1. Product Variety and Quality

2. 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?

3. Modeling horizontal differentiation
Address models
Consumers have preferences over the characteristics of products
Monopolistic competition model
Consumers have preferences over goods and a taste for variety

4. 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?

5. 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

6. 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

7. Suppose that the monopolist
sets a price of p1
The spatial model
Price
Price
p1 + tx
p1 + t.x V V
All consumers within
distance x1 to the left
and right of the shop
will by the product t t
What determines
x1? p1
z = 0 x1 x1
z = 1
1/2
Shop 1
p1 + tx1 = V, so x1 = (V – p1)/t

8. The spatial model 2 Suppose the firm reduces the price to p2? Price
p1 + t.x
p1 + t.x V V
Then all consumers
within distance x2
of the shop will buy
from the firm p1 p2
z = 0 x2 x1 x1 x2
z = 1
1/2
Shop 1

9. 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 p(N, 1) = N(V – t/2 – c) – F.

10. 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*?

11. Location with two shops
Delivered price to
consumers at the
market center equals
their reservation price
Suppose that the entire market is to be served
Price
Price
If there are two shops
they will be located
symmetrically a
distance d from the
end-points of the
market V
p(d)
The maximum price
the firm can charge
is determined by the
consumers at the
center of the market
p(d)
What determines
p(d)?
Now raise the price
at each shop
Start with a low price
at each shop d
1/2
1 - d
z = 0
z = 1
Shop 1
Shop 2
Suppose that
d < 1/4
The shops should be
moved inwards

12. Location with two shops 2
Delivered price to
consumers at the
end-points equals
their reservation price
The maximum price
the firm can charge
is now determined
by the consumers
at the end-points
of the market
Price
Price V
p(d)
p(d)
Now what
determines p(d)?
Now raise the price
at each shop
Start with a low price
at each shop d
1/2
1 - d
z = 0
z = 1
Shop 1
Shop 2
Now suppose that
d > 1/4
The shops should be
moved outwards

13. Location with two shops 3
It follows that
shop 1 should
be located at
1/4 and shop 2
at 3/4
Price at each
shop is then
p* = V - t/4
Price
Price V
V - t/4
V - t/4
Profit at each shop
is given by the
shaded area c c
z = 0
1/4
1/2
3/4
z = 1
Shop 1
Shop 2
Profit is now p(N, 2) = N(V - t/4 - c) – 2F

14. Profit is now p(N, 3) = N(V - t/6 - c) – 3F
By the same argument
they should be located
at 1/6, 1/2 and 5/6
What if there
are three shops?
Three shops
Price
Price V
Price at each
shop is now
V - t/6
V - t/6
V - t/6
z = 0
1/6
1/2
5/6
z = 1
Shop 1
Shop 2
Shop 3
Profit is now p(N, 3) = N(V - t/6 - c) – 3F

15. Optimal number of shops
A consistent pattern is emerging.
Assume that there are n shops.
They will be symmetrically located distance 1/n apart.
How many
shops should
there be?
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
It follows that p(N, n) = V - t/2n
Aggregate profit is then p(N, n) = N(V - t/2n - c) – nF

16. Optimal number of shops 2
Profit from n shops is p(N, n) = (V - t/2n - c)N - nF
and the profit from having n + 1 shops is:
p*(N, n+1) = (V - t/2(n + 1)-c)N - (n + 1)F
Adding the (n +1)th shop is profitable if p(N,n+1) - p(N,n) > 0
This requires tN/2n - tN/2(n + 1) > F
which requires that n(n + 1) < tN/2F.

17. 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.

18. 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

19. 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.

20. 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.
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.
If Store 1 cuts its price  below V.
It loses N/2 from all current customers
It gains N(V - )/4 by stealing all price-sensitive customers from Store 2

21. Price Discrimination and Imperfect Competition 3
MORAL 1: Both firms have a real incentive to cut price.
This ultimately proves self-defeating
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
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.

22. 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.

23. Price Discrimination and Imperfect Competition 5
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:
a) passengers flying on a ticket with restrictions pay less;
b) price reduction shrinks as concentration rises
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.
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.

24. Product Quality

25. 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

26. Choosing quality
Quality – vertical attributes of a product (ALL consumers agree that a product X is of higher quality than another product Y)
Firms choose both quantity and quality
Profit maximization
MR of an increment of quality is equal to its MC
Key problem: asymmetric information

27. Asymmetric information
Lemons problem
How would you describe an equilibrium?
Why is this a problem?
Adverse selection
Moral hazard
One side of a transaction has an incentive to change the terms of the exchange, unobserved by the other side

28. Asymmetric information: types of goods
Search goods: consumers have sufficient everyday knowledge or can accurately predict quality of a product BEFORE purchase
Experience goods: quality can be determined by consumers only AFTER purchase

29. Search goods
Why manufacturers and service companies do not provide a moderate quality at a moderate price (why price/quality ratio rare works in real life)?
Aim: increase profit by capturing consumer surplus (we assume imperfect competition here)
Mechanism: quality discrimination (Highest quality level is chosen solely on grounds of independent profit maximization, but a firm needs preventing switching high-end consumers to low-end products)
versioning / damaged goods
widening the range of quality offered

30. Experience goods: strategies
Reputation
Aim: repeat sales (customer loyalty)
Reputation is transferrable across consumers (“word of mouth” as a promotion tool) and across markets (exploiting established reputation in new markets)
Commitment
warranty (how to use for quality discrimination?)
reputation (why restaurants in tourist areas are so bad?)
Investment as a form of commitment: what is a signal of quality in this case?

31. Modeling commitment “Pure reputation model” (Shapiro, 1983)
Only new products are of unknown quality in the first period
Consumers learn true quality after purchase and inform other potential buyers
Decision: investment in reputation in the first period vs. earning a rent from selling high-quality products in all subsequent periods
Assume that companies don’t “milk” their reputation
“Advertising models” (Nelson, 1970, 1978)
Decision: price / advertising expenses combination to prevent entry of low-quality producers
Why “burning money” / noninformative advertising exists? (Warning: explanation for new experience goods only)

32. Price and advertising as signals of quality
Higher price – Higher Quality
Theory: Yes
More advertising – High Quality
Theory: it depends (on the cost of information)

33. Empirical testing Caves and Greene (1996)
Source of information: Consumer Reports (ranking products by objective characteristics – use as measures of quality)
Method: correlation analysis
Findings:
rank correlation coefficient for price-quality 0.38 for list prices, 0.27 for transaction prices
Is it a strong or weak correlation?

34. Why weak?
Price-quality correlation is higher for product categories that include more brands (greater scope for vertical differentiation)
Lower for “convenience goods” (heavy advertising and frequent repeat purchase)
Weakest for product that can use image advertising to build customer loyalty (horizontal differentiation)

35. Testing Nelson model
Conclusion: quality signaling is not a particularly important determinant of advertising in consumer goods (median values of the rank correlations are close to zero)
In some product categories correlation in very strong positive, in some – strong negative)
Advertising outlays tend to increase with quality for innovative goods (providing information)
Advertising is less correlated with quality of convenience goods (horizontal differentiation)

36. Case: health care markets

37. Commodity Bundling and Tie-In Sales

38. Introduction Firms often bundle the goods that they offer
Microsoft bundles Windows and Explorer
Office bundles Word, Excel, PowerPoint, Access
Bundled package is usually offered at a discount
Bundling may increase market power
GE merger with Honeywell
Tie-in sales ties the sale of one product to the purchase of another
Tying may be contractual or technological
IBM computer card machines and computer cards
Kodak tie service to sales of large-scale photocopiers
Tie computer printers and printer cartridges
Why? To make money!

39. Willingness to pay for Casablanca Willingness to pay for Godzilla
Bundling: an example
How much can
be charged for
Godzilla?
How much can
be charged for
Casablanca?
Two television stations offered two old Hollywood films
Casablanca and Son of Godzilla
Arbitrage is possible between the stations
Willingness to pay is:
If the films are sold
separately total
revenue is $19,000
$7,000
Willingness to pay for Casablanca
Willingness to pay for Godzilla
$2,500
Station A
$8,000
$2,500
Station B
$7,000
$3,000

40. Bundling: an example 2 How much can be charged for the package?
Bundling is profitable
because it exploits
aggregate willingness
pay
Bundling: an example 2
Now suppose
that the two films are
bundled and sold
as a package
If the films are sold
as a package total
revenue is $20,000
Willingness to pay for Casablanca
Willingness to pay for Godzilla
Total Willingness
to pay
Station A
$8,000
$2,500
$10,500
Station B
$7,000
$3,000
$10,000
$10,000

41. Bundling
Extend this example to allow for mixed bundling: offering products in a bundle and separately

42. Mixed bundling What should a firm actually do?
There is no simple answer
mixed bundling is generally better than pure bundling
but bundling is not always the best strategy
Each case needs to be worked out on its merits

43. An Example Four consumers; two products; MC1 = $100, MC2 = $150 A $50
Reservation Price for Good 1
Reservation Price for Good 2
Sum of Reservation Prices
Consumer A
$50
$450
$500 B
$250
$275
$525
$300
$220
$520 C D
$450
$50
$500

44. The example 2 Consider simple monopoly pricing Good 1 should be sold
Good 1: Marginal Cost $100
Consider simple
monopoly pricing
Price
Quantity
Total revenue
Profit
$450 1
$450
$350
$300 2
$400
Good 1 should be sold
at $250 and good 2 at
$450. Total profit
is $450 + $300
= $750
$600
$250
$250 3
$750
$450
$50 4
$200
-$200
Good 2: Marginal Cost $150
Price
Quantity
Total revenue
Profit
$450
$450 1
$450
$300
$275 2
$550
$200
$220 3
$660
$210
$50 4
$200
-$400

45. The example 3 Now consider pure bundling The highest bundle
Reservation Price for Good 1
Reservation Price for Good 2
Sum of Reservation Prices
Consumer
The highest bundle
price that can be
considered is $500
All four consumers will buy
the bundle and profit is
4x$ x($150 + $100)
= $1,000 A
$50
$450
$500 B
$250
$275
$525
$300
$220
$520 C D
$450
$50
$500

46. The example 4 Now consider mixed bundling All four consumers buy
Take the monopoly prices p1 = $250; p2 = $450 and a bundle price pB = $500
All four consumers buy
something and profit is
$250x2 + $150x2
= $800
Reservation Price for Good 1
Reservation Price for Good 2
Sum of Reservation Prices
Consumer
Can the seller improve
on this? A
$50
$450
$500
$500 B
$250
$275
$500
$525
$300
$250
$220
$520 C D
$250
$450
$50
$500

47. The example 5 This is actually the best that the firm can do
Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520
All four consumers buy
and profit is $300 +
$270x2 + $350
= $1,190
Reservation Price for Good 1
Reservation Price for Good 2
Sum of Reservation Prices
Consumer A
$50
$450
$450
$500 B
$250
$275
$520
$525
$300
$220
$520
$520 C D
$450
$450
$50
$500

48. Bundling again Bundling does not always work
Mixed bundling is always more profitable than pure bundling
Mixed bundling is always better than no bundling
But pure bundling is not necessarily better than no bundling
Requires that there are reasonably large differences in consumer valuations of the goods
Bundling is a form of price discrimination
May limit competition

49. Tie-in sales What about tie-in sales?
“like” bundling but proportions vary
allows the monopolist to make supernormal profits on the tied good
different users charged different effective prices depending upon usage
facilitates price discrimination by making buyers reveal their demands

50. Tie-in sales 2
Suppose that a firm offers a specialized product – a camera – that uses highly specialized film cartridges
Then it has effectively tied the sales of film cartridges to the purchase of the camera
this is actually what has happened with computer printers and ink cartridges
How should it price the camera and film?
suppose also that there are two types of consumer, high-demand and low-demand, with one-thousand of each type
high demand P = 16 – Qh; low demand P = 12 - Ql
the company does not know which type is which

51. Tie-in sales 3 Film is produced competitively at $2 per picture
so film is priced at $2 per picture
Suppose that the company leases its cameras
if priced so that all consumers lease then we can ignore production costs of the camera
these are fixed at 2000c
Now consider the lease terms

52. Tie-in sales: an example 2
So the firm can set a lease charge of $50 to each type of consumer: it cannot discriminate
Recall that the film sells at $2 per picture
High-Demand
Consumers
Low-Demand
Consumers
Profit is $50 from each low-demand and high-demand consumer. Total profit is $100,000
High-demand consumers take 14 pictures
Demand: P = 16 - Q
Demand: P = 12 - Q $ $
Consumer surplus for high-demand consumers is $98
Consumer surplus for low-demand consumers is $50
$16
$12
Low-demand consumers take 10 pictures
$98
$50 $2 $2 14 16 10 12
Quantity
Quantity

53. Tie-in sales example 3
This is okay but there may be room for improvement
Redesign the camera to tie the camera and the film
technological change that makes the camera work only with the firm’s film cartridge
Suppose that the firm can produce film at a cost of $2 per picture
Implement a tying strategy that makes it impossible to use the camera without this film

54. Tie-in sales: an example 2
Tying increases the
firm’s profit
$16 16
$12 12
High-Demand
Consumers
Low-Demand
Demand: P = 16 - Q
Demand: P = 12 - Q $
Quantity $2
Aggregate profit is now $48,000 + $56,000 = $104,000
Lease the camera at $32. Profit is $32 plus $16 in film profits = $48
Profit is $32 plus $24 in film profits = $56
Each high-demand consumer will lease the camera at $32
Consumer surplus for low-demand consumers is $32
Low-demand consumers take 8 pictures
High-demand consumers take 12 pictures
$32
$32 $4 $4
$24
$16 12 8

55. Tie-in sales example 3 Why does tying increase profits?
high-demand consumers are offered a quantity discount under both the original and the tied lease arrangement
but tying solves the identification and arbitrage problems
film exploits its monopoly in film supply
high-demand consumers are revealed by their film purchases
quantity discount is then used to increase profit
arbitrage is not an issue: both types of consumers pay the same lease and the same unit price for film

56. Tie-in sales example 4 Can the firm do even better?
Redesign the camera so that the film cartridge is integral
offer two types of integrated camera/film package: high capacity and low capacity
what capacities?
This is similar to second-degree price discrimination
design two cameras with socially efficient capacities: 10 picture and 14 picture
lease these as integrated packages

57. Tie-in sales: an example 2
Aggregate profit is now $50,000 + $58,000 = $108,000
$16 16
$12 12
High-Demand
Consumers
Low-Demand
Demand: P = 16 - Q
Demand: P = 12 - Q $
Quantity $2
High-demand consumers get $40 consumer surplus by leasing the 10-picure camera
Low-demand consumers will pay up to $70 to lease the 10-picure camera
So high-demand consumers can be charged $86 to lease the 14-picture camera 10 12
$40
$70
$70
$16 10 14

58. Network externalities
Product complementarities can generate network effects
Windows and software applications
substantial economies of scale
strong network effects
leads to an applications barrier to entry
new operating system will sell only if applications are written for it
but…
So product complementarities can lead to monopoly power being extended

59. Anti-trust and bundling
The Microsoft case is central
accusation that used power in operating system (OS) to gain control of browser market by bundling browser into the OS
need\ to show
monopoly power in OS
OS and browser are separate products with no need to be bundled
abuse of power to maintain or extend monopoly position
Microsoft argued that technology required integration
further argued that it was not “acting badly”
consumers would benefit from lower price because of the complementarity between OS and browser

60. Microsoft and Netscape
Complementarity products
so merge?
what if Netscape refuses?
then Microsoft can develop its own browser
MC ≈ 0 so competition in the browser market drives price close to zero
but then get the outcome of merger firm through competition
So Microsoft is not “acting badly”
But
JAVA allows applications to be run on Internet browsers
Netscape then constitutes a threat
need to reduce their market share

61. And now… This view gained more force & support in Europe
bundling of Media Player into Windows
Competition Directorate found against Microsoft
Microsoft Appealed
Microsoft finally lost its appeal in September, 2007
Result: Microsoft ordered to stop bundling and forced to pay fine of €497 (finally settled in October, 2007)
Some economists upset by this decision arguing that as price discrimination, bundling often expands the market, AND also that bundling/tying can reflect competition and not just market power

62. Competitive Bundling/Tying
Bundling and tying are very commonly observed phenomena
Perhaps too commonly observed to be just the outcome of monopoly power
Is there a way to understand competitive bundling?
Yes! Salinger and Evans (2005) and Evans (2006)
It may well be the case that the structure of demand and the nature of scope and scale economies force competitive firms to bundle tie their goods

63. Competitive Bundling/Tying 2
Consider the table on the next slide and assume consumer willingness to pay is $20 for most preferred option
Competitive firm can’t offer pain reliever & decongestant separately, To do so incurs
total fixed cost of $600
Marginal cost of $4
Breakeven price = $6
50 by pain relief alone and pay $6 per unit
50 by decongestant alone and pay $6 per unit
100 buy both and pay $12 per combined unit
Total Revenue = $1800; Total cost = $600 + $4x150 + $4x150 = $1800
Rival could sell bundled product for $10 and steal all 100 customers interested in joint goods who now pay $12

64. Competitive Bundling/Tying 3
$8.50 is lowest feasible price and is achieve by only offering the bundled product
Product
Pain Relief
Decongestant
Bundle
Demand 50
100
Costs
Fixed Cost
$300
Marginal Cost $4 $7
Feasible Prices
Separate Goods $6
-----
Pure Bundling
----
$8.50
Mixed Bundling
$10
Bundle + Good 1 $9
Bundle + Good 2
Moral: competitive pressure may be the underlying reason for much bundling

65. Antitrust and tying arrangements
Tying arrangements have been the subject of extensive litigation
Current policy
tie-in violates antitrust laws if
there exists distinct products: tying product & tied one
firm tying the products has sufficient market power in the tying market to force purchase of the tied good
tying arrangement forecloses or has the potential to foreclose a substantial volume of trade
As time passes, approach is more and more of a rule-of-reason standard with increasing recognition that whether price discrimination or competitive pressure is the reason, bundling/tying is often welfare-improving