Lecture 3 Ecos2201 Gs Tab

Differentiation

Differentiation provides a degree of market power

Two forms of product differentiation, quality (vertical) and variety (horizontal)

Quality includes reliability, durability, features, and performance

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Variety includes colour, shape, appearance, location (geographical space and product space)

The degree of differentiation has implications for the success of entry

The profitability of entry depends very much on the response of incumbents

If entrant locates close to incumbent in product space price competition fierce and entry unprofitable

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It entrant has low costs relative to incumbent then entry can be profitable even if locate close.

Successful Entry - high differentiation and low costs relative to incumbent

Unsuccessful Entry - low differentiation and high costs relative to incumbent

Lets look at this more closely

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Competition in Differentiated Products

Hotelling Model: Customers are located uniformly on a line

With product space, a point on the line represents a customers most preferred position (oak in chardonnay)

Firms are located on this line at say L and R.

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The cost of a customer located at L moving to R is c (transport cost or loss to customer of not purchasing most preferred product type)

Consider a customer located the fraction x of the way from L to R

The price of the product at L is pL and at R is pR

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The total cost of the customer located at x purchasing from the firm at L is pL + xc and from the firm at R is pR + (1 - x)c

The customer buys from the location with the lowest total cost

There is a marginal customer, x*; who is indifferent between purchasing from either location.

x*is defined by

pL + x*c = pR + (1 - x)c

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Solving gives

If pR = pL; the marginal customer is halfway between L and R: If pR > pL the marginal customer is to the right of the midpoint, so more customers prefer to buy from L

Note that

Question: What does this imply for large and small c?

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1*2 2

R Lp px

c

* 1

2R

dx

dp c

Answer: When c is large an increase in pR only increases x* a small amount and so R loses few sales

On the other hand, when c is small an increase in pR increases x* by a large amount and so R loses many sales

So c has the interpretation of the degree of differentiation. The higher is c; the more the products are differentiated

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Let production costs be zero and the total number of customers be N

The profit of firm L is

Question: Determine the best response functions of firms L and R and the Nash equilibrium in prices

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*L Lp x N

Answer: Best Response for L: pL = (c+pR)/2

Best Response for R: pR = (c+pL)/2

Nash Equilibrium:

the two firms share the market equally

Firm Profit:

firm profit is increasing in c: The more differentiated are theproducts the higher is profit

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* *L Rp c p

2L R

cN

Endogenous Location

Two Stage Game: In first stage firms choose location (strategic variable). In second stage, given location, firms choose prices (tactical variable). Solve backwards. We have already solved second stage. So now solve first stage.

To begin assume prices are fixed and equal

Question: Determine the Nash equilibrium in location


Answer: Consider L locating at left end of line and R at right end of line. Is this a Nash equilibrium?

No, If R moves a little to the left, the marginal consumer shifts to the left and R serves more customers thus increasing profit. So R locating at the right end is not a best response to Llocating at left end.


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In fact, the best response for R is to move to a point just to the right of L. It then captures nearly the whole market. But this is not a Nashequilibrium for the best response of L to this is to locate just to the right of R.

The Nash equilibrium in locations is for both firms to locate next to each other in the middle - minimal differentiation

Hotelling model often applied to political parties.


What is the Nash equilibrium in locations if there is price competition?


We saw above that where there was price competition, firm profit was increasing in c.

Therefore, firms should choose locations to maximise c. That is they should locate at the ends of the line - maximal differentiation


If both locate in the middle, c = 0; and both make zero profit. The best response of firm R to L locating in the middle is to locate at the right end. And best response of L to this is to locate at the left end.

By moving away the firm can raise its own price but gets the further benefit that its rival also raises its price. Competition is less fierce.


Customers are not usually distributed evenly on a line. Need to locate where the customers are but then also locating close to competitors.In this case need to avoid price competition by differentiating in another dimension.

Car dealers located close to each other on Parramatta Rd, but sell different makes to lessen direct competition

David Jones and Myer both sell beds and located next to each other. Sell the same brands, but different models to reduce directcompetition.


Spatial Preemption

Firms can operate more than one store or sell more than one variety of a product.

Can a firm fill the product space so that entry is not profitable

Once again consider Hotelling model. Now assume there is a fixed cost of F to create a new location.

How far apart must two stores be to prevent entry (make it unprofitable)?


Let transport cost per-unit of distance be t; and let distance between two stores be d. Assume there is one customer for very unit of distance, so there are d customers between the two stores


We saw above that the stores price at c = td

An entrant would locate half way between the two stores (to maximise differentiation). So after entry, transportation costs are

The profit of entrant is price multiplied by quantity so

1

2c td

21 1 1.

2 2 4E td d td


Entry is unprofitable if

that is if

So firms can deter entry through there choice of d; distance apart. Many stores close together or many products close together, (varieties of cereal) can deter entry.

EF

2F

dt


Note that if incumbents can increase the entrants fixed costs then they can locate further apart, make more profit, and still deter entry.

Think about how incumbents might increase the fixed costs of entrants


Creating Synergies

Synergies exist where the value of the whole is greater than the sum of the parts

Microsoft Word, Excel, and PowerPoint are more valuable to the customer when used together, because it is easy to move from one to the other, than the sum of their value used separately


Synergies create scope economies – producing multiple products together has higher value, or lower cost, than producing the products in separate firms

Synergies lock-in customers, once use Microsoft applications keep using them and they also encourage customers to keep using a product even though it is inferior to a competitorsproduct - PowerPoint vs Latex


Where there are synergies customers are wary of purchase because get locked-in and technology may change. To alleviate this fear firms can offer cheap or free upgrades eg. new mobile phones at reduced rates to existing customers.

This reduces price competition between firms as consumersare locked-in. If they offer new phones to new customers this encourages defection and encourages rivals to do the same, price competition is strengthened.


Technological Races

Incumbent firms that are technological leaders are often superseded by entrants with new technology. Why do incumbents not undertake enough Research and Development to remain atthe technology forefront?

The reason is what Arrow (1962) termed the ‘replacement effect’ and what McAfee calls cannibalization.


Consider an incumbent selling a product. If it undertakes R&D and discovers a new product, this product cannibalizes (replaces) some of the profit it was making on its old product. On the other hand, a potential entrant suffers no such effect, it makes new sales but does not lose any on an existing product


Incumbent technological leaders need to be aware of this problem and structure the organisation to overcome it.

Perhaps by encouraging competition between R&D teams within a firm or rewarding continuous small improvements via incentive schemes


Patent Strategy

A patent gives its holder monopoly power over the product covered by the patent. It primary role is to provide a reward, in the form ofmonopoly profit, for innovation.

Patent strategy is a strategy to minimise competition through the use of the patent system and trade secrets.


Patent or Trade Secret

A patent gives monopoly power for a fixed period of time but then the new product or technology is freely available to all A problem with patents is that they can be examined and reverse engineered, a different but similar product emerges as a competitor. Patents reveal information


Trade secrets have no legal protection and only lasts as long as the secret does. This can be a long time though, formula for Coca-Cola

Trade secrets also overcome the problem of revealing details of the new technology in the patent, however, it can be difficult to keep thesecret. Workers can sell their knowledge to competitors


Protective Patents

A firm discovers a new technology or product and patents it. In the process of the discovery it tries many paths and learns about alternative routes

By patenting the different routes it can delay the appearance of competing technologies


Licensing

A firm with a patent can license other firms to use the technology or produce the product. The licensor receives fixed fee and/or royalty (per-unit) payments from the licensee.

Although a competitor is produced the effects of competition are reduced to some extent by the royalty


The licensor can gain because the licensee is in a better position to exploit the new technology or product because of its distribution network

Consider two firms 1, and 2 that produce a homogeneous product with identical technology.

Marginal cost is constant and equal to

Each sells at p0.

1 20 0c c

1 20 0q q


Firm 1 discovers a new technology that reducesmarginal cost to

It patents the technology. In the absence of licensing firm 1sells

and makes more profit because its costs are lower.

Firm 1 now licenses the technology to firm 2 and charges a per-unit royalty of

Question: What are equilibrium outputs of both firms, is licensing profitable?

1 21 0c c

1 1 21 0 1q q q

2 10 1r c c


Answer: With licensing and the royalty, equilibrium outputs and price are the same because the licensees costs plus royalty are the same as in the absence of licensing. The profit of Firm 1 is equal to what in made in the absence of licensing PLUS

21.r q


Hedonic Prices

How does a firm determine the price of a new product?

The idea of Hedonic Pricing is that a product’s value is the sum of the value of its attributes


There is a base model Mazda 3 and then there are many add-ons. The same applies for other brands and makes. By analysing the price of these different cars and their attributes each attribute can be valued.

Use Regression analysis. Once attributes are valued, price new product by summing values of attributes


Hedonic pricing works well for different mixes of existing attributes, but has problems if a new product has attributes that are new.

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Lecture 3 Ecos2201 Gs Tab