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13.4 Product Differentiation. When firms produce similar but differentiated products, they can be differentiated in two ways: Vertical Differentiation – consumers consider one product vastly superior to another ex) Processed Cheddar and Blue Cheese ex ) Flip Phone and Smart Phone - PowerPoint PPT Presentation
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13.4 Product DifferentiationWhen firms produce similar but differentiated products, they can be differentiated in two ways:
Vertical Differentiation – consumers consider one product vastly superior to another
ex) Processed Cheddar and Blue Cheese
ex) Flip Phone and Smart Phone
Horizontal Differentiation – consumers consider one product a POOR substitute for the other, and may pay more for the “better” product
ex) Swiss Cheese and Cheddar Cheese
ex) Iphone and Samsung Galaxy
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13.4 Product DifferentiationHorizontal Differentiation ≈ Brand Loyalty
Firms spend money on advertising and “exclusive deals” to maintain horizontal differentiation
A product with WEAK horizontal differentiation will be MORE sensitive to its own and rivals’ price changes.
(Small price change =>Large demand change)
A product with STRONG horizontal differentiation will be LESS sensitive to its own and rivals’ price changes.
(Small price change =>Small demand change)
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13.4 Product Differentiation
Shift in demand is due to a change in rivals’ price.
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Bertrand Competition – Horizontally Differentiated Products
Assumptions:
Firms set price*Differentiated productSimultaneous Non-cooperative
*Differentiation means that lowering price below your rivals' will not result in capturing the entire market, nor will raising price mean losing the entire market so that residual demand decreases smoothly
5Chapter Thirteen
Q1 = 100 - 2P1 + P2 "Coke's demand"Q2 = 100 - 2P2 + P1 "Pepsi's demand"
MC1 = MC2 = 5
What is Coke’s residual demand when Pepsi’s price is $10? $0?
Q1(10) = 100 - 2P1 + 10 = 110 - 2P1
Q1(0) = 100 - 2P1 + 0 = 100 - 2P1
Q1 = 100 - 2P1 + P2 "Coke's demand"Q2 = 100 - 2P2 + P1 "Pepsi's demand"
MC1 = MC2 = 5
What is Coke’s residual demand when Pepsi’s price is $10? $0?
Q1(10) = 100 - 2P1 + 10 = 110 - 2P1
Q1(0) = 100 - 2P1 + 0 = 100 - 2P1
Bertrand Competition – Differentiated
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110100
D0
D10
Chapter Thirteen
Residual Demand
Pepsi’s price = $0 for D0 and $10 for D10
Coke’s Price
Coke’s Quantity
7Coke’s Quantity
MR0
D0
0
MR10
110100
D10
Chapter Thirteen
Marginal Revenue (from Residual Demand)
Pepsi’s price = $0 for D0 and $10 for D10
Each firm maximizes profits based on its residual demand by setting MR (based on residual demand) = MC
Coke’s Price
5
8
5
27.5
MR0
D0
0
D10
MR10
30
45 50
110100
Chapter Thirteen
Optimal Price and Quantity
When MC=MR, we calculate price and quantityCoke’s
Price
Coke’s Quantity
Example: MR=MC
MRR(10) = 55 - Q1(10) = 5
Q1(10) = 50P1(10) = 30
Therefore, firm 1's best response to a price of $10 by firm 2 is a price of $30
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Reaction Functions
Q1 = 100 - 2P1 + P2 "Coke's demand"Q2 = 100 - 2P2 + P1 "Pepsi's demand"MC1 = MC2 = 5
Solve for firm 1's reaction function for any arbitrary price by firm 2
P1 = 50 - Q1/2 + P2/2MR = 50 - Q1 + P2/2MR = MC => 5 = 50 - Q1 + P2/2Q1 = 45 + P2/2(continued)
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Reaction Functions
Q1 = 100 - 2P1 + P2 "Coke's demand"Q2 = 100 - 2P2 + P1 "Pepsi's demand"MC1 = MC2 = 5Q1 = 45 + P2/2
Continue Solving for the reaction function
Q1 = Q1
100 - 2P1 + P2 = 45 + P2/2P1 = 27.5 + P2/4 Likewise, P2 = 27.5 + P1/4
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P1 = 27.5 + P2/4, P2 = 27.5 + P1/4Q1 = 100 - 2P1 + P2 "Coke's demand"Q2 = 100 - 2P2 + P1 "Pepsi's demand"
Solving for price and quantity:P1 = 27.5 + P2/4P1 = 27.5 + (27.5 + P1/4 )/44P1 = 110 + 27.5 + P1/4 3.75P1 =137.5 P1* = 110/3 = P2* (Due to symmetry)
Q1 = 100 - 2P1 + P2
Q1 = 100 - 110/3 Q1* = 190/3 = Q2* (by symmetry)
Equilibrium
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P1* = 110/3 = P2* Q1* = 190/3 = Q2*MC1 = MC2 = 5 Calculating Profits. 1* = TR-TC 1* = (P1* - MC1) Q1* 1* = (110/3 - 5) 190/3 1* = 2005.55 = 2* (By symmetry)
Equilibrium
Both Coke and Pepsi make profits of 2005.55 when they produce 63.3 each at a price of $36.67 each.
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P2 = 110/3 •
BertrandEquilibrium
27.5
Chapter Thirteen
Pepsi’sPrice (P2)
Coke’s Price (P1)
P2 = 27.5 + P1/4(Pepsi’s R.F.)
P1 = 27.5 + P2/4 (Coke’s R.F.)
Equilibrium and Reaction Functions
P1 = 110/327.5
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Equilibrium Notes
Equilibrium occurs when all firms simultaneously choose their best response to each others' actions. Graphically, this amounts to the point where the best response functions cross.Profits are positive in equilibrium since both prices are above marginal cost!Even if we have no capacity constraints, and constant marginal cost, a firm cannot capture all demand by cutting price.
15Chapter Thirteen
Horizontal Differentiation Solving Steps
1) Use Residual Demand (given)2) Calculate (residual) MR3) MR=MC and demand to find reaction functions
(in terms of Prices)4) Use reaction functions to solve for P’s5) Use P’s to solve for Q`s 6) Solve for `s7) Summarize
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13.5 Monopolistic Competition
Assumptions:
Firms set priceDifferentiated productsMany buyers and sellersFree entry and exit
Products are ASSUMED to be imperfect substitutes for each other.Due to differentiated products, each firm has its own residual demand curve and optimizes like a monopoly:
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Average Cost
Quantity
Price
Short-Run Profit
q*
P*
MRChapter Thirteen
13.5 Short Run Monopolistic Competition
D
Marginal Cost
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Monopolistic Competition ExampleP = 100 - Q TC = 10+Q2
Calculate Equilibrium price and QuantityTR = PQ = 100Q – Q2 MR = ∂TR/ ∂Q = 100 - 2Q
MC = ∂TC/ ∂Q =2QMR = MC 100 - 2Q = 2QQ* = 25
P = 100 – QP = 100 – 25P* = 75
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Monopolistic Competition Example
P = 100 - Q Q* = 25TC = 10+Q2 P* = 75
Calculate ProfitsAC = TC/Q = 10/Q+Q* = TR – TC = (P-AC)Q* = (32.5-10)45 = 1,012.5* = (75- [10/25+25])25* = (75- [10/25+25])25* = $1240
This firm will charge a price of $75 and sell 25 units for profits of $1240
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Average Cost
Quantity
Price
Short-Run Profit
25
75
MRChapter Thirteen
13.5 Short Run Monopolistic Competition Example
D
Marginal Cost
25.4
21Chapter Thirteen
Monopolistic Competition, Short-RunSolving Steps
1) Use Residual Demand (given)2) Calculate (residual) MR3) MR=MC to solve for P4) No Step (Take a bread, eat a sandwich)5) Use P to solve for Q 6) Solve for `s7) Summarize
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Long-Run Monopolistic CompetitionIn the short run, profit is availableThere is free entry and exit
THEREFOREFirms will enter, decreasing individual residual demand until:
P=AC (profits=0)
Note: P≠MC since MC ≠ AC in these examples
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Average Cost
Quantity
Price
Marginal Cost
q*
P*=AC
MRChapter Thirteen
Monopolistic Competition Long Run Equilibrium
Dnew Dold
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Chapter 13 Conclusions1) Market structure is determined by:
a) Number of Firms
b) Product Differentiation
2) Market structure can be measured using the 4-firm concentration ratio (4CR) or the Herfindahl-Hirschman Index (HHI)
3) In a Cournot oligopoly firms choose quantities and make profits
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Chapter 13 Conclusions4) In a Bertrand Oligopoly firms choose
prices and make no profits (Perfect Competition outcome)
5) In a Stackleberg Oligopoly one firm acts first, for higher output and profits
6) A Dominant Firm works as a monopoly once the fringe has been removed from the demand
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Chapter 13 Conclusions7) A Dominant Firm has incentives to keep
the competitive fringe small
8) Oligopolies with differentiated products operate with their demand curves SLIGHTLY affected by rivals
9) Monopolistic Competition works like a monopoly, but free entry eliminates profits.
10) Economics is awesome