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Product Variety and Quality
1
Introduction
• Most firms sell more than one product
• Products are differentiated in different ways
– horizontally
• goods of similar quality targeted at consumers of
different types
– how is variety determined?
– is there too much variety
– vertically
• consumers agree on quality
• differ on willingness to pay for quality
– how is quality of goods being offered determined?
2
Modeling horizontal differentiation
• Address models
– Consumers have preferences over the characteristics of
products
• Monopolistic competition model
– Consumers have preferences over goods and a taste for
variety
3
Horizontal product differentiation
• Suppose that consumers differ in their tastes
– firm has to decide how best to serve different types of
consumer
– offer products with different characteristics but similar
qualities
• This is horizontal product differentiation
– firm designs products that appeal to different types of
consumer
– products are of (roughly) similar quality
• Questions:
– how many products?
– of what type?
– how do we model this problem?
4
A spatial approach to product variety
• The spatial model (Hotelling) is useful to
consider
– pricing
– design
– variety
• Has a much richer application as a model of
product differentiation
– “location” can be thought of in
• space (geography)
• time (departure times of planes, buses, trains)
• product characteristics (design and variety)
– consumers prefer products that are “close” to their
preferred types in space, or time or characteristics
5
A Spatial approach to product variety 2
• Assume N consumers living equally spaced along Main
Street – 1 mile long.
• Monopolist must decide how best to supply these
consumers
• Consumers buy exactly one unit provided that price
plus transport costs is less than V.
• Consumers incur there-and-back transport costs of t
per mile
• The monopolist operates one shop
– reasonable to expect that this is located at the center of Main
Street
6
Suppose that the monopolist
The spatial model
Price
sets a price ofPrice
p1
p1 + tx
p1 + t.x
V
V
All consumers within
distance x1 to the left
and right of the shop
will by the product
z=0
t
t
p1
x1
1/2
What determines
x1?
x1
z=1
Shop 1
p1 + tx1 = V, so x1 = (V – p1)/t
7
The spatial model
Price
p1 + t.x
Suppose the firm
2reduces the price
Price
p1 +tot.xp2?
V
V
Then all consumers
within distance x2
of the shop will buy
from the firm
z=0
p1
p2
x2
x1
1/2
x1
x2
z=1
Shop 1
8
The spatial model 3
• Suppose that all consumers are to be served at price p.
– The highest price is that charged to the consumers at the ends of
the market
– Their transport costs are t/2 : since they travel ½ mile to the shop
– So they pay p + t/2 which must be no greater than V.
– So p = V – t/2.
• Suppose that marginal costs are c per unit.
• Suppose also that a shop has set-up costs of F.
• Then profit is p(N, 1) = N(V – t/2 – c) – F.
9
Monopoly pricing in the spatial model
• What if there are two shops?
• The monopolist will coordinate prices at the two shops
• With identical costs and symmetric locations, these prices
will be equal: p1 = p2 = p
– Where should they be located?
– What is the optimal price p*?
10
Location with two shops
Delivered price to
Suppose that the entire market is
Price
If there are two shops
they will be located
V
symmetrically a
distance d from the
The
maximumofprice
end-points
the p(d)
the firmmarket
can charge
is determined
Now raisebythethe
price
consumers
at the
at each
shop
Start
with
a
low
center of the marketprice
at each shop
Suppose that
d < 1/4
z=0
consumers at the
tomarket
be served
center equals
their reservation price Price
V
p(d)
What determines
p(d)?
d
Shop 1
1/2
1-d
Shop 2
z=1
The shops should be
moved inwards
11
Delivered price to
consumers at the
end-points equals
their reservation price
Location with two shops 2
The maximum price
the firm can charge
is now determined
by the consumers
at the end-points
of the market
Price
Price
V
V
p(d)
p(d)
Now raise the price
at each shop
Start with a low price
at each shop
Now suppose that
d > 1/4
Now what
determines p(d)?
z=0
d
Shop 1
1/2
1-d
Shop 2
z=1
The shops should be
moved outwards
12
It follows that Location
shop 1 should
be located at
Price
1/4 and shop 2
at 3/4
with two shops 3
Price at each
shop is then
p* = V - t/4
Price
V
V
V - t/4
V - t/4
Profit at each shop
is given by the
shaded area
c
c
z=0
1/4
Shop 1
1/2
3/4
Shop 2
z=1
Profit is now p(N, 2) = N(V - t/4 - c) – 2F
13
Three shops
What if there
are three shops?
By the same argument
they should be located
at 1/6, 1/2 and 5/6
Price
Price
V
Price at each
shop is now
V - t/6
V
V - t/6
z=0
V - t/6
1/6
Shop 1
1/2
Shop 2
5/6
z=1
Shop 3
Profit is now p(N, 3) = N(V - t/6 - c) – 3F
14
Optimal number of shops
• A consistent pattern is emerging.
• Assume that there are n shops.
• They will be symmetrically located distance 1/n apart.
• We have already considered n = 2 and n = 3. How many
shops should
• When n = 2 we have p(N, 2) = V - t/4
there be?
• When n = 3 we have p(N, 3) = V - t/6
• It follows that p(N, n) = V - t/2n
• Aggregate profit is then p(N, n) = N(V - t/2n - c) – nF
15
Optimal number of shops 2
Profit from n shops is p(N, n) = (V - t/2n - c)N - nF
and the profit from having n + 1 shops is:
p*(N, n+1) = (V - t/2(n + 1)-c)N - (n + 1)F
Adding the (n +1)th shop is profitable
if p(N,n+1) - p(N,n) > 0
This requires tN/2n - tN/2(n + 1) > F
which requires that n(n + 1) < tN/2F.
16
An example
Suppose that F = $50,000 , N = 5 million and t = $1
Then tN/2F = 50
For an additional shop to be profitable we need n(n + 1) < 50.
This is true for n < 6
There should be no more than seven shops in this case: if
n = 6 then adding one more shop is profitable.
But if n = 7 then adding another shop is unprofitable.
17
Some intuition
• What does the condition on n tell us?
• Simply, we should expect to find greater product variety
when:
– there are many consumers.
– set-up costs of increasing product variety are low.
– consumers have strong preferences over product characteristics
and differ in these
• consumers are unwilling to buy a product if it is not “very close”
to their most preferred product
18
Empirical Application: Price Discrimination
and Imperfect Competition
Although we have presented price discrimination and
product design (versioning) issues in the context of a
monopoly, these same tactics also play a role in more
competitive settings of imperfect competition
Imagine a two-store setting again
Assume N customers distributed evenly between the two
stores, each with maximum willingness to pay of V .
No transport cost—Half of the consumers always buys at
nearest store. Other half always buys at cheapest store.
19
Price Discrimination and Imperfect
Competition 2
If both stores operated by a monopolist, set price = V.
Cannot set it higher of there will be no customers.
Setting it lower though gains nothing.
What if stores operated by separate firms?
Imagine P1 = P2 = V. Store 1 serves N/4 pricesensitive customers and N/4 price-insensitive ones.
The same is true for Store 2.
If Store 1 cuts its price  below V.
It loses N/2 from all current customers
It gains N(V - )/4 by stealing all pricesensitive customers from Store 2
20
Price Discrimination and Imperfect
Competition 3
MORAL 1: Both firms have a real incentive to cut price.
This ultimately proves self-defeating
In equilibrium, both still serve N/2 customers but now
do so at a price closer to cost.
This is especially frustrating in light of the “brandloyal” or price-insensitive customers
Cutting their price does not increase their likelihood
of shopping at a particular place. It just loses revenue.
MORAL 2: Unlike the monopolist who sets the same
price to everyone, these firms have an incentive to
discriminate and so continue to charge a high price to
loyal consumers while pricing low to others.
21
Price Discrimination and Imperfect
Competition 4
The intuition then is that price discrimination may be
associated with imperfect competition and become more
prominent as markets get more competitive (but still less
than perfectly competitive).
This idea is tested by Stavins (2001) with airline prices.
Restrictions such as a required Saturday night stay-over
or an advanced purchase serve as screening mechanism
for price-sensitive customers. Hence, restrictions lead to
lower ticket price.
Stavins (2001) idea is that price reduction associated with
flight restrictions will be small in markets that are not
very competitive.
22
Price Discrimination and Imperfect
Competition 5
Stavins (2001) looks at nearly 6,000 tickets covering 12
different city-pair routes in September, 1995.
She finds strong support for the dual hypothesis that:
a) passengers flying on a ticket with restrictions pay less;
b) price reduction shrinks as concentration rises
In highly competitive (low HHI) markets, a Saturday
night restriction leads to a $253 price reduction but only
a $165 reduction in less competitive ones.
In highly competitive (low HHI) markets, an Advance
Purchase restriction leads to a $111 price reduction but
only a $41 reduction in less competitive ones.
23
Product Quality
24
Monopoly and product quality
• Firms can, and do, produce goods of different qualities
• Quality then is an important strategic variable
• The choice of product quality determined by its ability to
generate profit; attitude of consumers to q uality
• Consider a monopolist producing a single good
– what quality should it have?
– determined by consumer attitudes to quality
•
•
•
•
prefer high to low quality
willing to pay more for high quality
but this requires that the consumer recognizes quality
also some are willing to pay more than others for quality
25
Choosing quality
• Quality – vertical attributes of a product (ALL
consumers agree that a product X is of higher
quality than another product Y)
• Firms choose both quantity and quality
• Profit maximization
– MR of an increment of quality is equal to its MC
• Key problem: asymmetric information
26
Asymmetric information
• Lemons problem
– How would you describe an equilibrium?
– Why is this a problem?
• Adverse selection
• Moral hazard
– One side of a transaction has an incentive to change the
terms of the exchange, unobserved by the other side
27
Asymmetric information: types of goods
• Search goods: consumers have sufficient everyday
knowledge or can accurately predict quality of a
product BEFORE purchase
• Experience goods: quality can be determined by
consumers only AFTER purchase
28
Search goods
• Why manufacturers and service companies do not
provide a moderate quality at a moderate price
(why price/quality ratio rare works in real life)?
• Aim: increase profit by capturing consumer
surplus (we assume imperfect competition here)
• Mechanism: quality discrimination (Highest quality
level is chosen solely on grounds of independent profit maximization,
but a firm needs preventing switching high-end consumers to low-end
products)
– versioning / damaged goods
– widening the range of quality offered
29
Experience goods: strategies
• Reputation
– Aim: repeat sales (customer loyalty)
– Reputation is transferrable across consumers (“word of
mouth” as a promotion tool) and across markets
(exploiting established reputation in new markets)
• Commitment
– warranty (how to use for quality discrimination?)
– reputation (why restaurants in tourist areas are so bad?)
– Investment as a form of commitment: what is a signal
of quality in this case?
30
Modeling commitment
• “Pure reputation model” (Shapiro, 1983)
– Only new products are of unknown quality in the first period
– Consumers learn true quality after purchase and inform other
potential buyers
– Decision: investment in reputation in the first period vs. earning a
rent from selling high-quality products in all subsequent periods
– Assume that companies don’t “milk” their reputation
• “Advertising models” (Nelson, 1970, 1978)
– Decision: price / advertising expenses combination to prevent entry
of low-quality producers
– Why “burning money” / noninformative advertising exists?
(Warning: explanation for new experience goods only)
31
Price and advertising as signals of quality
• Higher price – Higher Quality
– Theory: Yes
• More advertising – High Quality
– Theory: it depends (on the cost of information)
32
Empirical testing
• Caves and Greene (1996)
– Source of information: Consumer Reports (ranking
products by objective characteristics – use as measures
of quality)
– Method: correlation analysis
– Findings:
• rank correlation coefficient for price-quality 0.38 for list prices,
0.27 for transaction prices
• Is it a strong or weak correlation?
33
Why weak?
• Price-quality correlation is higher for product
categories that include more brands (greater scope
for vertical differentiation)
• Lower for “convenience goods” (heavy
advertising and frequent repeat purchase)
• Weakest for product that can use image
advertising to build customer loyalty (horizontal
differentiation)
34
Testing Nelson model
• Conclusion: quality signaling is not a particularly
important determinant of advertising in consumer
goods (median values of the rank correlations are
close to zero)
• In some product categories correlation in very
strong positive, in some – strong negative)
– Advertising outlays tend to increase with quality for
innovative goods (providing information)
– Advertising is less correlated with quality of
convenience goods (horizontal differentiation)
35
Case: health care markets
36
Commodity Bundling and Tie-In
Sales
37
Introduction
• Firms often bundle the goods that they offer
– Microsoft bundles Windows and Explorer
– Office bundles Word, Excel, PowerPoint, Access
• Bundled package is usually offered at a discount
• Bundling may increase market power
– GE merger with Honeywell
• Tie-in sales ties the sale of one product to the purchase of another
• Tying may be contractual or technological
– IBM computer card machines and computer cards
– Kodak tie service to sales of large-scale photocopiers
– Tie computer printers and printer cartridges
• Why? To make money!
38
Bundling: an example
How
much canfilms
• Two television stations offered two old
Hollywood
How much can
be charged for
– Casablanca and Son of Godzilla
be charged for
If the films are sold
Godzilla?
• Arbitrage is possible betweenCasablanca?
the stations
separately total
• Willingnessrevenue
to pay is:
is $19,000
$7,000
Willingness to Willingness to
pay for
pay for
Casablanca
Godzilla
Station A
$8,000
$2,500
Station B
$7,000
$3,000
$2,500
39
Bundling:
How much can
an
example
2
beBundling
charged
forprofitable
is
thebecause
package?
it exploits
Now suppose
aggregate willingness
that the two films are
If and
the films
Willingness
to sold
Willingness
Total
payto
bundled
sold are
as pay
a package
total pay for
for
Willingness
as a package
revenue
is $20,000Godzilla
Casablanca
to pay
Station A
$8,000
$2,500
$10,500
Station B
$7,000
$3,000
$10,000
$10,000
40
Bundling
• Extend this example to allow for mixed bundling:
offering products in a bundle and separately
41
Mixed bundling
• What should a firm actually do?
• There is no simple answer
– mixed bundling is generally better than pure bundling
– but bundling is not always the best strategy
• Each case needs to be worked out on its merits
42
An Example
Four consumers; two products; MC1 = $100, MC2 = $150
Consumer
Reservation
Price for
Good 1
Reservation
Price for
Good 2
Sum of
Reservation
Prices
A
$50
$450
$500
B
$250
$275
$525
C
$300
$220
$520
D
$450
$50
$500
43
The example 2
Price
$450
$300
$250
$50
Price
$450
$275
$220
$50
Good 1: Marginal Cost $100
Quantity
TotalConsider
revenue simple
Profit
monopoly
pricing
1
$450
$350
2
$400
$600
Good 1 should be sold
3
$750
$450
at $250 and good 2 at
4
$200
-$200
$450. Total profit
Good 2: Marginal
Cost +
$150
is $450
$300
Quantity
= Total
$750revenue
1
2
3
4
$450
$550
$660
$200
Profit
$300
$200
$210
-$400
44
The example
3 consider pure
Now
bundling
Consumer
A
B
C
D
Reservation
Reservation
Price forThe highest
Price for
bundle
Good 1 price that
Good
2 be
can
considered
isbuy
$500
All four
consumers
will
$50
$450
the bundle and profit is
4x$500
$100)
$250- 4x($150 +
$275
= $1,000
$300
$220
$450
$50
Sum of
Reservation
Prices
$500
$525
$520
$500
45
The example
Now4 consider mixed
Take the monopoly prices p1 = $250; p2 = $450 and
a bundle price pB = $500
bundling
All four consumers buy
something
and profit
is
Reservation
Reservation
Consumer
Price +
for$150x2 Price for
Can the$250x2
seller
improve
Good
1
Good 2
=
$800
on this?
Sum of
Reservation
Prices
A
$50
$450
$500
B
$250
$275
$525
$500
C
$300
$250
$220
$520
D
$450
$250
$50
$500
46
The example 5
Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520
This is actually
the best Reservation
that the
Reservation
All four consumers
buy
Consumer
do for
Price+forfirm can
Price
and profit is $300
Good 1
$270x2 + $350
= $1,190
A
$50
Good 2
Sum of
Reservation
Prices
$450
$450
$500
B
$250
$275
$525
$520
C
$300
$220
$520
D
$450
$450
$50
$500
47
Bundling again
• Bundling does not always work
• Mixed bundling is always more profitable than pure
bundling
• Mixed bundling is always better than no bundling
• But pure bundling is not necessarily better than no
bundling
– Requires that there are reasonably large differences in
consumer valuations of the goods
• Bundling is a form of price discrimination
• May limit competition
48
Tie-in sales
• What about tie-in sales?
– “like” bundling but proportions vary
– allows the monopolist to make supernormal profits on the tied
good
– different users charged different effective prices depending
upon usage
– facilitates price discrimination by making buyers reveal their
demands
49
Tie-in sales 2
• Suppose that a firm offers a specialized product – a
camera – that uses highly specialized film cartridges
• Then it has effectively tied the sales of film cartridges to
the purchase of the camera
– this is actually what has happened with computer printers and
ink cartridges
• How should it price the camera and film?
– suppose also that there are two types of consumer, highdemand and low-demand, with one-thousand of each type
– high demand P = 16 – Qh; low demand P = 12 - Ql
– the company does not know which type is which
50
Tie-in sales 3
• Film is produced competitively at $2 per picture
– so film is priced at $2 per picture
• Suppose that the company leases its cameras
– if priced so that all consumers lease then we can ignore
production costs of the camera
• these are fixed at 2000c
• Now consider the lease terms
51
Tie-in
sales:
an
example
2
So the firm can set a
$
$16
Recall
theof $50
lease that
charge
High-Demand
Low-Demand
film sells at $2
Consumers to each type of Profit
Consumers
is $50 from each
per
picture
consumer:
it cannotlow-demand and highHigh-demand
Demand: P = 16 - Q
Demand: P = 12 - Q
discriminate
consumers take 14
demand consumer. Total
pictures$
profit is $100,000
Consumer surplus
Consumer
surplus
for high-demand
$12
consumers is $98
$98
for low-demand
consumers
Low-demand
is $50
consumers take 10
pictures
$50
$2
$2
14 16
Quantity
10 12
Quantity
52
Tie-in sales example 3
• This is okay but there may be room for improvement
• Redesign the camera to tie the camera and the film
– technological change that makes the camera work only with
the firm’s film cartridge
• Suppose that the firm can produce film at a cost of $2
per picture
• Implement a tying strategy that makes it impossible to
use the camera without this film
53
Tie-in sales: an example 2
High-Demand Aggregate profit
Low-Demand
is
now the camera at
Lease
Profit
is $32 plus
Consumers
Consumers
$48,000 + $56,000
= Profit is $32
$32.
$24 in film profits =
Tying increases
theDemand:
$104,000
plusP =$16
Demand: P = 16 - Q
12 -in
Qfilm
Each
$56 high-demandfirm’s profit
profits
= $48
Consumer
surplus
consumer will lease
$
$
the camera at $32
High-demand
$12
consumers take 12
pictures
$16
$32
$4
$2
for low-demand
consumers
Low-demand
is $32
consumers take 8
pictures
$32
$4
$2
$24
12
Quantity
16
$16
8
12
Quantity
54
Tie-in sales example 3
• Why does tying increase profits?
– high-demand consumers are offered a quantity discount
under both the original and the tied lease arrangement
– but tying solves the identification and arbitrage problems
• film exploits its monopoly in film supply
• high-demand consumers are revealed by their film
purchases
• quantity discount is then used to increase profit
• arbitrage is not an issue: both types of consumers pay the
same lease and the same unit price for film
55
Tie-in sales example 4
• Can the firm do even better?
• Redesign the camera so that the film cartridge is integral
– offer two types of integrated camera/film package: high capacity
and low capacity
– what capacities?
• This is similar to second-degree price discrimination
– design two cameras with socially efficient capacities: 10 picture
and 14 picture
– lease these as integrated packages
56
Tie-in sales:
High-Demand
Consumers
$
$16
12
Aggregate profit is now
an $50,000
example
2
+ $58,000 =
$108,000
Low-Demand
Consumers
High-demand
Demand:consumers
P = 16 - Q get $40
Demand: P = 12 - Q
Low-demand
high-demand
consumerSo
surplus
consumers will pay
by leasingconsumers
the 10- can$ be
up to $70 to lease
picurecharged
camera $86 to lease
the 10-picure
$12
the 14-picture
camera
camera
$40
$70
$2
$70
$16
10 14 16
Quantity
$2
10 12
Quantity
57
Network externalities
• Product complementarities can generate network effects
– Windows and software applications
• substantial economies of scale
• strong network effects
– leads to an applications barrier to entry
• new operating system will sell only if applications are written for it
• but…
• So product complementarities can lead to monopoly
power being extended
58
Anti-trust and bundling
• The Microsoft case is central
– accusation that used power in operating system (OS) to gain
control of browser market by bundling browser into the OS
– need\ to show
• monopoly power in OS
• OS and browser are separate products with no need to be bundled
• abuse of power to maintain or extend monopoly position
– Microsoft argued that technology required integration
– further argued that it was not “acting badly”
• consumers would benefit from lower price because of the
complementarity between OS and browser
59
Microsoft and Netscape
• Complementarity products
–
–
–
–
so merge?
what if Netscape refuses?
then Microsoft can develop its own browser
MC ≈ 0 so competition in the browser market drives price
close to zero
– but then get the outcome of merger firm through competition
• So Microsoft is not “acting badly”
• But
– JAVA allows applications to be run on Internet browsers
– Netscape then constitutes a threat
– need to reduce their market share
60
And now…
• This view gained more force & support in Europe
– bundling of Media Player into Windows
– Competition Directorate found against Microsoft
• Microsoft Appealed
• Microsoft finally lost its appeal in September, 2007
– Result: Microsoft ordered to stop bundling and
forced to pay fine of €497 (finally settled in October,
2007)
– Some economists upset by this decision arguing that
as price discrimination, bundling often expands the
market, AND also that bundling/tying can reflect
competition and not just market power
61
Competitive Bundling/Tying
• Bundling and tying are very commonly
observed phenomena
– Perhaps too commonly observed to be just the
outcome of monopoly power
– Is there a way to understand competitive bundling?
• Yes! Salinger and Evans (2005) and Evans (2006)
• It may well be the case that the structure of
demand and the nature of scope and scale
economies force competitive firms to bundle tie
their goods
62
Competitive Bundling/Tying 2
• Consider the table on the next slide and assume consumer
willingness to pay is $20 for most preferred option
– Competitive firm can’t offer pain reliever & decongestant
separately, To do so incurs
• total fixed cost of $600
• Marginal cost of $4
• Breakeven price = $6
– 50 by pain relief alone and pay $6 per unit
– 50 by decongestant alone and pay $6 per unit
– 100 buy both and pay $12 per combined unit
• Total Revenue = $1800; Total cost = $600 + $4x150 +
$4x150 = $1800
– Rival could sell bundled product for $10 and steal all 100
customers interested in joint goods who now pay $12
63
Competitive Bundling/Tying 3
Product
$8.50 is lowest
Pain Relieffeasible
Decongestant
price and isBundle
Demand
Costs
Fixed Cost
Marginal Cost
Moral:100
competitive
50 by only
achieve
pressure may be the
offering the bundled
underlying reason for
product
$300
$300
$300
much bundling
$4
$4
$7
50
Feasible Prices
Separate Goods
Pure Bundling
Mixed Bundling
Bundle + Good 1
Bundle + Good 2
$6
---$10
$10
----
$6
---$10
---$10
----$8.50
$10
$9
$9
64
Antitrust and tying arrangements
• Tying arrangements have been the subject of extensive
litigation
• Current policy
– tie-in violates antitrust laws if
• there exists distinct products: tying product & tied one
• firm tying the products has sufficient market power in
the tying market to force purchase of the tied good
• tying arrangement forecloses or has the potential to
foreclose a substantial volume of trade
• As time passes, approach is more and more of a rule-ofreason standard with increasing recognition that
whether price discrimination or competitive pressure is
the reason, bundling/tying is often welfare-improving
65