Product Differentiation

Suggested reading
Tirole J (1988) The Theory of Industrial Organization, MIT Press, ch 7, and section 2.1 of chapter 2

Church & Ware (2000) Industrial Organization: a Strategic Approach, McGraw-Hill, ch. 11

Other sources:
Martin S (2001), Advanced Industrial Economics, Blackwell, Oxford, chapter 4
Beath J & Katsoulacos (1991), The Economic Theory of Product Differentiation, Cambridge
University Press
Cabral L (2000), Introduction to Industrial Organization, MIT, chapter 12

Preliminaries

I Motivation – why important?

• To introduce greater ‘realism’: in the real world, most products are not
homogeneous, they’re differentiated (variety of brands offered by firms).
Consider: beer, breakfast cereals, PCs, cars, supermarkets, newspapers; but, on
the other hand, sugar, salt, petrol, cement.

Within the academic literature, introducing differentiation into our models:

• helps resolve the Bertrand paradox

• helps our understanding of the sources of market power: are high prices due to
monopoly power & collusion, or due to very differentiated brands (with
considerable brand loyalty), or both?

• provides underpinnings for econometric estimation of demand systems

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• provides insights for understanding determinants and evolution of market structure

• is essential for understanding the likely impact of mergers between firms selling
substitute brands

• II Key dimensions and definitions

(i) terminology: for Tirole, the industry or market is the aggregate concept, with
individual firms selling different products. I prefer to refer to individual firms selling
different brands of the same product, e.g. Stella Artois or Guiness are brands of beer

(ii) horizontal or vertical? Think of a product as a bundle of characteristics: physical

attributes, quality, location, time, availability, etc.

• In many cases, consumers have different tastes, (value characteristics

differently); if so, no objective way of saying brand A > brand B, they’re just
different. Even if both brands sell at same price, some consumers prefer A,
and some will prefer B (e.g. Brie and Parmesan): horizontal differentiation.

• In other cases, all consumers have the same ranking of brands by quality – a
small fast PC is preferred to a large slow PC; a light bulb which lasts for 2
months preferred to one which lasts for 1 month. In these cases, if all brands
sold at the same price, all consumers would buy the same one – quality can be
objectively observed. This is vertical differentiation.

(iii) do brands compete locally or globally? In a given market, are all brands
substitutes for all others, or do they merely compete with those brands which are
‘close’ to them? Consider beer, cigarettes, newspapers, restaurants, TV.

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Model (Based on Shaked & Sutton)
There exist n firms each with a product of quality uk (labelled so that u1>u2>…>un)
and a price pk

There exists a continuum of consumers with identical tastes but different incomes t.
t is uniformly distributed with density S (S=size of the market) on a support [a,b],
with a>0.
Consumers buy one unit of the good (the market is covered), and have utility

U(t,k)=uk (t-pk)

The game
1. Firms decide on entry (fixed cost >0)
2. They decide on quality of the good
3. They decide prices and sell (zero marginal costs)

Proposition: If b<2a, only one firm will enter the industry at equilibrium (whatever S)

(As income becomes less concentrated, more firms can enter; e.g., if 2a<b<4a, two
firms will enter at equilibrium. Generally, the number of firms which coexist
at equilibrium is finite even as S goes to infinity)

Proof of the proposition

We show that two firms cannot co-exist at equilibrium. Firms’ demand is derived by
finding the consumer indifferent between the two qualities:

From: u1 (t-p1) ≥ u2 (t-p2), we obtain:

u1 p1 − u 2 p 2
t  t12 ( p1 , p 2 , u1 , u 2 ) =
u1 − u 2

All consumers with income t ≥ t12 will buy 1, all others will buy 2. Therefore:

q1 = b-t12 ; q2 = t12-a

Profits can be written as:

 u p − u 2 p2   u p − u 2 p2 
1 =  b − 1 1  p1  2 =  1 1 − a  p2
 u1 − u 2   u1 − u 2 
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By setting dΠi/dpi=0 we obtain the best reply functions:
b(u1 − u 2 ) + u 2 p2 a(u 2 − u1 ) + u1 p1
R1 : p1 = R2 : p1 =
2u1 2u 2

Equilibrium prices are given by:

(2b − a )(u1 − u 2 ) (b − 2a )(u1 − u 2 )

p1 = p2 =
3u1 3u 2

Therefore, if b<2a there exists no equilibrium with positive p2, and firm 2 will not
enter the industry.

Equilibrium, when b>2a

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5
Generalisation

The finiteness property holds if the cost of producing a higher quality does not fall
upon variable costs. It holds across a number of different specifications (see e.g.,
Shaked-Sutton, 1987)

Sutton (1991): Endogenous Sunk costs and market structure: Advertising

Sutton (1991) puts the result to an empirical test. It shows that in advertising-
intensive industries as S increases the industry does not become fragmented.
Advertising is an endogenous sunk cost:
- endogenous because, differently from set-up costs, is a variable that can
be chosen by the firm
- sunk, because, after having undertaken the investment, it cannot be
recovered
1/N 1/N

(i)
(ii)
(iii)

size size
Endogenous sunk costs Exogenous sunk costs
(i) high exogenous sunk costs w.r.t endogenous sunk cost
(ii) intermediate exogenous sunk costs w.r.t endogenous sunk cost
(iii) low exogenous sunk costs w.r.t endogenous sunk cost

While in free-entry models with homogenous or horizontally differentiated

products but with exogenous sunk costs concentration (1/N) has a lower bound

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 that goes down to zero as market size increases, in models with vertically
differentiated products and with endogenous sunk costs concentration has a
lower bound that does not go to zero as size increases
Intuition: there is a competitive escalation in advertising such that, if the size of
the market is sufficiently large, firms that invest aggressively gain increasing
market shares

The logic of the bound approach, that is the existence of a limit to concentration
(which can go to zero or not) as size increases clashes with the view of those who
maintain that “anything can happen in oligopoly”. We must look for some robust
results that do not depend on the specific assumptions of a model (price versus
quantity competition, homogeneous versus differentiated goods, simultaneous
versus sequential games, and so on).

Sutton (1998): Technology and market structure

Why in some high R&D industries concentration is high while in other
concentration remains low?

Entrant spend an amount K to obtain a profit equal to a Y, where Y is the amount

of sales in the previous period.

α= a/K is the escalation parameter

high α: by investing K the entrant can obtain high profits
low α: by investing K the entrant cannot obtain high profits

In high- α industries there is high R&D investment and concentration increases,

while in low- α industries concentration does not increase.

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Examples of high- α industries: where there is high substitutability (camera tapes
after technological change, telecommunication equipment after opening to the
global market, aircraft industry)

Examples of low- α industries: low substitutability and products fill different niche
positions (flowmeters and measurement instruments, pharmaceutical industry)
Sutton (1991) puts the result to an empirical test.