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Product Differentiation
Lecture 9


Quality Differences

1. Goal to product differentiation

  • Boost demand

  • Decrease a product's elasticity of demand

  • Thus, firm can raise the price

  • Horizontal product differentiation - company offers different product characteristics but products have similar quality

    • Most computer companies sell similar computers

    • Toshiba, HP, Dell, etc.

  • Vertical product differentiation - companies offer different products that differ in quality

    • Asus produces its own motherboards and produces greater quality computers

2. Search goods – goods we try but have no experience; however, consumer cannot determine quality

  • Experience goods – consumers know about product quality because the have experience with them

  • Asymmetric – seller / producer knows about the quality

    • Consumers do not know about quality

  • Consumers use

    1. Reputation – consumers know a firm makes quality

      • Examples: Nike shoes and Apple computers

    2. Commitment – producer offers a warranty

      • Producer replaces or fixes product if product breaks

    3. Firms may advertise

      • Provides information about quality

      • Firms want repeat customers

      • If firm provides low-quality product, then customers find out. Firm wastes resources for advertising

3. Asymmetric information problem

  1. If consumers have trouble identifying quality, then producers can take advantage and do shoddy work, overcharge, etc.

    • Sellers have more information than the buyers

    • Examples: car repairs, medical treatment, etc

  2. Some firms do not care about

    • Reputation

    • Warranties

    • Advertising

    • Repeat customers

  3. Firms may produce low quality

  4. Example 1: Restaurants in tourist areas

    • Restaurants could serve over priced, low quality meals

    • Customers are not likely to return

  5. Example 2: Buyers have trouble assessing quality of used cars

    • Lemons Model

      • High-quality used cars are not sold

      • Low-quality used cars are sold

      • A welfare loss

  6. Example 3: eHarmony

    • Adverse selection - people posting information know the truth and can post false information and old photographs

    • Viewers do not know if information is correct

    • Exaggerate job titles, salaries, marital status, or use 20-year-old photographs

    • Majority report being above average in looks

    • Photographs

      • Men with no photograph receive 25% of the responses than men with photographs

      • Women with no photograph receive 17% of the responses than women with photographs

    • Could drive the good candidates from the market?

    • Many professionals with little free time

    • Caveat emptor - "Let the buyer beware"

  7. Example 4: Home insurance

    • Adverse selection - people who buy insurance are more likely to use it

    • The insurance company charges everyone 2% insurance on the value of their house

    • Homeowners who are careful, prudent, etc. are not likely to use insurance and they do not buy the policy because it is too expensive

    • Homeowners who are careless, reckless, etc. are likely to use the insurance, and they buy the policy

    • Insurance companies have payouts that may cause them to raise premiums

    • Note - Governments in the United States force residents to buy insurance for car, house, medical, etc.

4. Add quality to profits

  • Inverse demand function, P(q, s,), where q is quantity and s is quality

    • Law of Demand is Equation 1

    • Higher quality dictates a higher price, Equation 2

  • Cost function, C(q, s)

    • Marginal cost is Equation 3

    • Higher quality dictates a higher production cost, Equation 4

  • Profit maximization

Equation 5

  • If quality increases by one unit, then this term, Equation 6, is the increase in revenue for providing better quality

  • If quality increases by one unit, then this term, Equation 7, is the increase in cost for providing better quality

  • Graph below

Increase in a firm's revenue when firm increases quality

  • Note: MR should change but the graph would get messy

  • Production is frozen at q*

  • Graph below

Increase in consumers' surplus, when a firm improves the quality

Hotelling's Law

1. Hotelling's Law

  • Consumers buy a product if Ri ≥ P + t ∙ d

    • Ri is a person's reservation price or maximum he or she is willing to pay

    • P is the product's price

    • t is the travel cost per kilometer, and assume all consumers have the same cost

    • d is the distance to travel to store

  • The city is graphed as a straight line, and is shown below

    • The length corresponds to the distance travelled by the consumer

Hotelling's City

  • Where is the optimal place for the store?

    • If a store locates itself at Point A, consumers have lower travel if they live near Points A, B, and C

    • However, consumers living at Points D and E have greater travel costs

    • Thus, the business locates at Point C

  • If the business wants two stores, where is the optimal place to locate?

    • Opening a new store is a fixed costs, so it does not play a role in the MR = MC decision

    • If the business locates the stores at Points A and E, then C has the greatest transportation costs

    • If the business locates the stores at Points B and D, then the two stores cut the transportation costs in half

      • Think about for people who live at Points A and E

      • Ri ≥ P + ½ t ∙ d

      • The stores can charge a greater price without losing consumers

      • United States - a fast food restaurant or Starbuck's on every street corner usually at a gas station

  • The business wants to locate three stores. Where are the optimal places?

Hotelling's City

  • The business locates the stores at Points B, D, and F

    • The consumers' transportation costs are lower

    • The business can raise prices without losing consumers

  • Two firms are competing for consumers

    • Again, we have the linear city below

Hotelling's City

  • It turns into a game

    • The first business opens at Point B while the second business opens at Point D

    • Each capture half the market

    • One business will move to Point C to capture more of the market and offers a similar product to the other business

    • The other business must move to Point C to compete

    • Firms offer similar products to attract the most consumers

    • Socially not optimal because the consumers' transportation costs are greater

  • Note - can apply the same logic to product differentiation

    • The transportation costs becomes a measure of dis-utility

      • Consumers derive less utility

      • Examples

        • Sweetness for breakfast cereals

        • Differences in quality

  • Common for a business to create multiple products to take up shelf space even though products are similar

  • Developing a product entails fixed costs which is not part of the MR = MC

2. Results

  1. Firms use product differentiation to increase price and profits

  2. A greater price results from a greater reservation price or the number of brands or stores increases

  3. Market price must fall if transportation costs increase

  4. Firms increase the degree of product differentiation of transportation cost increase or disutility cost of consuming the product falls

  5. Firms increase the degree of product differentiation if number of consumers increase

  6. Firms increase the degree of product differentiation if fixed costs decrease for developing a new product or building a new store

  7. The number of stores or brands tend to exceed the socially optimal number of stores and brands

Monopolistic Competition

Comparing monopolistic competition to purely competitive markets

1. Similarities:

  1. Incentives to innovative and adopt technology that reduces costs

  2. Earn zero economic profit in the long run

    • Economic profits attract new firms to the market

      • Supply increases and curve shifts right

      • Price decreases until firms earn zero economic profit

    • Economic losses cause some firms to leave the market

      • Supply decreases and curve shifts left

      • Price increases until firms earn zero economic profit

2. Differences:

  1. Allocative efficiency - goods desired by consumers are produced at the lowest cost P = MC

    • Pure competitive market is allocative efficient

      • P = MR = MC

    • Monopolistic competitive market is not allocative efficient

      • P > MR = MC

  2. Productive efficiency - goods are produced at minimum long-run costs

    • P = min ATC

    • Competitive market is productive efficient

    • Monopolistically competitive market is not productive efficient

      • Producing less output at a higher price

      • Too much duplication

        • Many restaurants, gas stations, & stores

        • Consolidate them so they produce larger output

Price Taker Price Searcher with low entry barriers
Price Price
Purely competitive firm is earning zero economic profits Price searcher is earning zero economic profits
Quantity Quantity
Blue arrow

Historically, economist criticized monopolistic competitive markets. Recently economists are more positive about them, because consumers have a variety of quality and styles to choose from.

Quality Discrimination

Quality Discrimination – monopolist supplies at least two products that differ in quality

  1. Similar to 2nd degree price discrimination

    • Monopolist has no information about customers

    • Get customer to self-select in quality

  2. Indifference curve – as quality increases, then consumers will pay a higher price to remain at the same utility level

Quality disvrimination

  1. If a monopolist chooses price, P*, and quality level, s*, then both groups buy the same product

    • P* and s* is the average quality product

  2. Monopolist has to produce a low-quality and high-quality product

    • Force customers into their groups and extract consumers' surplus from customers who prefer higher quality

    • This explains why a monopolist cannot offer a product with average quality


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