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Unformatted text preview: S I D E R E Â· M E N S Â· E A D E M Â· M U T A T O University of Sydney ECOS2201  Lecture 3 1 Differentiation â€¢ Differentiation provides a degree of market power â€¢ Two forms of product differentiation, quality (vertical) and variety (horizontal) â€¢ Quality includes reliability, durability, features, and performance 2 â€¢ Variety includes colour, shape, appearance, location (geographical space and product space) â€¢ The degree of differentiation has implications for the success of entry â€¢ The profitability of entry depends very much on the response of incumbents â€¢ If entrant locates close to incumbent in product space price competition fierce and entry unprofitable 3 â€¢ It entrant has low costs relative to incumbent then entry can be profitable even if locate close. â€¢ Successful Entry high differentiation and low costs relative to incumbent â€¢ Unsuccessful Entry low differentiation and high costs relative to incumbent â€¢ Lets look at this more closely 4 Competition in Differentiated Products â€¢ Hotelling Model: Customers are located uniformly on a line â€¢ With product space, a point on the line represents a customers most preferred position (oak in chardonay) â€¢ Firms are located on this line at say L and R . See Figure 1 5 â€¢ The cost of a customer located at L moving to R is c (transport cost or loss to customer of not purchasing most preferred product type) â€¢ Consider a customer located the fraction x of the way from L to R â€¢ The price of the product at L is p L and at R is p R 6 â€¢ The total cost of the customer located at x purchasing from the firm at L is p L + xc and from the firm at R is p R + (1 x ) c â€¢ The customer buys from the location with the lowest total cost â€¢ There is a marginal customer, x * , who is indifferent between purchasing from either location. x * is defined by p L + x * c = p R + (1 x * ) c (1) 7 â€¢ Solving gives x * = 1 2 + p R p L 2 c â€¢ If p R = p L , the marginal customer is halfway between L and R. If p R > p L the marginal customer is to the right of the midpoint, so more customers prefer to buy from L . See Figure 2 â€¢ Note that dx * dp R = 1 2 c â€¢ Question: What does this imply for large and small c ? 8 â€¢ Let production costs be zero and the total number of customers be N â€¢ The profit of firm L is Î L = p L x * N â€¢ Question: Determine the best response functions of firms L and R and the Nash equilibrium in prices 9 â€¢ Endogenous Location â€¢ Two Stage Game : In first stage...
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