Econ 340 Industrial Economics

Product Differentiation/ Monopolistic Competition

Prof. Dr. Murat Yulek

How can Hermes sell a bag at USD 70,000?

• http://abcnews.go.com/Business/women-enter-luxury-hermes-chanel-handbags-collectors-market/story?id=20321851

Homogenous goods

• An homogeneous goods is the substitute of the other.– E.g. The consumer does not distinguish photocopy

paper produced by Firm 1 or 2. They are all the same to her so long as their technical specs are the same and thus they give the same satisfaction.

Differentiated goods

• Are all goods really homogenous?– Coke vs pepsi?– Hermes bag vs no name bag?

• They may have the same technical specs and the same functionality. But the consumer has different perception of them.

Homogenous vs Differentiated Goods

• For homogenous goods: As each firm’s product is a perfect substitute of the rival good, the residual demand curve faced by each firm is highly elastic (almost flat). If the firm raises its price it will lose all its residual demand.

For differentiated goods: firm faces downward sloping demand curve and thus a certain amount of market power.

Homogenous vs Differentiated Goods

Remember: in an homogenous good set up, firms may try to form cartels to increase market power (and thus profits).

Alternatively, they may try to change the “set up” itself by differentiating their goods from rivals.

Analysis of Product Differentiation

• Product differentiation is generally analysed under two settings:– Single market models– Spatially (geographically) separated markets

Single Market Models (SMM)

In SMM models (representative consumer models) firms face the same market demand and compete with each other to receive a share.

E.g. Shampoo market

Single Market Models (SMM)/Monopolistic Competition

Modelling SMMs:Firms can be assumed to behave Cournot (quantity) or Bertrand (price) type. Chamberlein (1933) is used here following Perloff and Carlton.

Single Market Models (SMM)

How Chamberlein (1933) model works:• Firms behave Cournot fashion• Rival firms examine the industry and the incumbents. Note that

their cost structure is identical and there is perfect information.• If in the existing configuration of the market there are non-zero

profits to be exploited, then the next firm enters the market. And tptal profits fall.

• This is repeated until total profits are zero (p=AC). Beyond this number of incumbents there is no incentive for an additional firm to enter. Existing incumbents do not leave the market as their factor costs are paid for (capital and labor) although they do not make any economic profit.

Single Market Models (SMM)/Monopolistic Competition:

Homogenous Good

• E.g. Numerical example from the book

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods with Cournot behavior• More firms will enter the market until

MR=MC; that is zero economic profit for each firm.

• However; only a limited of companies will cater to the market. Thus the result is not socially optimal, i.e., lower quantity and higher price than a competitive equilibrium.

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods• Existence of fixed costs: If fixed costs are high, less

firms will be able to enter the market as the differential between price and AC will be low attracting less firms.

Why so?The firm operates at MR=MC to determine its

output (q). MR and MC are independent of the fixed cost but AC is. So, at a given equilibrium, if FC is high than, unit (and total) profit is small.

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods• Welfare outcome: Moreover, remember that in monopolistic competition there are a number of producers in the market. There is a first -best (welfare improving) solution to that: let a single company cater to the market but regulate it so that it sets price equal to MC. The government will need to subsidize the company but that will still be socially better than monopolistic competition.

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods• Welfare outcome: At the first

best, the monopoly loses money as it is forced to price at MC. That loss has to be financed (subsidized) by the government. But the outcome is still better than monopolistic competition. Because each monopolistic competitor has to bear the same FC which in monopoly case would be born by only one firm.

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods• Welfare outcome: Monopolistic competition is sub-optimal even to subsidized-

regulated monopoly (first best)

Cons Surplus

Profits Welfare Subsidy required

P (USD)

Q

First best- regulated monopoly

259.30 -6.40 252.80 6,40 0.28 720

Monopolistic Comp

204.80 0 204.80 0 0.36 640

Unregulated Monopoly

64.80 123.20 188.00 0 0.64 360

Competition 259.20 0 259.20 0 0.28 720

Single Market Models (SMM)/Monopolistic Competition: Homogenous Good Case

Suggested results of the model: Undifferentiated goods• Welfare outcome: Monopolistic competition is sub-optimal even to subsidized-

regulated monopoly (second best)

If the government allows one firm (monopoly) but regulates and subsidizes it, welfare outcome is improved. But it is politically not feasible for a government to subsidize a firm. An alternative solution is limiting the number of entry to maximize social welfare. That is a second-best solution for the government. In the case we take, the government would limit entry to three firms to maximize CS (although industry profits are zeroed at eight firms).

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

All the above was for the case where the good was homogenous.How about the case where the good is differentiated?

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

Main results:When the good is differentiated there are two (not one; that is price) sources of inefficiency:Sub-optimal price (price higher than MC) and sub-optimal variety (too many or too little variety).

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

Main results (continued):- Fixed costs may sub-optimally reduce the

variety: when FC are too high, even if p>AVC, the firm may opt not to produce different varieties because p<AC and thus the firm would lose money by producing more output (variety). That would reduce the CS.

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

Main results (continued):- Reaction of rivals: when a firm launches a new

brand (of the same good class) it ignores the effects on rivals. The rivals do the same. That would lead to too many brands competing on price.

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

Main results (continued):- Reaction of rivals: when a firm launches a new

brand (of the same good class) it ignores the effects on rivals. The rivals do the same. That would lead to too many brands competing on price.

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

• The resulting number of brands will be determined by the counteracting effects of fixed costs and ignoring rival reaction.

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case

Single Market Models (SMM)/Monopolistic Competition: Differentiated Good Case