Information and Monopolistic Competition

Author(s): Steve Salop

Source: The American Economic Review , May, 1976, Vol. 66, No. 2, Papers and
Proceedings of the Eighty-eighth Annual Meeting of the American Economic
Association (May, 1976), pp. 240-245
Published by: American Economic Association

Stable URL: https://www.jstor.org/stable/1817228

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 INFORMATION AND MARKET STRUCTURE
Information and Monopolistic Competitio
BY STEVE SALOP*
Information gathering and transmission
have been gaining a larger role in the
economy over time. M. Porat (1975) has
estimated that the production, processing
and distribution of information goods and
services account for over a quarter of GNP.
George Stigler (1961), George Akerlof
(1970), and the papers in Edmund Phelps's
volume (1970) showed the presence of im-
perfect information gives firms market
power at least in the short run and often in
the long run as well. Peter Diamond (1971)
showed that the existence of costly in-
formation gathering led to an equilibrium
in which each small firm charged not the
competitive price but rather the monopoly
price. Later papers have expanded Dia-
mond's work for markets with different
production and information gathering and
transmission technologies. T hese papers
find that if information is costly, each
small firm obtains market power, and the
equilibrium (if one exists) is characterized
by prices above competitive levels and
sometimes price dispersion as well. The
relevant market structure with imperfect
information is not perfect competition but
rather monopolistic competition.
I. The Basic Competitive Framework
There are a potentially infinite number
of identical firms which can produce a
homogeneous commodity from a produc-
tion technology with fixed cost T and in-
creasing marginal cost function MC(q).
* Federal Reserve Board. These are the views of
the author and should not be interpreted as the views
of the Board of Governors. I am grateful to my col-
laborator, Joseph Stiglitz, and L. J. Dillard, M.
Porat, and the editorial assistance of G. Edelen.
240
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Thus, the average cost curve is U-shaped,
attaining its minimum at (p*, q*).
There are a large number of consumers
L, who wish to consume this commodity.
We begin by assuming that each consumer
has an identical perfectly inelastic demand
for one unit of the commodity at all prices
below pm. (Thus, pm can be interpreted as
the dollar valuation of the commodity's
marginal utility. It is most convenient to
think of this commodity as a durable
which is bought only once by each con-
sumer.)
A monopolistic producer surely charges
a price equal to pm. If there is free entry
into this market, new firms drive down the
price until it falls to the competitive price
p*. No price dispersion is possible since
each perfectly informed consumer will ap-
proach the lowest priced firm.
II. Imperfect Information
In a Lancaster framework, the utility
services derived from any commodity is a
complex function of the characteristics
that specify the commodity. The net util-
ity surplus equals the utility services
derived less its price. Given a choice among
competing commodities, the "best buys"
are those brands with highest net surplus.
Initially, a consumer has imperfect ex-
pectations regarding the net surplus of
each good. These imperfect priors derive
from his general knowledge and past in-
formation gathering and experience. It is
useful to think of this as a dynamic learn-
ing process. The prior can be thought of as
a probability distribution of the net sur-
plus of a commodity. The distribution may
VOL. 66 NO. 2 INFORMATION AND MARKET STRUCTURE 241
be an unbiased estimate of the actual net
surplus (rational expectations) or may be
biased due to incorrect extrapolation of
the past, unseen commodity specification
changes, past sampling realizations, false
claims, or general ignorance. The forma-
tion of the prior is made more difficult
since the relevant questions may not even
be known until after some information is
gathered.
The cost of information gathering will
depend on the technology of information
production and diffusion, the type, com-
plexity and number of commodities, and
the consumer's priors and preferences.
These will define the speed of the learning
process. Information gathering improves
the quality of the posterior distribution.
The expected value of information can be
viewed as the increase in expected net sur-
plus from the information. The effective
cost of information includes its resource
and nonpecuniary costs and will depend on
the consumer's cost of time, preferences,
analytic ability, experience and under-
standing of the market. For example, bar-
gain hunters and (presumably) economists
have low costs.
Depending on its cost, complete or in-
complete information may be gathered. By
complete information, we mean informa-
tion that enables the consumer to purchase
the best buy available. By incomplete, we
mean that his expected net surplus will lie
somewhere between the average and the
best buy. For incomplete information
gathering, the consumer must choose the
sample size, minimum acceptable net sur-
plus level, or reservation price.
Nelson (1970) contrasts two modes of
information gathering, "experience" and
"search." By "experience," we mean the
knowledge obtained from actually using
the commodity. This information may be
gathered from personal use or from the ex-
perience of acquaintances (shared informa-
tion). It is more likely to be utilized for in-
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expensive nondurables with unknown qual-
ity that are consumed each period. Experi-
ence information is generally incomplete,
since every commodity is not sampled,
and, in addition, the actual performance of
a brand may be a random variable. By
"search," we mean sampling before pur-
chase by studying consumer magazines,
visiting or phoning stores, reading ad-
vertisements, etc. Price information may
be generated by search. In principle, search
may yield complete information. For ex-
ample, one could envision a magazine like
Consumer Reports that publishes all the
relevant information; a truthful guarantee
has much the same effect.
There are important interactions (ex-
ternalities) among consumers in the pro-
cess. For example, if a consumer (having
had one economics course) thinks that
search by other consumers keeps the mar-
ket honest so that price reflects quality, he
need gather no information himself but
will purchase the commodity with the
greatest market share (John Conlisk and
Dennis Smallwood). Alternatively, if a
consumer believes in the Lemon's Prin-
ciple, he will drop out of the market alto-
gether (Akerlof).
Before analyzing this market, let us ask
the question of why low cost consumers do
not arbitrage the information differences
away. Stated another way, since the mar-
ginal cost of distributing the information
is nearly zero, why won't competition
among information producers drive down
the price? First, consumers face the same
information problem with respect to in-
formation sellers as they do with respect
to the commodities themselves. Each
magazine must be evaluated and its con-
tent processed and analyzed. Furthermore,
since the dissemination of the information
by each magazine exhibits decreasing
average costs, the information industry
cannot be competitive in long-run equilib-
rium.
242 AMERICAN ECONOMIC ASSOCIATION MAY 1976

III. Equilibrium

We now analyze the behavior and equi-

librium price structure of this commodity
market. Initially, the dynamics of the
learning process are ignored. An equilib- p =Pn-~-g-4-
rium in this market is n-prices p= (pi,
P2___ /
P2, . *. , pn) each charged by a proportion
/3= (p13 032, * , *3,^) of the N-firms in pro-
duction such that the following price and
entry competition conditions are satisfied: qn q2 q

FIGURE 1
(1) Price Competition (Maximum Profits).
Each firm chooses the price (and quan-
price be above the monopoly price. The
tity) which maximizes its profits given
exact specification of the equilibrium will
its knowledge regarding the behavior of
depend on the production technology, the
consumers and other firms (i.e., its de-
information gathering technology, and the
mand curve).
joint distribution of consumers, utility
(2) Entry Competition (Zero Profits). No
valuations and search costs.
new firm wishes to enter the market.
A simplified example can highlight the
The exact specification of a firm's de- properties of the equilibrium. Assume that
mand curve depends on the informational L-consumers all have identical valuations
and strategy assumptions we make about pm, known with certainty. Prior price ex-
firms. We will assume that a firm chooses pectations are rational but limited. Con-
a price given (i) tbe prices chosen by the sumers know the correct set of prices and
other (N-1) firms and (ii) the search rules proportions { p, d }, but a priori, they lack
of consumers. Thus, a firm is a "Nash" the knowledge of which firms charge which
competitor vis-a-vis other firms and a price. (This assumes away lemons and
"Stackleberg" competitor vis-a-vis con- two-armed bandits.) For a cost ci, con-
sumers. Condition (2) is the free entry as- sumer i can purchase complete information
sumption. We assume that entry occurs if from Consumer Reports in the form of the
profits are positive; hence, it is the zero complete price-location correspondence.
profit condition. There are only two groups of consumers,
In order to demonstrate the existence of a proportion a with cost cl> 0 and a pro-
the equilibrium, we follow the method of portion (1-a) with higher cost c2>cl. In
proposing a potential equilibrium set of spite of overwhelming empirical evidence
n-prices p= I Pi, P2) . .. p. 1, proportions to the contrary (A. Tversky), we assume
jIY= (a', * * *, |x outputs q= (ql, q2 ....consumers gather information in a rational,
q), and a number of firms-NS, and then maximizing
see manner.
if any of the existing N-firms wishes to If both groups have perfect information
change its price or if any potential entrants (c1= c2= 0), the competitive equilibrium
wish to enter. A potential equilibrium is an (p=p*) will obtain. If there are enough
actual equilibrium if both deviant be- perfectly informed consumers (cj =O, a
havior and entry are unprofitable. An high), the competitive equilibrium can still
equilibrium can be pictured as in Figure 1. obtain in spite of c2 > 0. This is an example
The minimum price (pi) will never be of the externality informed consumers give
below the competitive price, for that would to the uninformed. The weight of their
yield negative profits. Nor will the highest search keeps the market competitive.

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VOL. 66 NO. 2 INFORMATION AND MARKET STRUCTURE 243

If both groups have positive cost, the p'

competitive equilibrium cannot occur. A
pL
deviant firm could raise its price slightly P

above the competitive price and lose no

customers. The only possible single-price
equilibrium is the monopoly price, with en-
try competition driving profits to zero at
this high price (Diamond). That equi-
librium will obtain only if information
costs are large for both groups. At this
equilibrium, in order to induce consumers
to pay the cost of discovering its location,
a deviant firm would have to follow the
unprofitable strategy of charging a price
below the competitive price.
If lowering price to induce search is
profitable, a two-price equilibrium (TPE)
will obtain in which a proportion f of the
firms charge the competitive price (pi = p*) An interesting example of this process is
and the rest charge a higher price no greater that of dynamically captive markets. Sup-
than the monopoly price (pm>ph>p*).
Every type-1 consumer purchases com-
plete information and pays the lower price.
TI he higher price has the property that the
type-2's do not find it worthwhile to pur-
chase information. However, a proportion
d of the type-2's are lucky and randomly
select a low-priced firm. Entry competition
occurs until every firm makes zero profits.
When only complete information can be
purchased, a TPE obtains even when there
are many types of consumers (Salop and
Stiglitz). In contrast, when incomplete in-
formation can be purchased, there will be
as many prices in equilibrium as there are
types of consumers (Gerald Butters, Peter
von zur Muehlen).
If costs have little dispersion and are not upwards towards the monopolv price.
too high, there is no TPE either. However,
a single "limit price" pL exists with the
following property. A deviant firm could
increase its profits by raising its price
above pL . But if it does act in this short-
run interest, it will destroy the equilibrium period. No firm's price ever settles down,
by inducing other firms to drastically cut
price to induce search. Prices may begin
to oscillate between the competitive price
P*
time
FIGURE 2
p* and the limit price. The exact dynamics
will depend on the dynamic learning pro-
cess by consumers and firms. In general,
prices may creep up slowly to above the
limit price which induces a price war down
to p*, only to again begin the upward
creep. (See Figure 2.) The frequency and
regularity of the cycle will depend on the
time adjustment speeds of price changes,
entry, and the learning by consumers.
pose consumers have better information
regarding the brand they are now consum-
ing than about other brands they con-
sumed in the past or have never consumed.
This asymmetry in information gives each
firm market power over its current risk-
averse customers since there are effectively
"moving costs" of uncertainty from chang-
ing brands. If these moving costs are high
enough, every firm can act like a complete
monopolist over its segment of the market.
Some deviant firm may find it profitable to
subsidize these moving costs by charging
a lower price. It gains customers who in
turn become its captive as the information
from their past experience decays. Hence,
the deviant firm can creep its own price
Y. Shilony shows that a mixed strategy
equilibrium in which each firm changes its
price every period results from such a
"captive market model," even when the
commodities are nondurables bought every
so imperfections in information remain
forever. This analysis also has the interest-
ing feature that the firms could form a

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244 AMERICAN ECONOMIC ASSOCIATION MAY 1976
Icycle p II C=1 C2
I limit I p
[ Pi r)ipricci
pr=p* !/
ita-hlghow
TPE P"'P> __cyl
Pi or~~~i u
price
p =
FIGURE 3
C"noncooperative cartel" that needs to col-
lude only once to set the random pricing
rules. Once the cartel is begun, no single
firm will ever find it profitable to cheat by
deviating from the rule.
The various types of equilibria discussed
are summarized in Figure 3.
IV. Advertising
The firms themselves may engage in in-
formation transmission through truthful
advertising and guarantees. This does not
change the basic result. For example, sup-
pose expensive large ads and inexpensive
small ads are available, type-i consumers
are likely to notice both sizes, and type-2
consumers are likely to see only large ads.
Then, firms that run large ads incur higher
fixed advertising costs, charge a higher
price and sell only to type-2's. On the
other hand, suppose a firm sends ads out
randomly, and each consumer chooses the
firm with the cheapest advertised price
from the ads received. In this model, price
dispersion results even if consumers are
identical (Butters). In both approaches,
the highly advertised brands have higher
costs and charge higher prices in equilib-
rium. Of course, this equilibrium result is
different from the short run practice of a
low priced deviant advertising its lower
price. False advertising, bait-and-switch,
dishonored warranties and other forms of
fraud have also been assumed away in this
analysis, though they are certainly profit-
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able in the short run, and in the long run
too if there are new suckers (ignorant con-
sumers) born every minute.
V. Price Discrimination
So far we have focused on price disper-
sion arising from search cost dispersion in
which poorly informed consumers pay
higher prices. When consumers differ in
their valuations as well, monopolistic com-
petition will generate price discrimination
against consumers with both high costs
and high valuations. Low valuation-high
cost consumers will not purchase. A mo-
nopolist may also use dispersion in search
costs to price discriminate against uniden-
tifiable consumers with inelastic demand
curves (high pm's here). If he permits price
dispersion (through unadvertised specials
or contrived heterogeneity), the high cost
consumers will search less and hence pay
higher effective prices on average. If these
customers have more inelastic demand,
then price dispersion acts as a price dis-
criminating tie-in of search (a "bad") with
the commodity he produces (Salop).
VI. Competition vs. Welfare
The existence of many similar brands
tends to increase effective search costs.
Suppose a consumer must purchase a
brand in order to gauge its utility (an
"experience" good). Optimal search would
consist of sampling brands without replace-
ment until an acceptable one is found. In
this case, entry competition has two coun-
tervailing effects. The usual entry effect
increases choice and decreases prices. On
the other hand, in sampling without re-
placement, small population sizes are pre-
ferred to large ones. For example, suppose
there are 3 firms and a consumer evaluates
the net surplus of these 3 brands as { 5, 10,
15 }. If he samples without replacement 3
times, he will certainly attain the maxi-
mum utility level of 15. If the number of
firms doubles to 6 and the distribution of
VOL. 66 NO. 2 INFORMATION AND MARKET STRUCTURE 245
utility levels remains identical (i.e., {5, 5,
10, 10, 15, 15 }), then a sample of size 5 is
required to obtain a level of 15 with cer-
tainty. A sample of size 3 will give ex-
pected maximum utility of only 13.1. Thus,
the tradeoff between search intensity and
utility level worsens, just as it would from
an increase in effective search costs. In
equilibrium, the increased cost tends to
raise prices, ceteris paribus. The net effect
of increased competition may be either to
raise or lower prices. Thus, there may be a
tradeoff between competition an(d static
welfare.
REFERENCES
G. Akerlof, "The Market for 'Lemons':
Qualitative Uncertainty and the Market
Mechanism," Quart. J. Econ., 1970.
G. Butters, "Equilibrium Distributions of
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1975, Rev. Econ. Studies, forthcoming.
P. Diamond, "A Model of Price Adjustment,"
J. Econ. Theory, 1971.
P. Nelson, "Information and Consumer Be-
havior," J. Publ. Econ., 1970.
E. Phelps, et al., Microeconomic Foundations
of Inflation and Employment Theory, New
York 1970.
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for Communication Research, Stanford
1975.
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, "A Two-Armed Bandit Theory of
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Information, Price Dispersion and Price
Discrimination," Federal Reserve Board
1973.
and J. Stiglitz, "Information, Price
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Quality in Markets Where Consumers are
Imperfectly Informed and Naive," Univ. of
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