Topic 3: Essay Plans
1. Explain why prices are likely to rise as products become more differentiated.
> Define product differentiation (vertical/horizontal)
Product differentiation is when goods sold in a market are differentiated, this could be based on
horizontal or vertical differentiation.
Horizontal product differentiation is when goods are differentiated based on a specific feature such
as packaging or taste e.g. Pepsi vs Coca-Cola.
Whereas vertical product differentiation is when products are differentiated based on quality e.g.
BMW vs Fiat.
> Explain endogenous price model -> 1ST Model in Topic 3- Models and diagrams doc (which is an
adaptation of Hotelling’s model)
- Outline assumptions of the model
- Cross price
elasticity of demand shows: demand is less responsive to a rival’s price when products are more
differentiated (as K increases so XED falls). As product differentiation increases equilibrium market
prices increase since firms less worried about being undercut by rival since if rival undercuts when
product differentiation is higher less demand will go to the rival.
- Could demonstrate this point with values put into formula like model 2 case -> the price changing
with 2 different degrees of product differentiation
- Explain end results PN = k, as k increases prices will rise
Equilibrium prices are greater than MC provided products are differentiated
The more products are differentiated (demand is less responsive to a change in its rivals price and
to a change in its own price) the less intense price competition, prices are higher and profits are
higher – shown by best response function
- NE diagram with best responses-> State in words referring to the diagram-> as k falls BRi shifts
inwards for each firm (can be seen from the intercepts), lower NE prices result- becoming closer to
the perfect comp level
Whereas as k rises BRi shifts outwards for each firm away from the origin, NE price rises resulting in
prices becoming closer to monopoly level prices
> Model based on symmetric differentiation also demonstrates this result -> 4th model
- Explain end results PN = k(1-2x), as k increases prices will rise
> Discuss examples that demonstrate this
- Feenstra and Levinsohn (1995) used a model to estimate mark-ups in the market for automobiles
in the USA based on a data set for 82 different models sold in 1987. They found that the mark-ups
ranged from essentially zero on compact cars where the product space was crowded and observed
that mark-ups were much higher for more expensive automobiles where the product space was not
nearly as crowded.
, > Can argue statement may not occur in some cases: Multi-product monopolist model ‘Second
model’
- State if we now reconsider the first model but now assume a monopolist owns both stores which
could be following a merger will show the statement is not always true.
- Since as product differentiation increases the monopoly price actually falls -> Could be because as
the monopolists product is evolving/changing it may not be profitable to keep increasing prices or it
may be because by differentiating its product it enters into a new segment of the market it wants to
predatory price in until it can fully establish its product line.
- So for models of competition the statement is true but for models in which there is no competition
the statement may hold true
* If spare words could mention the OPEC case here in more detail
“The Organization of the Petroleum Exporting Countries (OPEC) is a cartel consisting of 14 of the
world's major oil-exporting nations. OPEC aims to regulate the supply of oil in order to set the price
on the world market.”
> Conclude:
- Statement can be seen to apply to cases of competition
- When k rises prices rise since as XED and own price elasticity of demand fall – so consumers taste
preferences can be seen to impact this e.g. if low XED for 2 products
- Products seen as more differentiated- consumers willing to pay more for a differentiated product
seen as more preferable
- Profitable for firms to increase prices with product differentiation
- Statement can be seen to apply to cases of competition but not for all cases in which there is a lack
of competition e.g. monopoly and oligopoly – one specific case would be a cartel, prices likely to rise
without greater product differentiation also like in case discussed for monopoly- predatory pricing
- So prices rise even if not very differentiated products but firms have market power- OPEC*
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