Product Variety and Quality under Monopoly. Introduction Most firms sell more than one product Products are differentiated in different ways –horizontally.

Product Variety and Quality under Monopoly

Introduction

• Most firms sell more than one product• Products are differentiated in different ways

– horizontally• goods of similar quality targeted at consumers of

different types– how is variety determined?– is there too much variety

– vertically• consumers agree on quality• differ on willingness to pay for quality

– how is quality of goods being offered determined?

Horizontal product differentiation• Suppose that consumers differ in their tastes

– firm has to decide how best to serve different types of consumer

– offer products with different characteristics but similar qualities

• This is horizontal product differentiation– firm designs products that appeal to different types of

consumer– products are of (roughly) similar quality

• Questions:– how many products?– of what type?– how do we model this problem?

A spatial approach to product variety• The spatial model (Hotelling) is useful to

consider– pricing– design– variety

• Has a much richer application as a model of product differentiation– “location” can be thought of in

• space (geography)• time (departure times of planes, buses, trains)• product characteristics (design and variety)

– consumers prefer products that are “close” to their preferred types in space, or time or characteristics

An geographic example of product variety

McDonald’s Burger King Wendy’s

A Spatial approach to product variety 2• Assume N consumers living equally spaced along Main

Street – 1 mile long.• Monopolist must decide how best to supply these

consumers• Consumers buy exactly one unit provided that price

plus transport costs is less than V.• Consumers incur there-and-back transport costs of t

per mile• The monopolist operates one shop

– reasonable to expect that this is located at the center of Main Street

The spatial model

z = 0 z = 1

Shop 1

t

x1

Price Price

All consumers withindistance x1 to the leftand right of the shopwill by the product

All consumers withindistance x1 to the leftand right of the shopwill by the product

1/2

V V

p1

t

x1

p1 + tx p1 + t.x

p1 + tx1 = V, so x1 = (V – p1)/t

What determinesx1?

What determinesx1?

Suppose that the monopolist sets a price of p1

Suppose that the monopolist sets a price of p1

The spatial model 2

z = 0 z = 1

Shop 1

x1

Price Price

1/2

V V

p1

x1

p1 + t.x p1 + t.x

Suppose the firmreduces the price

to p2?

Suppose the firmreduces the price

to p2?

p2

x2 x2

Then all consumerswithin distance x2

of the shop will buyfrom the firm

Then all consumerswithin distance x2

of the shop will buyfrom the firm

The spatial model 3

• Suppose that all consumers are to be served at price p.– The highest price is that charged to the consumers at the ends of

the market

– Their transport costs are t/2 : since they travel ½ mile to the shop

– So they pay p + t/2 which must be no greater than V.

– So p = V – t/2.

• Suppose that marginal costs are c per unit.

• Suppose also that a shop has set-up costs of F.

• Then profit is (N, 1) = N(V – t/2 – c) – F.

Monopoly pricing in the spatial model

• What if there are two shops?

• The monopolist will coordinate prices at the two shops

• With identical costs and symmetric locations, these prices will be equal: p1 = p2 = p– Where should they be located?

– What is the optimal price p*?

Location with two shops

Suppose that the entire market is to be servedSuppose that the entire market is to be servedPrice Price

z = 0 z = 1

If there are two shopsthey will be located

symmetrically a distance d from theend-points of the

market

If there are two shopsthey will be located

symmetrically a distance d from theend-points of the

market

Suppose thatd < 1/4

Suppose thatd < 1/4

d

V V

1 - dShop 1 Shop 2

1/2

The maximum pricethe firm can chargeis determined by the

consumers at thecenter of the market

The maximum pricethe firm can chargeis determined by the

consumers at thecenter of the market

Delivered price toconsumers at the

market center equalstheir reservation price

Delivered price toconsumers at the

market center equalstheir reservation price

p(d) p(d)

Start with a low priceat each shop

Start with a low priceat each shop

Now raise the priceat each shop

Now raise the priceat each shop

What determinesp(d)?

What determinesp(d)?

The shops should bemoved inwards

The shops should bemoved inwards

Location with two shops 2

Price Price

z = 0 z = 1

Now suppose thatd > 1/4

Now suppose thatd > 1/4

d

V V

1 - dShop 1 Shop 2

1/2

p(d) p(d)

Start with a low priceat each shop

Start with a low priceat each shop

Now raise the priceat each shop

Now raise the priceat each shop

The maximum pricethe firm can charge is now determined by the consumers at the end-points

of the market

The maximum pricethe firm can charge is now determined by the consumers at the end-points

of the market

Delivered price toconsumers at theend-points equals

their reservation price

Delivered price toconsumers at theend-points equals

their reservation price

Now what determines p(d)?

Now what determines p(d)?

The shops should bemoved outwards

The shops should bemoved outwards

Location with two shops 3

Price Price

z = 0 z = 11/4

V V

3/4Shop 1 Shop 2

1/2

It follows thatshop 1 shouldbe located at

1/4 and shop 2at 3/4

It follows thatshop 1 shouldbe located at

1/4 and shop 2at 3/4

Price at eachshop is thenp* = V - t/4

Price at eachshop is thenp* = V - t/4

V - t/4 V - t/4

Profit at each shopis given by the

shaded area

Profit at each shopis given by the

shaded area

Profit is now (N, 2) = N(V - t/4 - c) – 2FProfit is now (N, 2) = N(V - t/4 - c) – 2F

c c

Three shops

Price Price

z = 0 z = 1

V V

1/2

What if there are three shops?

What if there are three shops?

By the same argumentthey should be located

at 1/6, 1/2 and 5/6

By the same argumentthey should be located

at 1/6, 1/2 and 5/6

1/6 5/6Shop 1 Shop 2 Shop 3

Price at eachshop is now

V - t/6

Price at eachshop is now

V - t/6

V - t/6 V - t/6

Profit is now (N, 3) = N(V - t/6 - c) – 3FProfit is now (N, 3) = N(V - t/6 - c) – 3F

Optimal number of shops

• A consistent pattern is emerging.• Assume that there are n shops.

• We have already considered n = 2 and n = 3.

• When n = 2 we have p(N, 2) = V - t/4

• When n = 3 we have p(N, 3) = V - t/6

• They will be symmetrically located distance 1/n apart.

• It follows that p(N, n) = V - t/2n

• Aggregate profit is then (N, n) = N(V - t/2n - c) – nF

How manyshops should

there be?

How manyshops should

there be?

Optimal number of shops 2

Profit from n shops is (N, n) = (V - t/2n - c)N - nFand the profit from having n + 1 shops is:

*(N, n+1) = (V - t/2(n + 1)-c)N - (n + 1)F

Adding the (n +1)th shop is profitable if (N,n+1) - (N,n) > 0

This requires tN/2n - tN/2(n + 1) > F

which requires that n(n + 1) < tN/2F.

An example

Suppose that F = $50,000 , N = 5 million and t = $1

Then tN/2F = 50

For an additional shop to be profitable we need n(n + 1) < 50.

This is true for n < 6

There should be no more than seven shops in this case: if n = 6 then adding one more shop is profitable.

But if n = 7 then adding another shop is unprofitable.

Some intuition• What does the condition on n tell us?

• Simply, we should expect to find greater product variety when:– there are many consumers.

– set-up costs of increasing product variety are low.

– consumers have strong preferences over product characteristics and differ in these

• consumers are unwilling to buy a product if it is not “very close” to their most preferred product

How much of the market to supply• Should the whole market be served?

– Suppose not. Then each shop has a local monopoly– Each shop sells to consumers within distance r– How is r determined?

• it must be that p + tr = V so r = (V – p)/t• so total demand is 2N(V – p)/t• profit to each shop is then = 2N(p – c)(V – p)/t – F• differentiate with respect to p and set to zero:• d/dp = 2N(V – 2p + c)/t = 0• So the optimal price at each shop is p* = (V + c)/2• If all consumers are served price is p(N,n) = V – t/2n

– Only part of the market should be served if p(N,n)< p*– This implies that V < c + t/n.

Partial market supply

• If c + t/n > V supply only part of the market and set price p* = (V + c)/2

• If c + t/n < V supply the whole market and set price p(N,n) = V – t/2n

• Supply only part of the market:– if the consumer reservation price is low relative to marginal

production costs and transport costs

– if there are very few outlets

Social optimumAre there too

many shops ortoo few?

Are there toomany shops or

too few?What number of shops maximizes total surplus?What number of shops maximizes total surplus?

Total surplus is therefore NV - Total CostTotal surplus is therefore NV - Total Cost

Total surplus is then total willingness to pay minus total costsTotal surplus is then total willingness to pay minus total costs

Total surplus is consumer surplus plus profit

Consumer surplus is total willingness to pay minus total revenue

Profit is total revenue minus total cost

Total willingness to pay by consumers is N.V

So what is Total Cost?So what is Total Cost?

Social optimum 2

Price Price

z = 0 z = 1

V V

Assume thatthere

are n shops

Assume thatthere

are n shops

Consider shopi

Consider shopi

1/2n 1/2n

Shop i

t/2nt/2nTotal cost istotal transport

cost plus set-upcosts

Total cost istotal transport

cost plus set-upcosts

Transport cost foreach shop is the areaof these two triangles

multiplied byconsumer density

Transport cost foreach shop is the areaof these two triangles

multiplied byconsumer density

This area is t/4n2 This area is t/4n2

Social optimum 3Total cost with n shops is, therefore: C(N,n) = n(t/4n2)N + nF

= tN/4n + nF

Total cost with n + 1 shops is: C(N,n+1) = tN/4(n+1)+ (n+1)F

Adding another shop is socially efficient if C(N,n + 1) < C(N,n)

This requires that tN/4n - tN/4(n+1) > F

which implies that n(n + 1) < tN/4F

The monopolist operates too many shops and, more generally, provides too much product variety

The monopolist operates too many shops and, more generally, provides too much product variety

If t = $1, F = $50,000,N = 5 million then this

condition tells usthat n(n+1) < 25

If t = $1, F = $50,000,N = 5 million then this

condition tells usthat n(n+1) < 25

There should be five shops: with n = 4 adding another shop is efficient

There should be five shops: with n = 4 adding another shop is efficient

Product variety and price discrimination• Suppose that the monopolist delivers the product.

– then it is possible to price discriminate

• What pricing policy to adopt?– charge every consumer his reservation price V

– the firm pays the transport costs

– this is uniform delivered pricing

– it is discriminatory because price does not reflect costs

Product variety and price discrimination• Suppose that the monopolist delivers the product.

– then it is possible to price discriminate

• What pricing policy to adopt?– charge every consumer his reservation price V

– the firm pays the transport costs

– this is uniform delivered pricing

– it is discriminatory because price does not reflect costs

Product variety and price discrimination 2• Should every consumer be supplied?

– suppose that there are n shops evenly spaced on Main Street

– cost to the most distant consumer is c + t/2n

– supply this consumer so long as V (revenue) > c + t/2n• This is a weaker condition than without price

discrimination.• Price discrimination allows more consumers to be

served.

Product variety & price discrimination 3

• How many shops should the monopolist operate now?—Suppose that the monopolist has n shops and is supplying

the entire market. —Total revenue minus production costs is NV – Nc—Total transport costs plus set-up costs is C(N, n)=tN/4n + nF—So profit is (N,n) = NV – Nc – C(N,n)—But then maximizing profit means minimizing C(N, n)

—The discriminating monopolist operates the socially optimal number of shops.

Monopoly and product quality• Firms can, and do, produce goods of different qualities• Quality then is an important strategic variable• The choice of product quality determined by its ability to

generate profit; attitude of consumers to q uality• Consider a monopolist producing a single good

– what quality should it have?– determined by consumer attitudes to quality

• prefer high to low quality• willing to pay more for high quality• but this requires that the consumer recognizes quality• also some are willing to pay more than others for quality

Demand and quality

• We might think of individual demand as being of the form– Qi = 1 if Pi < Ri(Z) and = 0 otherwise for each consumer i

– Each consumer buys exactly one unit so long as price is less than her reservation price

– the reservation price is affected by product quality Z

• Assume that consumers vary in their reservation prices

• Then aggregate demand is of the form P = P(Q, Z)

• An increase in product quality increases demand

Demand and quality 2Begin with a particular demand curve

for a good of quality Z1

Begin with a particular demand curvefor a good of quality Z1

Price

Quantity

P(Q, Z1)

P1

Q1

If the price is P1 and the product qualityis Z1 then all consumers with reservationprices greater than P1 will buy the good

If the price is P1 and the product qualityis Z1 then all consumers with reservationprices greater than P1 will buy the goodR1(Z1)

These are theinframarginal

consumers

These are theinframarginal

consumers

This is themarginalconsumer

This is themarginalconsumer

Suppose that an increase inquality increases thewillingness to pay of

inframarginal consumers morethan that of the marginal

consumer

Suppose that an increase inquality increases thewillingness to pay of

inframarginal consumers morethan that of the marginal

consumer

Then an increase in productquality from Z1 to Z2 rotates

the demand curve aroundthe quantity axis as follows

Then an increase in productquality from Z1 to Z2 rotates

the demand curve aroundthe quantity axis as follows

R1(Z2)

P2

Quantity Q1 can now besold for the higher

price P2

Quantity Q1 can now besold for the higher

price P2

P(Q, Z2)

Demand and quality 3

Price

Quantity

P(Q, Z1)

P1

Q1

R1(Z1)

Suppose instead that an increase in

quality increases thewillingness to pay of marginal

consumers morethan that of the inframarginal

consumers

Suppose instead that an increase in

quality increases thewillingness to pay of marginal

consumers morethan that of the inframarginal

consumers

Then an increase in productquality from Z1 to Z2 rotates

the demand curve aroundthe price axis as follows

Then an increase in productquality from Z1 to Z2 rotates

the demand curve aroundthe price axis as follows

P(Q, Z2)

Once again quantity Q1 can now be sold for a

higher price P2

Once again quantity Q1 can now be sold for a

higher price P2

P2

Demand and quality 4• The monopolist must choose both

– price (or quantity)– quality

• Two profit-maximizing rules– marginal revenue equals marginal cost on the last unit sold for

a given quality– marginal revenue from increased quality equals marginal cost

of increased quality for a given quantity• This can be illustrated with a simple example:

P = Z( - Q) where Z is an index of quality

Demand and quality 5P = Z( - Q)

Assume that marginal cost of output is zero: MC(Q) = 0

Cost of quality is C(Z) = Z2

This means that quality iscostly and becomesincreasingly costly

This means that quality iscostly and becomesincreasingly costly

Marginal cost of quality = dC(Z)/d(Z)

= 2Z

The firm’s profit is:

(Q, Z) =PQ - C(Z) = Z( - Q)Q - Z2

Demand and quality 6

Again, profit is:

(Q, Z) =PQ - C(Z) = Z( - Q)Q - Z2

The firm chooses Q and Z to maximize profit.

Take the choice of quantity first: this is easiest.

Marginal revenue = MR = Z - 2ZQ

MR = MC Z - 2ZQ = 0 Q* = /2

P* = Z/2

Demand and quality 7Total revenue = P*Q* = (Z/2)x(/2) = Z2/4

So marginal revenue from increased quality isMR(Z) = 2/4

Marginal cost of quality isMC(Z) = 2Z

Equating MR(Z) = MC(Z) then gives

Z* = 2/8Does the monopolist produce too high or too low quality?

Demand and quality: multiple products

• What if the firm chooses to offer more than one product?

– what qualities should be offered?

– how should they be priced?

• Determined by costs and consumer demand

Demand and quality: multiple products 2

• An example:– two types of consumer

– each buys exactly one unit provided that consumer surplus is nonnegative

– if there is a choice, buy the product offering the larger consumer surplus

– types of consumer distinguished by willingness to pay for quality

• This is vertical product differentiation

Vertical differentiation• Indirect utility to a consumer of type i from consuming a

product of quality z at price p is Vi = i(z – zi) – p – where i measures willingness to pay for quality;– zi is the lower bound on quality below which consumer type i

will not buy– assume 1 > 2: type 1 consumers value quality more than type 2– assume z1 > z2 = 0: type 1 consumers only buy if quality is

greater than z1:• never fly in coach• never shop in Wal-Mart• only eat in “good” restaurants

– type 2 consumers will buy any quality so long as consumer surplus is nonnegative

Vertical differentiation 2• Firm cannot distinguish consumer types

• Must implement a strategy that causes consumers to self-select– persuade type 1 consumers to buy a high quality product z1 at a

high price

– and type 2 consumers to buy a low quality product z2 at a lower price, which equals their maximum willingness to pay

• Firm can produce any product in the range

• MC = 0 for either quality type

z, z

Vertical differentiation 3

For type 2 consumers charge maximum willingness to pay for the low quality product: p2 = 2z2

Suppose that the firm offers two products with qualities z1 > z2

Now consider type 1 consumers: firm faces an incentive compatibility constraint

1(z1 – z1) – p1 > 1(z2 – z1) – p2

Type 1 consumers prefer the high

quality to the low quality good

1(z1 – z1) – p1 >

Type 1 consumers have nonnegative consumer surplus from the high

quality good

These imply that p1 < 1z1 – (-2)z2 There is an upper limit on the price that can be charged for the high quality good

Vertical differentiation 4• Take the equation p1 = 1z1 –1 –2)z2

– this is increasing in quality valuations

– increasing in the difference between z1 and z2

– quality can be prices highly when it is valued highly

– firm has an incentive to differentiate the two products’ qualities to soften competition between them

• monopolist is competing with itself

• What about quality choice?– prices p1 = 1z1 – (1 – 2)z2; p2 = 2z2

• check the incentive compatibility constraints

– suppose that there are N1 type 1 and N2 type 2 consumers

Vertical differentiation 5Profit is

N1p1 + N2p2 =

N11z1 – (N11 – (N1 + N2)2)z2

This is increasing in z1 so set z1 as high as possible: z1 =

For z2 the decision is more complex

(N11 – (N1 + N2)2) may be positive or negative

z

Vertical differentiation 6Case 1: Suppose that (N11 – (N1 + N2)2) is positive

Then z2 should be set “low” but this is subject to a constraint

Recall that p1 = 1z1 – (-2)z2 So reducing z2 increases p1

But we also require that 1(z1 – z1) – p1 >

Putting these together gives:21

112

zz

The equilibrium prices are then: 21

1122

zp

111 zzp

Vertical differentiation 7

• Offer type 1 consumers the highest possible quality and charge their full willingness to pay

• Offer type 2 consumers as low a quality as is consistent with incentive compatibility constraints

• Charge type 2 consumers their maximum willingness to pay for this quality– maximum differentiation subject to incentive compatibility

constraints

Vertical differentiation 8Case 1: Now suppose that (N11 – (N1 + N2)2) is negative

Then z2 should be set as high as possible

The firm should supply only one product, of the highest possible quality

What does this require?

From the inequality offer only one product if: 11

2

21

1

NN

N

Offer only one product:

if there are not “many” type 1 consumers

if the difference in willingness to pay for quality is “small”

Should the firm price to sell to both types in this case? YES!

Empirical Application: Price Discrimination and Imperfect Competition

Although we have presented price discrimination and product design (versioning) issues in the context of a monopoly, these same tactics also play a role in more competitive settings of imperfect competition

Imagine a two-store setting again

Assume N customers distributed evenly between the two stores, each with maximum willingness to pay of V .

No transport cost—Half of the consumers always buys at nearest store. Other half always buys at cheapest store.

Price Discrimination and Imperfect Competition 2

If both stores operated by a monopolist, set price = V.Cannot set it higher of there will be no customers.

If Store 1 cuts its price below V. It loses N/2 from all current customers

Setting it lower though gains nothing.What if stores operated by separate firms?

Imagine P1 = P2 = V. Store 1 serves N/4 price-sensitive customers and N/4 price-insensitive ones. The same is true for Store 2.

It gains N(V - )/4 by stealing all price-sensitive customers from Store 2

Price Discrimination and Imperfect Competition 3

MORAL 1: Both firms have a real incentive to cut price.

This ultimately proves self-defeating

Cutting their price does not increase their likelihood of shopping at a particular place. It just loses revenue.MORAL 2: Unlike the monopolist who sets the same price to everyone, these firms have an incentive to discriminate and so continue to charge a high price to loyal consumers while pricing low to others.

In equilibrium, both still serve N/2 customers but now do so at a price closer to cost.This is especially frustrating in light of the “brand-loyal” or price-insensitive customers

Price Discrimination and Imperfect Competition 4

The intuition then is that price discrimination may be associated with imperfect competition and become more prominent as markets get more competitive (but still less than perfectly competitive).

This idea is tested by Stavins (2001) with airline prices. Restrictions such as a required Saturday night stay-over or an advanced purchase serve as screening mechanism for price-sensitive customers. Hence, restrictions lead to lower ticket price.Stavins (2001) idea is that price reduction associated with flight restrictions will be small in markets that are not very competitive.

Price Discrimination and Imperfect Competition 6

Stavins (2001) looks at nearly 6,000 tickets covering 12 different city-pair routes in September, 1995. She finds strong support for the dual hypothesis that:

In highly competitive (low HHI) markets, a Saturday night restriction leads to a $253 price reduction but only a $165 reduction in less competitive ones.

a) passengers flying on a ticket with restrictions pay less;b) price reduction shrinks as concentration rises

In highly competitive (low HHI) markets, an Advance Purchase restriction leads to a $111 price reduction but only a $41 reduction in less competitive ones.

Price Discrimination and Imperfect Competition 5

Variable Coefficient t-Statistic Coefficient t-Statistic

SaturdayNight Stay – 0.408 – 4.05 ----- -----Required

Saturday Night Stay 0.792 3.39 ----- -----RequiredxHHI

Advance Purchase ----- ----- – 0.023 –5.53 RequiredAdvance Purchase ----- ----- 0.098 8.38RequiredxHHI

NOTE: HHI is the Herfindahl Index. A Saturday Night Stay or an Advance Purchase lowers the price significantly. But the HHI terms show that this effect weakens as market concentration increases.

Demand and quality A1Price

Quantity

Z1

P(Q,Z1)

How does increased quality affect demand?

How does increased quality affect demand?

Z2P(Q, Z2)

MR(Z1)

MR(Z2)

/2

Q*

P1 = Z1/2

P2 = Z2/2

When quality is Z1

price isZ1/2

When quality is Z1

price isZ1/2

When quality is Z2

price isZ2/2

When quality is Z2

price isZ2/2

Demand and quality A2Price

Quantity

Z1

Z2

/2

Q*

P1 = Z1/2

P2 = Z2/2

An increase in quality fromZ1 to Z2 increases

revenue by this area

An increase in quality fromZ1 to Z2 increases

revenue by this areaSocial surplus at quality Z1

is this area minus qualitycosts

Social surplus at quality Z1

is this area minus qualitycosts

Social surplus at quality Z2

is this area minus qualitycosts

Social surplus at quality Z2

is this area minus qualitycosts

So an increase is quality fromZ1 to Z2 increases surplus

by this area minus theincrease in quality costs

So an increase is quality fromZ1 to Z2 increases surplus

by this area minus theincrease in quality costs

The increase in total surplus is greater than the increase in profit.

The monopolist produces too little quality

Demand and qualityDerivation of aggregate demand

Order consumers by their reservation prices

Aggregate individual demand horizontally

Price

Quantity1 2 3 4 5 6 7 8

Location choice 1

d < 1/4

We know that p(d) satisfies the following constraint:

p(d) + t(1/2 - d) = V

This gives: p(d) = V - t/2 + td

p(d) = V - t/2 + td

Aggregate profit is then: (d) = (p(d) - c)N

= (V - t/2 + td - c)N

This is increasing in d so if d < 1/4 then d should be increased.

Location choice 2

d > 1/4

We now know that p(d) satisfies the following constraint:

p(d) + td = V

This gives: p(d) = V - td

Aggregate profit is then: (d) = (p(d) - c)N

= (V - td - c)N

This is decreasing in d so if d > 1/4 then d should be decreased.