SUMMARY: Industrial organization. Markets and strategies., Sintesi del corso di Economia Industriale

Scarica SUMMARY: Industrial organization. Markets and strategies. e più Sintesi del corso in PDF di Economia Industriale solo su Docsity! CHAPTER 14 PRODUCT DIFFERENTIATION Introduction ○ Product homogeneity assumption is not a good approximation in many markets. ○ Possible solution: treat each product as a separate good. ○ Problem 1​: difficult to estimate demand. Problem 2​: difficult to forecast demand for new products. ○ Possible solution: ​place some structure into heterogeneity​. We are dealing with the issue of a product differentiation. We are trying to place some structure into heterogeneity. Heterogeneous products​ → to try to address this question, we use what is called the characteristics approach. 14.1 DEMAND FOR DIFFERENTIATED PRODUCTS In the previous chapters ​in particular in Chapter 8 ​we assumed that oligopoly competition takes place in a homogenous-product industry. This is a reasonable assumption for industries such as copper, but probably not for industries such as cars: a Toyota is not the same thing as a Volkswagen, and even within the Toyota family we find significant differences across models. Characteristics approach ➢ Example: housing market. Extreme degree of product differentiation: each individual house is different. However, each house is characterized by objective, measurable characteristics: location, total area, number of bathrooms, . . . So, one can imagine that when we look for a house, actually we are not looking for a house, but we are looking for a bundle or characteristic like the location, the size of the house, the number of bathrooms, and then we attach a price to each of these characteristics. So in a word it is as if the utility we derive for a house depends on the utility we derived for one given characteristic, ​plus​ the utility derived for another given characteristic, ​minus ​the price that we would pay for that particular house. ​(applied formula from below) Suppose there is one seller and all consumers agree on each characteristic’s value (all consumers agree on how much each characteristic is worth). Then, willingness to pay (inverse demand) can be found by estimating ​hedonic prices​. In this context, the ​characteristics approach ​to product demand allows for an approach that is both realistic and feasible: instead of estimating the demand for each individual house, we estimate the demand for each characteristic. The implicit prices of each characteristic​ (such as size and air conditioning),​ measured by regressions such as the above, are referred to as ​hedonic prices. Having estimated the demand for each characteristic, we can then better estimate the demand for a particular house, that is, a house with a particular set of characteristics. Demand for differentiated products – Utility consumer type i for product ​j – Compare utility from different products and purchase accordingly – Practical difficulties In the previous section, I showed how to model and measure consumer demand in a world with differentiated products. The next step is to understand how firms compete in markets with product differentiation. 14.2 COMPETITION WITH DIFFERENTIATED PRODUCTS I consider the case when price is the main strategic variable​, as in the Bertrand model ​(Section 8.1)​. Differently from the Bertrand model, I assume that the product is not homogeneous, so that it's not enough to price lower than the rival in order to capture all market demand. Vertical product differentiation ​corresponds to the case when consumers unanimously prefer more of a given characteristic (even if the intensity of such preference varies). Horizontal differentiation​ refers to the case when different buyers' preferences for a given characteristic have different signs; that is, some think it's a good thing, some think it's a bad thing. – How do firms position themselves? – (If products are different) how do firms compete in prices? In the case of Bertrand, this was pretty easy → I know that if I prize below my rival, I get the entire market, because everybody buys from me. In the case of differentiated goods. this is not exactly the case → I know that if I price below my rival, some consumers that would have bought from my rival will buy from me, but I don't know exactly how many. Two types of differentiation. – Important distinction regarding differentiation: - Vertical differentiation​ (quality):​ consumers agree on what is better. - Horizontal differentiation​ (taste):​ different consumers have different ideal points. VERTICAL PRODUCT DIFFERENTIATION – Products only differ along one dimension: ​quality​. – Different consumers have different valuation for higher quality. – Example: ​everyone prefers a larger house, but some more so than others. Competition with vertical differentiation The timing​ (the "rules of the game")​ are similar to the Bertrand model ​(Section 8.1)​: firms simultaneously set prices ​p​i​ ; consumers choose which firm they want to buy from; and finally firms produce and supply the amount demanded, where each unit costs ​c​ to produce. "Vertical" refers to the fact that all agree that a higher value of ​v​ implies a better product. – Firms simultaneously set prices ​(as in Bertrand model). – Unit cost: ​c – Product ​j ​: quality ​vj ​ , price ​pj – Assume without loss of generality that ​v​2​ > v​1 – Total number of consumers equal to N = 1 – Each consumer is different depending on a parameter ​b ​∈​ [b​L ​, b​H ​] ​which illustrates how much she loves quality. – The utility the consumer with taste parameter b derives from product ​j – Increase in ​v ​1 ​: positive direct effect, negative strategic effect. - The closer ​v​1 ​ to ​v​2 ​, the more competitive pricing is; in the limit, ​v​1 ​= ​v​2 ​, back to Bertrand. HORIZONTAL PRODUCT DIFFERENTIATION Consider a one-mile-long beach with two ice cream vendors, one at each end. Both venders offer the same product, but they offer it at different locations. For this reason, consumers value their ice cream options differently. Since the physical product is the same, consumer choice amounts to comparing price and location. The situation exemplified by the ice cream example is actually more general. First, it generalizes to any situation wherein sellers and buyers are physically located at different places and a transportation cost must be paid by buyers in order to purchase from a specific seller​ (gas stations, restaurants, steel mills, etc.). Second, by analogy, it also applies to situations wherein sellers offer products which differ according to some characteristic and buyers differ among themselves as to how they value such characteristic. Our model is known as the ​Hotelling model​: the timing ​(the "rules of the game") ​are similar to the Bertrand model ​(Section 8.1)​. Firms simultaneously set prices ​p​i​ ; consumers choose which firm they want to buy from; and finally firms produce and supply the amount demanded, where each unit costs ​c​ to produce. Figure 14.2 illustrates consumer demand. Along the horizontal axis we measure each consumer's "address," that is, their preferred product characteristic. Similarly to the model of vertical product differentiation, determining the Nash equilibrium of the Hotelling model graphically is not as easy as in the Bertrand case ​(cf Section 8.1)​. However, Figure 14.2 shows that, unlike the Bertrand case, a small change in price does not imply a big change in demand. Moreover, it is not sufficient for one firm to price lower than its rival for the firm to capture all market demand. – Consumers distributed along line segments. – Firms located at extreme points. – Consumer utility decreases in distance with respect to seller. – Literal interpretation (physical distance) or as metaphor for differences in taste. – Known as ​Hotelling model – Useful to analyze price and location decisions (similar to vertical differentiation model) - direct effect - strategic effect HOTELLING MODEL: ★ the characteristics space * utility e Each consumer has an ideal good, x: alternatively, the consumer is “located” in x. @ If the consumers consumes a good located in y, she derives utility U-t(x — y), where è U is the utility from the good è x— y is the distance from the ideal good a t is the cost of distance (aka, transportation cost) * consumers @ Each consumer wants to consume one unit of the good only @ N consumers, uniformly distributed along the unit line * the marginal consumer e patid) _ TT Pet 185) pra — a 4 TT i PE Pi "x 0 5 _ / Bi 1 @ Assume two goods only, A and B, at prices pa e pg e The indifferent (aka, marginal) consumer is at x* e Those on the left to x* demand good A; those to the right, the good 8. ° Analysis similar to the case of vertical differentation Profits are ma(a. b. pa. pg) and mg(a, b. pa. pp) Solve by backward induction In the second stage @ Taking a and b as given, firms choose prices pa and pe è In equilibrium, dra(.) Org(.) Opa pg è Equilibrium prices are da(a, b) and de(a, b) @ In the first stage © ° e Anticipating optimal choices of prices in the second stage, firms choose a and b e Profits are ta(a, b, ba(a, b), pe(a, b)) te(a, b, Pa(a,b), dela, b)) e Taking b as given, a change in a has this effect on firm A's profits CLIO) _ Orta.) £ Ata(.) ODa X OTa(.) Odg da da Oba da bs da =0 (+) GC) dra(.) n Ara(.) Ota(.) Ode da da Obg da direct effect strategic effect Effetto diretto ° gral) > 0: given prices, firm A's profits increase as it gets closer to the rival Effetto strategico è SPE < 0: as firm A gets closer to the rival, its price goes down ° PRO) > 0: a reduction in firm B's price damages firm A's profits Which effect is stronger?? Strategic effect is weak if price is a weak instrument e high transportation cost, so that consumers are “loyal" ® exogenous prices è collusion Product differentiation and market power – Important takeaway from the previous two models: ​the greater the degree of product differentiation, the greater the degree of market power​. – Product differentiation provides a solution to the "Bertrand trap" ​(Section 8.1)​: in fact, contrary to the prediction of the Bertrand model, price competition does not necessarily lead to pricing at marginal cost level. – The latter is only true under the​ (somewhat extreme) ​assumptions of homogeneous product, no capacity constraints, and no repeated interaction. – See also capacity constraints and repeated interaction (Chapters 8 and 9). If price competition is very intense, then firms tend to locate far apart ​(high degree of differentiation). If price competition is not very intense, then firms tend to locate close to each other ​(low degree of differentiation). 14.3 ADVERTISING AND BRANDING – Previous analysis: products differentiated according to objective, measurable characteristics. – Often, differentiation is subjective: physically similar products perceived as different by consumers. – Effects of advertising and branding. Types of goods and types of advertising – Economists classify goods in two different categories: - search good​: ​features can be determined before purchase. - experience good​:​ features only determined after consumption. – The distinction between search goods and experience goods leads to a parallel classification of advertising expenditures: - informative advertising:​ describes product’s existence, characteristics, selling terms. - persuasive advertising:​ improves consumers’ perception. Branding – Coca-Cola formula: one of the world’s best kept secrets since 1886. ​Is secrecy valuable? – Coca-Cola is more than chemical formula: memories, social and psychological associations: ​branding​. – Different view of advertising: consumers demand bundle of physical characteristics and brand image. Role and value of brands Brands may also be associated with an ​implicit contract ​between buyer and seller. Branding also helps understand the practice of selling several products under the same name: ​umbrella branding ​(also known as brand extensions). If brands are bundled with physical products to produce consumer utility, then successful brand extensions should include products that fit. – Vehicle for implicit contract between buyer, seller. - Example:​ HP offers quality products; consumers expect that, pay a high price when HP is observed. – Vehicle for umbrella branding: selling several products under the same name. - Example:​ Virgin brand (from cola to airline to retirement plans). Advertising intensity – It can be shown that a profit-maximising firm chooses: where​ ​a ​ ​/​ ​R​ is the ​advertising-to-revenues ratio​, is the firm’s price elasticity of demand andε – Advertising to sales ratio increasing in advertising elasticity and decreasing in price elasticity of demand​. – The advertising to sales ratio is greater the greater the advertising elasticity of demand and the lower the price elasticity of demand (or the greater the price-cost margin) Advertising and price competition – Does advertising increase or decrease price competition?​ It depends! – Example A. Two firms offer different wines, consumers unaware of which is which. Effectively back to homogenous products, hence Bertrand. – In this context, informative advertising softens price competition. – Example B. First sell homogeneous products but consumers are not aware of each firm’s price. – In this context, informative advertising (what price each firm charges) leads to a solution closer to Bertrand. Advertising product characteristics tends to soften price competition. Advertising prices tends to intensify price competition. 14.4 CONSUMER BEHAVIOR AND FIRM STRATEGY – Previous subsections: consumer characteristics, advertising as sources of product differentiation. – De facto differentiation may also result from imperfect information and consumer behavior: - search costs; - shrouded attributes; - switching costs. – All imply departures from homogeneous-good competition — even if, objectively speaking, products are homogeneous. – Search costs​: cost of finding each firm’s sale price. – Failure of​ law of one price​ for homogeneous products (there cannot be two different prices for the same product). – Price dispersion​: the situation whereby different firms set different prices for the same product. With heterogeneous consumer search costs, some buy at higher price at a closer location, others will travel to find a lower price. Obfuscation ​→ practices, that is, they purposefully make selling terms unclear. – Many predicted the Internet would eliminate search costs, hence reduce price dispersion. – But: price dispersion similar in offline and online markets.