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Unformatted text preview: S I D E R E M E N S E A D E M M U T A T O University of Sydney ECOS2201  Lecture 3 1 Differentiation Differentiation provides a degree of market power Two forms of product differentiation, quality (vertical) and variety (horizontal) Quality includes reliability, durability, features, and performance 2 Variety includes colour, shape, appearance, location (geographical space and product space) The degree of differentiation has implications for the success of entry The profitability of entry depends very much on the response of incumbents If entrant locates close to incumbent in product space price competition fierce and entry unprofitable 3 It entrant has low costs relative to incumbent then entry can be profitable even if locate close. Successful Entry high differentiation and low costs relative to incumbent Unsuccessful Entry low differentiation and high costs relative to incumbent Lets look at this more closely 4 Competition in Differentiated Products Hotelling Model: Customers are located uniformly on a line With product space, a point on the line represents a customers most preferred position (oak in chardonay) Firms are located on this line at say L and R . See Figure 1 5 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) Consider a customer located the fraction x of the way from L to R The price of the product at L is p L and at R is p R 6 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 The customer buys from the location with the lowest total cost 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 Solving gives x * = 1 2 + p R p L 2 c 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 Note that dx * dp R = 1 2 c Question: What does this imply for large and small c ? 8 Let production costs be zero and the total number of customers be N The profit of firm L is L = p L x * N Question: Determine the best response functions of firms L and R and the Nash equilibrium in prices 9 Endogenous Location Two Stage Game : In first stage...
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