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CHAPTER 7: PRODUCT DIFFERENTIATION AND MONOPOLISTIC COMPETITION

1. The chapter considers models with products that are homogeneous (perfect substitutes) or with

low-degree differentiation (good substitutes).

2. The market structure is monopolistic competition in which firms can freely enter and exit

3. The case of highly differentiated products with few substitutes is more interesting.

4. Markets with highly differentiated markets are not monopolistically competitive. The high degree

of differentiation creates a (temporary) barrier to entry.

DEFINITIONS

Product Differentiation: Related products that have varying characteristics so that consumers do not

view them as perfect substitutes. Products are differentiated if there is some identical price for each

product in which some consumers are willing to purchase one product over another.

Horizontal Differentiation: Differences between products that increase perceived benefit for some

consumers but decrease it for others.

Vertical Differentiation: Distinction of a product that makes it better than the products of competitors.

Differentiation Advantage: One of the major strategies to achieve competitive advantage (positive

economic profits). When pursuing a differentiation advantage, firms seek to offer a higher perceived

benefit while maintaining costs that are comparable to competitors (consumer surplus and producer

surplus increase and consequently welfare [= CS + PS] will increase).

Value-created = Consumer Surplus + Producer Surplus

= (B P) + (P C)

= B C

where, B = perceived benefit P = price C = cost

Successful competitive advantage increases value (B C), allows consumers to capture some increased

value (B P), [otherwise they do not purchase the product], and increases profit for the firm (P C)

[otherwise do not seek competitive advantage].

Firms may not pursue competitive advantage (and therefore society loses some welfare) if the advantagecannot be sustained for some time period. Sustainable competitive advantage requires forces that limit

the extent to which the advantage can be duplicated or neutralized. Two groups of mechanisms:

1. Impediments (barriers) to imitation

2. Early-mover advantages

Trade-off: Product differentiation may increase welfare by increasing value (the good part), but to make

it sustainable requires some barriers to entry and worsens market structure (the bad part).

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MODEL 1: Representative Consumer Model

In this model the consumers are alike and view all products as equally good substitutes. With

monopolistic competition there is free entry.

Case 1: Undifferentiated Products

Each of the n firms shares the market demand equally and gets (1/n) share of the demand. The number

of firms, n, is determined by making n just large enough to yield zero economic profits.

Results:

1. Lower FC increases the number of firms, increases market output and lowers market price.

2. P > MC (allocative inefficiency) too little total output. Efficiency, in a sense, improves as more

firms enter.

3. Number of firms is excessive when MC are nonincreasing (natural monopoly case)

4. Better result than the Cournot oligopoly model with barriers to entry

Case 2: Differentiated Products

The essence of the model remains the same as the undifferentiated case. However, each firm faces a more

steeply downward sloping demand curve. (reflects a higher CS from the differentiation)

Results:

1. P > MC (allocative inefficiency) too little total output.

2. Variety (number of brands) may not be optimal.

3. May be too little variety (brands)

FC are too high and firms lose money (p < AC)

Firm creates value (increases welfare) but is unable to capture sufficient CS to make a

profit does not produce

Need impediments to imitation so that firms can charge a higher price to cover AC or

provide a prize to innovators for their discoveries leading to differentiation4. May be too many brands

With free entry firms enter until profit is exhausted

Firms entering have a negative external effect on other firms profit (PS)

Welfare may decrease with too many brands

CS increases are smaller that PS decreases

Also have additional FC with each new brand

5. As before price is too high (p > MC)

Inference:

Differentiation may require barriers to imitation to be welfare enhancing.

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Hotellings Location (Spatial) Model

This model is an example of horizontal differentiation. It can be extended to other forms of

differentiation along a (linear) dimension.

Consider the case of two firms deciding where to locate on a street with uniformly distributed consumers.

You could think of this as a zero-sum game.

Consider the Sales from two Ice Cream trucks.Other Truck

Beginning Middle End

Waldman Beginning 50, 50 25, 75 50, 50

Location Middle 75, 25 50, 50 75, 25

End 50, 50 25, 75 50, 50

1st number is Waldman payoff, 2nd number is other truck payoff

Or characterized as

Other Truck

Beginning Middle End

Waldman Beginning 0 -25 0Location Middle 25 0 25

End 0 -25 0

Number is change in Waldman share. Negative of number is change in other truck share

This is a dominant strategy equilibrium game, with each player choosing the action that is the best

response against any action the other might take.

Look for dominant strategies in the game above.

Other Truck

Beginning Middle EndWaldman Beginning 50, 50 25, 75 50, 50

Location Middle 75, 25 50, 50 75, 25

End 50, 50 25, 75 50, 50

The dominant strategy for each player in this zero sum game is to locate the truck in the middle.

The two firms will cluster together in the middle (no spatial differentiation), when there is no cost to

locating. This is the Bertrand equilibrium with homogenous products.

Alternatively, if the stores are located apart with costly relocation, we get the Bertrand equilibrium withdifferentiated products.

1. P > MC

2. Differentiation softens the price competition

3. Differentiation gives firms market power

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ISSUES

1. The Federal Trade Commission (FTC) often considers two issues when deliberating;

(i) Is competition lessened?

(ii) Are consumers harmed?

Should firms pursuing competitive advantage with a differentiation be considered bad behavior or

good?

2. Patents provide an impediment (barrier) to imitation as a reward for innovation (which leads todifferentiated products).

(i) If the FC for innovation is low should a patent be issued?

(ii) If the FC is high should a patent be issued?

3. Is price collusion more likely or less likely with differentiation? What if the differentiation is

vertical (based on quality)?