Product Di¤erentiation - Part I

1. Consider an industry with 4 …rms, where demand for the product produced
by Firm i is given by the inverse demand function

pi = 140 qi bQ i;
where qi is output by Firm i and Q i is the sum of the output by all
the other …rms in the industry. The cost function of Firm i is given by
C (qi) = 20qi + 10.

(a) Based on the inverse demand functions, how would you characterise
these products?
Solution: These products are horizontally di¤erentiated (as long as
b 2 (0; 1))
(b) Find the Nash equilibrium of a Cournot game where all 4 …rms choose
output simultaneously and independently.
Solution: The game is symmetric, so we can concentrate on solving
the pro…t maximisation problem of one of the …rms. Consider Firm 1,
which solves the following problem:
max 1 = (140 q1 b (q2 + q3 + q4) 20) q1 10:
q1
The …rst-order condition is given by
@ 1
= 140 2q1 b (q2 + q3 + q4) 20 = 0:
@q1
Since the game is symmetric, the Nash equilibrium will also be sym-
metric. Setting q1 = q2 = q3 = q4 and solving, the Nash equilibrium
is given by
120
q1 = q2 = q3 = q4 = :
2 + 3b
(c) Calculate the equilibrium price of each product for each of the following
parameter values:

i. b = 0

ii. b = 32

iii. b = 1
Give an interpretation of each of these three cases.
Solution: The equilibrium price for product i is given by
120 120
pi = 140 qi bQ i = 140 3b
2 + 3b 2 + 3b
8 + 3b
= 20 :
2 + 3b
If b = 0, the price is pi = 80. In this case, the products are
independent. If b = 23 , the price is pi = 50. In this case, the
products are horizontally di¤erentiated. Finally, if b = 1, the price
is pi = 44. In this case the product are homogeneous. Notice that
less product di¤erentiation leads to a lower price.
2. Consider a market with two goods, each of them produced and sold by a
di¤erent …rm. The inverse demand for Good 1, which is sold by Firm 1, is
given by
4 2
p1 = 120 q1 q2;
3 3
where p1 is the price of Good 1 and q1 and q2 are the quantities supplied
by Good 1 and Good 2, respectively. Similarly, the inverse demand for
Good 2 is given by
4 2
p2 = 120 q2 q1:
3 3
The two goods have the same cost of production, and the cost function
for Firm i is given by C (qi) = 36qi, i = 1; 2.
(a) Derive the direct demand function for each good. How would you
describe these two goods? Give a real-world example of what these
two goods could be.
Solution: The direct demand functions are found by simultaneously
solving the two inverse demand functions for q1 and q2, yielding
1
q1 = 60 p1 + p2
2
1
q2 = 60 p2 + p1:
2
These goods are horizontally di¤erentiated products, such as Coca-Cola
and Pepsi, for example.
(b) Suppose that the each …rm chooses the price of the good it produces.
These decisions are taken simultaneously and non-cooperatively.

i. Derive the best-response function of each …rm and draw the graphs
of these functions in a diagram.
Solution: The pro…t-maximisation problem of Firm 1 is
1
max 1 = (p1 36) 60 p1 + p 2 :
p1 2
The …rst-order condition is
@ 1 1
= 60 p1 + p2 (p1 36) = 0;
@p1 2
which yields the best-response function
1
p1 = 48 + p2:
4
 Since the game is symmetric, the best-response function of Firm 2
is equivalent:
1
p2 = 48 + p1:
4
ii. Find the Nash equilibrium of this game and calculate the pro…ts of
each …rm.
Solution: Setting the prices equal to each other and solving one of
the best-response functions, the Nash equilibrium is given by
p1 = p2 = 64:
This yields a demand for each product of
1
q1 = q2 = 60 64 + (64) = 28;
2
and a pro…t of

1 = 2 = (64 36) 28 = 784

(c) Suppose instead that the price decisions are made sequentially, where
Firm 1 can can commit to a price level that is observed by Firm 2
before this …rm makes its price choice.

i. Find the subgame perfect Nash equilibrium of this game.

Solution: The game is solved by backwards induction. At Stage 2,
the optimal price set by Firm 2 is given by the best-response function
derived above. At Stage 1, Firm 1 solves the following problem:
1 1
max 1 = (p1 36) 60 p1 + 48 + p1 :
2 4
The solution to this problem is
p1 = 66:
The optimal price chosen by Firm 2 is
1
p2 = 48 + (66) = 64:5
4
 This yields demand for each product equal to
1
q1 = 60 66 + (64:5) = 26:25
2
and
1
q2 = 60 64:5 + (66) = 28:5
2
ii. If you compare the equilibrium pro…ts of the two …rms, is the game
characterised by a …rst-mover advantage or by a second-mover ad-
vantage?
Solution: The equilibrium pro…ts of each …rm are given by

1 = (66 36) 26:25 = 787:5

and

2 = (64:5 36) 28:5 = 812:25:

Thus, when …rms compete on prices (and products are horizontally
di¤erentiated), there is a second-mover advantage!
3. There are two …rms in a market producing di¤erent brands of soft drink.
Firm 1 has the following inverse demand function:
2 1
p1 = 90 q1 q2;
3 3
while Firm 2 has an inverse demand function given by
2 1
p2 = 90 q2 q1:
3 3
The production costs of the two …rms are given by the cost functions
C1 (q1) = 15q1 + 2 and C2 (q2) = 30q2 + 1. The two …rms choose prices
simultaneously and independently.
(a) Find the best-response function of each …rm and draw them in a dia-
gram.
Solution: First we need to invert the inverse demand functions to derive
direct demand, given by
q1 = 90 2p1 + p2;
q2 = 90 2p2 + p1:
The pro…t-maximisation problem of Firm 1 is
max 1 = (p1 30) (90 2p1 + p2) 1:
p1
The …rst-order condition is
@ 1
= 90 2p1 + p2 2 (p1 30) = 0;
@p1
which yields the best-response function
1
p1 = 37:5 + p2:
4
The pro…t-maximisation problem of Firm 2 is

max 2 = (p2 15) (90 2p2 + p1) 2:

p2
The …rst-order condition is
@ 2
= 90 2p2 + p1 2 (p2 15) = 0;
@p2
which yields the best-response function
1
p2 = 30 + p1
4
(b) Find the Nash equilibrium outcome (prices and quantities).
Solution: Simultaneously solving the two-best response functions yields

p1 = 48;
p2 = 42:
Demand is equal to

q1 = 90 2 (48) + 42 = 36
and
q2 = 90 2 (42) + 48 = 54:

(c) Show graphically in the diagram how an increase in the marginal cost
of Firm 1 would change the Nash equilibrium.
Solution: Such a cost change would shift up the best-response curve
of Firm 1, leading to a higher equilibrium price for both …rms.
4. Consider a market with many …rms, where each …rm produces a di¤erent
brand of a horizontally di¤erentiated product. Demand for Brand i is given
by
100000 b
qi = pi ;
n
where n is the number of brands/…rms in the market and pi is the price of
Brand i, and where b > 1. The cost of production for Brand i is given by

Ci (qi) = qi + 500:
Suppose that the number of …rms in the market is so high that there is no
strategic interaction among them.
(a) Derive the pro…t maximising price for each brand as a function of b and
n.
Solution: The pro…t-maximisation problem of Firm i is
100000 b
max i = (pi 1) pi 500:
pi n
The …rst-order condition is
@ i 100000
= (1 b ) pi b ( b) p i b 1 = 0 ;
@pi n
which yields
b
pi = :
b 1
We see that the optimal price is decreasing in b (recall that b > 1).
Notice that a higher value of b makes the products less di¤erentiated.
In the limit, where b ! 1, products are homogeneous and the optimal
price is equal to marginal cost (which is equal to 1). We also see that
the optimal price does not depend on n.
(b) Suppose that there is free entry to the industry. Derive the equilibrium
number of brands in the market.
Solution: If pi = b b 1 , demand for each brand is

100000 b b
qi = ;
n b 1
so the pro…t of each brand is
b 100000 b b
i = 1 500
b 1 n b 1
1 b b 100000
= 500:
b 1 b 1 n
With free entry, the equilibrium number of brands is the value of n for
which
1 b b 100000
500 = 0;
b 1 b 1 n
which implies
1 b b
n = 200
b 1 b 1
(c) How does the equilibrium number of brands depend on the parameter
b? Explain.
Solution: Taking the …rst-order derivative of the equilibrium number
of brands with respect to b yields

@n 200 ln b b 1
= b
< 0:
@b b (b 1)
b 1
Thus, a higher value of b reduces the number of brands in the market.
Remember that a higher value of b implies less product di¤erentiation,
which reduces the market power of each …rm and therefore leads to
lower prices and lower pro…ts. Consequently, entry is pro…table for a
smaller number of …rms.
5. Consider a market with many …rms, where each …rm produces a di¤erent
brand of a horizontally di¤erentiated product. Demand for Brand i is given
by
qi = 240 npi;
where n is the number of brands/…rms in the market and pi is the price
of Brand i. The cost of production for Brand i is given by

Ci (qi) = qi + 10:
Suppose that the number of …rms in the market is so high that there is no
strategic interaction among them.
(a) Suppose that n = 60. Find the pro…t-maximising price for each brand.
Can this be characterised as a long-run monopolistically competitive
equilibrium? Explain.
Solution: The pro…t maximisation problem of Firm i is given by

max i = (pi 1) (240 npi) 10:

pi
The …rst-order condition is given by
@ i
= 240 npi n (pi 1) = 0;
@pi
which yields the following optimal price:
1 120
pi = + :
2 n
If n = 60, the price is 52 , which yields the following pro…ts:
5 5
i = 1 240 60 10
2 2
3 355 1025
= 10 = > 0:
2 2 4
Since pro…ts are positive, more …rms will enter the industry, so this
cannot be a long-run equilibrium.
(b) Find the equilibrium number of brands under free entry, and calculate
the price and quantity sold of each brand in this equilibrium.
Solution: In the long-run equilibrium, the price of each brand is
1 120
pi = + ;
2 n
which means that demand for each brand is
1 120 1
qi = 240 npi = 240 n + = 120 n:
2 n 2
In order to determine the equilibrium number of brands, we need to
apply the free-entry condition that pro…ts are zero, which means that
the price is equal to average cost:
pi = AC
()
1 120 10
+ =1+
2 n 120 12 n
()
n = 160:
Thus, in the long-run equilibrium, there are 160 …rms, each charging
a price of 45 , selling 40 units and earning a pro…t of 0.
6. Suppose that a …rm has a patented technology that makes it a monopolist
in the output market. The …rm faces demand

q = 1000 p
(where q is output and p is price) and its total costs are given by
1 2
c (q ) = 12500 + q :
4
(a) Find the price-output combination that maximises the monopolist’s
pro…ts.
Solution: The pro…t-maximisation problem of the …rm is
1
max = p (1000 p) (1000 p)2 12500:
p 4
The …rst-order condition is
@ 1
= 1000 2p + (1000 p) = 0 ;
@p 2
yielding
p = 600:
(b) Suppose that, after patent expiry, the …rm faces many entrants that
produce similar products, making the industry monopolistically com-
petitive. Because of the existence of close substitutes in the market,
the …rm’s demand reduces to
q= p:
Find the value of , and the …rm’s output and price, in the long-
run monopolistically competitive equilibrium. Illustrate the solution
graphically.
Solution: The long-run monopolistically competitive equilibrium is
characterised by (i) marginal revenue equal to marginal cost and (ii)
price equal to average cost, for each …rm. Revenue is
R (q ) = p (q ) q = ( q ) q;
so marginal revenue is
M R = R0 (q ) = 2q:
The condition that marginal revenue equals marginal cost is therefore:
1
2q = q:
2
And the condition that price equals average costs is
1 12500
q= q+ :
4 q
Simultaneously solving these two equations for and q yields

q = 100 and = 250:

The equilibrium price for each brand is therefore

p = 250 100 = 150:

(c) What would the long-run market price have been if this …rm operated
under perfect competition?
Solution: Under perfect competition, each …rm would produce at the
level of output that minimises average costs. At this point, average
costs equal marginal costs:
1 12500 1
q+ = q;
4 q 2
yielding
p
q = 100 5 223: 61:
This would yield a market price of
1 p p
p = MC = 100 5 = 50 5 111:8:
2
7. Consider a monopolistically competitive market with n …rms. Demand
facing each …rm is given by the inverse demand function p = 10 nq ,
where q is the …rm’s output. Each …rm has a cost function C (q ) = 5+ q 2.

(a) Suppose that n = 2. Calculate the pro…t-maximising output for each

…rm. Illustrate the solution in a …gure.
Solution: For n = 2, the pro…t-maximisation problem of each …rm is
max = (10 2q ) q q2 5:
q
The …rst-order condition is
@
= 10 4q 2q = 0;
@q
yielding
5
q= :
3
(b) Calculate the number of …rms in the long-run monopolistically com-
petitive equilibrium. Calculate also quantity per …rm, equilibrium price
and pro…ts. Illustrate the solution in a …gure.
Solution: In the long-run equilibrium, two conditions must hold: (i)
marginal revenue equal to marginal cost, and (ii) price equal to average
cost. The …rst condition is given by

10 2nq = 2q;
and the second condition is given by
5
10 nq = q + :
q
Simultaneously solving these two equations for n and q yields

n = 4 and q = 1.
The equilibrium price for each brand is therefore

p = 10 4 1 = 6.
Equilibrium pro…ts are

=6 1 12 5 = 0:
8. Consider a monopolistically competitive industry where demand for each
brand is given by
25 p
q= ;
n
where p is the price of the brand and n is the total number of brands.
Each brand can be produced according to the following cost function:
C (q ) = 5q + 5:

(a) Suppose that n = 10. Find the optimal price and output for each
brand. Is this a long run equilibrium? Explain why/why not.
Solution: If n = 10, the pro…t-maximisation problem of each …rm is
25 p
max = (p 5) 5;
p 10
which yields
p = 15:
Output for each brand is
25 15
q= = 1;
10
so pro…ts are
= (15 5) 1 5 = 5:
Since pro…ts are positive, this cannot be a long-run equilibrium.
(b) Find the long-run monopolistically competitive equilibrium in this in-
dustry.
Solution: A long-run equilibrium requires that (i) marginal revenue
equals marginal cost, and (ii) price equals average cost, for each …rm.
The inverse demand function is

p = 25 nq;
so marginal revenue is 25 2nq . The …rst condition is therefore given
by
25 2nq = 5;
while the second condition is given by
5
25 nq = 5 + :
q
Simultaneously solving these two equations yields
1
n = 20 and q = .
2
The price of each brand is therefore
1
p = 25 20 = 15;
2
and pro…ts are zero. (Notice that in this example entry reduces the de-
mand of each …rm without a¤ecting the pro…t-maximising price, which
is 15 regardless of the number of …rms/brands in the market).