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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-collectorsmarket/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 nonzero 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 subsidizedregulated monopoly (first best)
Cons
Surplus
Profits
Welfare
Subsidy
required
P
(USD)
Q
First bestregulated
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 subsidizedregulated 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