Competition in Capacity and Product

Differentiation
Microeconomics: Lecture 8

Shamika Ravi
BITSOM. 2022
 How does capacity affect price?
 We’ve seen how outcomes change when games are
repeated – now let’s turn to capacity
 Return to the benchmark toy model of widget sellers
 Assume that each firm has capacity to supply 20
widgets
 Total industry capacity is 40 widgets and demand is
100
 Demand exceeds capacity…so prices should be…?
 High
 Let’s see the payoff table:
How does capacity affect price?
Firm1/Firm2 Price= Rs.2 Price=
Rs.1.50
Price= Rs.2 30, 30 30, 20
Price= 20, 30 20, 20
Rs.1.50
 What is the outcome (equilibrium)?
 Both firms price Rs. 2 is the outcome of this game
 Now what happens when capacity is increased?
 Suppose both firms have 60 units capacity
 Industry capacity is 120 > demand of 100
 Does the price fall back to Rs.1.50?
 How does capacity affect price?
Firm1/Firm2 Price= Rs.2 Price=
Rs.1.50
Price= Rs.2 75, 75 60, 60
Price= 60, 60 50, 50
Rs.1.50
 Check: both firms pricing at Rs. 1.50 is not an outcome
 Both firms choose Rs. 2 is an equilibrium
 But how can that be??
 Total capacity > demand, so prices should fall!
 How does capacity affect price?
Firm1/Firm2 Price= Rs.2 Price=
Rs.1.50
Price= Rs.2 75, 75 60, 60
Price= 60, 60 50, 50
Rs.1.50
 Two reasons: first, firms were limited to choose from 2 and 1.50
 If they were free to choose any price – then prices would fall
 Secondly, the equilibrium price would still not fall to cost. Why?
 Because while total capacity >demand, what matters is capacity of each
firm to serve demand from price cut
 Cutting price gets me 10 additional customers but my revenue loss from
lower prices is more
How does capacity affect price?
 Lesson of the story: If firms could restrict capacities, prices
would be higher
 So why don’t firms do this?
 Greed.
 Go back to the earlier case when firms had capacity of 20
each
 Now suppose for a fee of Rs.60, each could raise capacity by
80
 Capacity is ‘lumpy’ so it’s increase of 80 at once or nothing
 Now each will first decide whether to expand and then
choose prices
 Suppose firm 2 does not expand – and you (firm 1) do…
 How does capacity affect price?
Firm1/Firm2 Price= Rs.2 Price=
Rs.1.50
Price= Rs.2 60, 30 60, 20
Price= 40, 0 20, 20
Rs.1.50
 Firm 1 has capacity of 100, firm 2 of 20
 Assume: 50 go to firm 2, and 30 are turned away
 This is like a worst case outcome for firm 1
 Outcome: both firms price high at Rs. 2
 Notice that firm 1 makes more profits now than with 20 capacity
 Similarly for firm 2: if it believes that firm1 will not expand, then it
will
How does capacity affect price?
 What happens when both firms increase capacity?
 Now both have the capacity to serve the entire market
 We are back to the benchmark case: both will price at Rs.
1.50 and earn profits of 50 – 60 = -10

 So – what will happen? Who increases capacity?

 How does capacity affect price?
Firm1/Firm2 Capacity = 100 Capacity = 20

Capacity = -10, -10 60, 30

100
Capacity = 20 30, 60 30, 30
 Can neither raising capacity be an equilibrium?
 No!
 Can both raising capacity be an equilibrium?
 No!
How does capacity affect price?
Firm1/Firm2 Capacity = 100 Capacity = 20

Capacity = -10, -10 60, 30

100
Capacity = 20 30, 60 30, 30
 There are two equilibria – one firm expands, the other
doesn’t
 So who gets to expand?
 Can you predict?
 One can’t say.
 Chicken game– you want the other to flinch (not expand)
 Expansion option
 Let me change the game: suppose I offered to sell you the
option to move first (for Rs. 5)
 To decide whether the option is valuable…check…
 If you expand first: firm 2’s most profitable response is to not
expand
 And you have profit of Rs. 60 – Rs. 5 = Rs. 55
 If you decide not to expand, then firm 2’s best response it to
expand
 And your profit will be Rs. 30
 So the option is worth it – each firm has the incentive to
expand
First Mover Advantage
 Lesson of the story: in the capacity expansion game, you
want to move first
 By moving first, you scare the opposition into not expanding
and therefore boosting profitability
 Is this a way to circumvent competition?
 No!
 What you don’t spend on direct competition, you will spend
indirectly on trying to convince your rival that you are the
first with a new factory, plant, distribution center…
 Credible announcements of expansion
 Cournot Duopoly Model
 This is the traditional model of competition in capacity/
quantity
 Strategies: simultaneous quantity choices
 Same information, no cooperation
 Market demand for widgets: Q= 1-P
 Where P is the price, total quantity produced Q ≤ 1
 Both firms have constant per unit cost of production: C
 If total amount produced is more than 1, P = 0
 Suppose firm 1 chooses Q1, and firm 2 chooses Q2
 Then market price: P = max{1-Q1 - Q2 , 0}
 Cournot Duopoly Model
 Firm 1’s profits: Q1 * max{1-Q1 - Q2 , 0} – C*Q1
 Firm 2’s profits: Q2 * max{1-Q1 - Q2 , 0} – C*Q2

 Notice: each firm’s revenue not only depends on it’s own

quantity choice, but also on its opponent’s choice
 In this game – strategies are quantity chosen
 It is obvious that no firm will choose quantity > 1
 Each player has as many strategies as numbers between
1 and 0
 So can’t show by matrix
 Cournot Duopoly Model
 Firm 1 chooses Q1 such that Q1 (1- Q1 - Q2 ) – C*Q1 is
maximum
 Q1 = (1- Q2 –C )/2 (Reaction Function of firm 1)

 Firm 2 chooses Q2 such that Q2 (1- Q1 - Q2 ) – C*Q2 is

maximum
 Q2 = (1- Q1–C )/2 (Reaction Function of firm 2)

 Nash Equilibrium is a pair of quantity choices (Q1, Q2) if Q1 is

an optimal response to Q2 and vice versa.
 Which means that the two conditions (reaction functions) must
hold at the same time
 Cournot Duopoly Model
 How to solve two linear equations in two unknowns?
 Plug one into the other!
 This gives you: Q1 = Q2 = (1 – C )/3
 Graphical representation
 Now show that: profits of each firm: (1 – C )2/9
Note:
 In duopoly: each firm makes less profit than as a

monopolist
 (Exercise: to do)

 But each makes more profit than in perfectly competitive

situation
 Cournot Duopoly Model

 Now there is less incentive to steal business from other

 The price is set such that market demand exactly equals
the capacities they have chosen
 Neither firm has the capacity to sell below market price
 Moving First (Stackelberg Model)
 Let’s make a change to the Cournot quantity game
 Firm 1 moves first – leader; firm two is a follower
 Firm 1 chooses a quantity and then firm 2 chooses
quantity
 Remember: Backward induction!
 Step 1: start with what firm 2’s reaction to firm 1 will be:
 Suppose firm 1 choose Q1 …
 …Firm 2’s reaction function will then be:
 Q2 = (1- Q1–C )/2
 This will mean that the market price P = (1- Q1 - Q2 )
 or P = (1- Q1+C )/2
 Moving First (Stackelberg Model)
 Step 2: Now look at what Firm 1 does. Firm 1’s profits:
Q1 * {(1- Q1+C )/2} - C Q1

 The quantity Q1 that maximizes this profit is: Q1 = (1-

C)/2
 By the reaction function of firm2, Q2 = (1-C)/4
 Corresponding to these choice of quantities:
 Firm 1’s profits is therefore = (1 – C )2/8
 Which is more than (1 – C )2/9 : profits when firms made
simultaneous capacity decisions (Cournot case)
 This is first mover advantage!
Differentiation
 Now let us relax the assumption of homogenous
products
 Vertical and horizontal differentiation
 Vertical: when your product is superior to your
competitor’s product – for all buyers
 This superiority allows one to extract price premium
 Horizontal differentiation: different product – neither
superior nor inferior, e.g. red vs. blue widgets
 This allows firms to price above cost
 Let’s get back to our benchmark toy model: widgets
Differentiation
 Firm 1 makes blue widgets, firm 2 makes red ones
 Manufacturing costs are same = Rs. 0.50 a unit
 Total 100 buyers
 50 buyers prefer blue widgets to red widgets
 They value a blue widget at Rs.4 and red widget at
Rs.2
 The other 50 prefer red widgets to blue ones and they
value a red widget at Rs.4 and blue widget at Rs. 2
 Suppose they can charge any price they like
Differentiation
 But just because someone likes blue widgets doesn’t
mean that they will only buy blue widgets
 Suppose PBW= Rs3.50; PRW= Rs.1
 What will a buyer who prefers blue widgets do?
 Compare consumer surplus
 So when prices are low enough, consumers might
switch

 So what price should a firm choose?

Differentiation
 Is pricing at cost an equilibrium?
 Apply 3 step recipe: consider blue firm
 At price of Rs. 0.50, it makes 0 profit
 If it raises price by 1 paisa – would it lose all customers?
 Blue lover’s consumer surplus from blue: 4 - 0.51
 Blue lover’s consumer surplus from red: 2 – 0.5
 So the consumers who prefer blue will continue to buy
blue
 And the firm increases its profit by raising price
 So pricing at cost is not an equilibrium
Differentiation
 Check if charging high price of Rs. 4 is an equilibrium
 Apply 3 step recipe: consider blue firm
 At price = Rs.4, it makes profit of Rs. 175
 Could blue firm make more profit by lowering its price?
 The only reason to lower would be to get new buyers: red
lovers
 To get them to buy, the blue firm has to lower price to Rs.
1.99
 The profit will then be Rs. 149 : which is lesser than
before…
 So blue firm has no incentive to cut prices
 Similarly red firm has no incentive to cut prices
 Differentiation
 Differentiation softens price competition
 There are two ways to think of differentiation:
1. It imposes psychological switching costs on buyers
 It costs blue lovers Rs 2 to switch to red widgets
 This is one reason why firms can price above their MC
2. Differentiation naturally divides markets into segments
 There is a strong market and a weak market
 Price cut must balance revenue gain from weak market
against revenue loss from strong market
 Sizeable strong market means less incentive to cut price
Market size and Differentiation
 Now suppose there are 99 blue lovers and 1 red lover
 Everything else is same as before
 Is price above cost sustainable?
 No
 Suppose both firms price at Rs.4
 Red firm’s profit is Rs. 3.50
 So if it drops price to Re.1, it captures the whole market
and its profit is 100*(1 - 0.5) = 50 which is more
 The only equilibrium is to price at cost – why?
 Because the red firm is differentiated but no one really
cares!
Differentiation
 Lesson of the story: one should differentiate in a way that
leads to a sizeable strong market
 Less obvious lesson: one should differentiate in a way that
leaves a sizeable strong market for one’s rival
 If they have no strong market – they have nothing to lose
from cutting price
 Dropping their price makes their product more attractive to
your strong market!
 Price discrimination in Differentiated markets
 Let’s get back to the earlier case of equally split market
 Suppose you are red firm: and could offer two prices
 A high price (Rs.4) to red lovers and a lower price (Rs.
1.50) to blue lovers
 Assume – you can prevent resale
 Would you like to do this?
 You go after your rival’s customers – they have to lower
prices – you could lose your strong market – then you lower
prices further - downward spiral…
 This type of price structure destroys benefits of
differentiation