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
Vertical product differentiation - companies offer different products that differ in quality
2. Search goods – goods we try but have no experience; however, consumer cannot determine quality
3. Asymmetric information problem
If consumers have trouble identifying quality, then producers can take advantage and do shoddy work, overcharge, etc.
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Sellers have more information than the buyers
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Examples: car repairs, medical treatment, etc
Some firms do not care about
Reputation
Warranties
Advertising
Repeat customers
Firms may produce low quality
Example 1: Restaurants in tourist areas
Example 2: Buyers have trouble assessing quality of used cars
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
Could drive the good candidates from the market?
Many professionals with little free time
Caveat emptor - "Let the buyer beware"
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
Cost function, C(q, s)
Profit maximization

If quality increases by one unit, then this term,
,
is the increase in revenue for providing better quality
If quality increases by one unit, then this term,
,
is the increase in cost for providing better quality
Graph below


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1. Hotelling's Law
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?
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The business locates the stores at Points B, D, and F
Two firms are competing for consumers
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
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
Firms use product differentiation to increase price and profits
A greater price results from a greater reservation price or the number of brands or stores increases
Market price must fall if transportation costs increase
Firms increase the degree of product differentiation of transportation cost increase or disutility cost of consuming the product falls
Firms increase the degree of product differentiation if number of consumers increase
Firms increase the degree of product differentiation if fixed costs decrease for developing a new product or building a new store
The number of stores or brands tend to exceed the socially optimal number of stores and brands
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Comparing monopolistic competition to purely competitive markets
1. Similarities:
Incentives to innovative and adopt technology that reduces costs
Earn zero economic profit in the long run
2. Differences:
Allocative efficiency - goods desired by consumers are produced at the lowest cost P = MC
Productive efficiency - goods are produced at minimum long-run costs
Price Taker |
Price Searcher with low entry barriers |
Price |
Price |
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Quantity |
Quantity |
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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. |
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Quality Discrimination – monopolist supplies at least two products that differ in quality
Similar to 2nd degree price discrimination
Indifference curve – as quality increases, then consumers will pay a higher price to remain at the same utility level

If a monopolist chooses price, P*, and quality level, s*, then both groups buy the same product
Monopolist has to produce a low-quality and high-quality product
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