering the lower full price
– consumers incur transport costs of t per unit distance in
travelling to a shop
• Recall the broader interpretation
• What prices will the two shops charge?

48
 Bertrand and the spatial model
xm marks the location of the
marginal buyer—one who is
Assume
What that
if shop shop 1 sets
1 raises
Price Price
indifferent between buying
price p and shop 2 sets
its price? 1 either firm’s good
price p2

p’1
p2
p1

x’m xm
All consumers to the And all consumers
x moves to the
Shop 1 left of xm buy from m
Shop 2
to the right buy from
left: some consumers
shop 1 shop 2
switch to shop 2

49
 Bertrand and the spatial model 2

p1 + txm = p2 + t(1 - xm) 2txm = p2 - p1 + t

xm(p1, p2) = (p2 - p1 + t)/2t How is xm
determined?
This is the fraction
There are N consumers in total
of consumers who
So demand to firm 1 is D = N(p2 - pbuy
1
1 + from
t)/2t firm 1
Price Price

p2
p1

xm

Shop 1 Shop 2
50
 Bertrand equilibrium
Profit to firm 1 is p1 = (p1 - c)D1 = N(p1 - c)(p2 - p1 + t)/2t
This is the best
p1 = N(p2p1 - p12 + tp1 + cp1 - cp 2 -ct)/2t
response function
Solve this
Differentiate with respect to pfor
1
firm 1 for p1
N
p1/ p1 = (p2 - 2p1 + t + c) = 0
2t
p*1 = (p2 + t + c)/2
This is the best response
What about firm 2? function
By symmetry,
for firm 2it has a
similar best response function.

p*2 = (p1 + t + c)/2

51
 Bertrand equilibrium 2
p2
p*1 = (p2 + t + c)/2 R1
p*2 = (p1 + t + c)/2
2p*2 = p1 + t + c R2
= p2/2 + 3(t + c)/2
c+t
 p*2 = t + c (c + t)/2
 p*1 = t + c
Profit per unit to each firm is t p1
(c + t)/2 c + t
Aggregate profit to each firm is Nt/2
52
 Bertrand competition 3

• Two final points on this analysis

• t is a measure of transport costs
– it is also a measure of the value consumers place on getting
their most preferred variety
– when t is large competition is softened
• and profit is increased
– when t is small competition is tougher
• and profit is decreased

• Locations have been taken as fixed

– suppose product design can be set by the firms
• balance “business stealing” temptation to be close
• against “competition softening” desire to be separate

53
 Choosing location

0 a 1-b 1

• a and b are the two independent shops’ distance from the two
extremes
• Where is it optimal to locate? You must anticipate future prices
• Sequential game:
First choose location
Then chose price
• The price will depend on location
• Look for subgame perfect equilibrium with backward induction
54
 Effects in choosing location
• Direct:
given the competitor’s position you want to get
closer to steal business

• Strategic effect:
moving away from the others allows to reduce the
intensity of price competition

• What to do?

55
 Looking for the equilibrium
• Profit of firm A
pA = pA(pA, pB, a, b)
• At second stage prices are determined with
A / pA = 0 and same for firm B
p*A = pA(a, b), p*B = pB(a, b)

• Hence we can write profits as

pA = pA(pA(a, b), pB(a, b), a, b)

56
 Now choosing the product

• We know that profit can be written as

pA = pA[pA(a, b), pB(a, b), a, b]
• Optimality condition for profits: This term is equal to 0!
dpA/da = (A/pA)(dpA/da) +
+ (A/pB)(dpB/da) +
+ A/a

57
 Now choosing the product
+ - +

Resta allora: dpA/da = (A/pB)(dpB/da) + A/a

Strategic effect Direct effect

• A/a > 0: given prices, optimal to get closer to rival

• A/pB > 0 : we would like the other increases price
• dpB/da < 0 : if I get closer to rival he reduces prices

Contrasting effect, what dominates?

Complex, it depends, see next…
58
 Now choosing the product
Strategic effect dominates so that maximal
differentiation if:
- high cross price elasticity
- The rival’s price is very sensitive to changes in my
position

Otherwise no equilibrium existence…

59
 Salop model: the circular city
A

Other
interpretations?
TV
programming!

B
60
Competition with vertical differentiation

61
 Demand with different consumers
Distributed uniformly on 0 , 1
qsH - pH

qsL- pL

0 l h 1
Assumptions for simplicity:
Nil costs
Maximal quality s*
Two firms H, L
62
 Demand and marginal consumers
• h value of q such that qsH - pH = qsL - pL
 h = (pH -pL)/(sH -sL)
 demand for firm H è 1 - h

• l value of q s.t.: qsL - pL = 0

 l = pL/sL
 demand for firm L è h - l

63
 Firms’ profits
pH = pH [1 - (pH -pL)/(sH -sL)]

pL = pL [(pH -pL)/(sH -sL) - pL/sL]

• Two stages games

64
 Last stage: prices
pH = pH [1 - (pH - pL)/(sH -sL)]
set pH/pH = 0
then pH = ½ (pL + sH -sL)

pL = pL [(pH -pL)/(sH -sL) - pL/sL]

set pL/pL = 0
then pL = ½ (sL/sH) pH

Notice that if sL<sH then pL < pH

65
 Best responses

pH BRL
BRH

Given
pL = ½ (sL/sH) pH

Equilibrium must be
asymmetric

pL

66
 Substituting prices
From pH = ½ (pL + sH -sL) e pL = ½ (sL/sH) pH
• pH = [2sH(sH -sL)]/(4sH -sL)
• pL = [sL(sH -sL)]/(4sH -sL)

• Profits become
• H = [4(sH)2 (sH -sL)]/(4sH -sL)2
• L = [sH sL (sH -sL)]/(4sH -sL)2

67
 First stage: find qualities
• Derive profits:
H: H / sH  4(sH)2 - 3 sH sL + 2(sL)2 > 0
 sH = s*
L: L / sL = 0  sL = (4/7) sH

ÞThe two firms always differentiate!

ÞThe low quality firms never wants to sell the same
product as the high quality, even if it sells a lower
quality product!

68
END OF PRODUCT
DIFFERENTIATION
69