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IO and Competition Policy (Fach) / Product differentiation (Lektion)
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- Representative consumer approach All consumers are identical with a variable demand for all products uniform distribution (cities vs. rural places) firms compete for all consumers perfect information representative consumers Trade Off: Minimum differentiation l strong competition among themselves. Maximum differentiation l lower competition
- Horizontal differentiation definition For equal prices, consumers do not agree on which is the preferred product 1. were all goods supplied at the same price different consumers would buy different products Examples: Pepsi/Cola, Black/White iPod, Moves, Books, Clothes 2. were all goods supplied at the price, consumers would differ in their ranking of products Examples: Chain stores l Location
- Vertical differentiation 1. For equal prices (set at MC) ALL consumers agree on which is the preferred one E.g. All consumers will always prefer the company that manufactures fuel efficient cars
- Limits of the Hotelling Model Costless relocation whilst product differentiation is costly Single-product firms whilst most firms are multi-product in consumer goods markets Exogenous preferences whilst firms influence consumers through advertising > Adv. expenditures are higher in industries where products are high substitutes Quality is a multi-facet phenomenon whilst theoretical models focus on one dimension Perfect information. In presence of asymmetric information about quality, high quality goods will be put out of the market
- A differentiation advantage allows the incumbent to command a price premium while deterring entry because customers recognize the incumbent’s brand and product quality
- The strengths of an incumbent firm’s brand can be its weaknesses 1. Easier for an entrant to distingish its product relative to the incumbents brand (online bookseller vs. traditional bookstores) 2. Easier for an entrant to expand into new markets under their existing brand (Starbuck) 3. Brand proliferation is a costly strategy that may not be able to address sufficient attention to critical segments4. Entrants can lower costs by standardizing, simplifying, lowering transaction costs
- Quality and variety in Competition policy: OECD study Concerns about quality as important as concerns about prices Quality at constant prices is harming consumers as much as P at constant Quality Cartels might conspire to decrease quality Entrenched monopolists tend to let the quality of their products slip Quality is Multi-dimensional whilst price is a single, objective factor Economic theory : unpredictable outcomes when both price and quality are variable Quality does not figure prominently in many competition decisions It is, however, systematically mentioned in the guidelines Examples: mergers, cartels, tying practices, vertical integration
- Product variety under free entry 1. Salop model with exogeneous product differentiation and symmetric distance between firrms and fixed entry costs no entry costs, all can enter the market excessiveentry:higher prices due to decreased output per firm and hence higher average costs more than compensate for increased diversity
- Sensitivity of the results of assumptions 1. Hotelling Game: linear transportation costs l in the middle of line - minimum differentiation - competition for market share quadratic transportation costs l at the ends of the line - maximum differentiation 2. Preferences also impact upon localization l uniform distribution makes equilibrium symmetric 3. If we relax the assumption that all producers face the same fixed and variable costs, an efficient entrant my make existing varieties unprofitable, forcing the incumbent to withdraw unprofitable varieties/leave the market
- Quality Choice - Different quality relaxed price competition Focus: Consumers willingsness to pay for quality l Distribution of quality is assumed to be uniform Marginal costs are assumed constant indeendent of quality - markets with vertical diffeentiation and quality dependent MC may be natural monopolies although entry costs are small - when prices are regulated, too much quality and yet not enough variety might be observed
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- Localized competition : Product variety with fixed number of firms Endogeneous prices and product differentiation for a given number of firms degree of differentiation is determined by balancing the competition and market size effect Firms charge a mark-up which increases with transport costs (switching costs) Basic model: transport cost is exogeneous increasing differentiation is decreasing competition = decreasing size of market Exogeneous prices: differentiation is minimum because firms compete only for market share
- When is Bertrand Price Competition the better model? Appropriate choice in case of unlimited capacity When prices are more difficult to adjust in the short run than quantities For instance, in the mail-order business, it is costly to print new catalogues or price-lists and, therefore, over some period of time, prices will remain fixed and quantities will adjust accordingly.
- When is Cournot the more appropriate model? Limited capacities (Plan, Train, Hotel) If Firms are price setters. Capacity-then-price model Quantities are more difficult to adjust than prices Holiday industry: hotel rooms or aircraft seats are usually booked more than one year before a given touristic season and, therefore, prices adjust to sell the available capacities (using, e.g., ‘last-minute discounts’). Technological models often change the model of a game
- Bertrand competition with uncertain costs Each firm has private information about its costs • Trade-off between margins and likelihood of winning the competition Lesson: In the price competition model with homogeneous products and private information about marginal costs, at equilibrium, • firms set price above marginal costs; • firms make strictly positive expected profits; • more firms → price-cost margins↓, output↑, profits↓; • Infinite number of firms → competitive limit.
- Price competition with differentiated products Firms may avoid intense competition by offering products that are imperfect substitutes Lesson: If products are more differentiated, firms enjoy more market power. Extensions • Localized competition with n firms: Salop (circle) model • Asymmetric competition with differentiated products
- Salop Model Circular Model PAY FIXED COST WHEN ENTRY => higher AC (compare Hoteling: costlessly choose where to locate) Diversity More firms in the circle mean that they are closer substitutes less market power entry = FC = higher AC Higher T flattens residual demand = more market power Socially optimal numbr: FC and Transportation cos => excessive entry Social planner = minimize T (the closer, the better)