Product Differentiation (Bertrand With Vertical PD) Easy Flashcards
Recall vertical PD means everyone knows one product is better.
So why do people buy the lower-quality product?
Price differences - cheaper
2 firms produce goods of different quality (v)
Let v2>v1 (v is better)
Consumers place value (b) on quality
So what is their utility function from buying from either firm (since assume only buy 1 good)
U1 = bv1 - p1
Or
U2 = bv2 - p2
Where is consumer indifferent between firm 1 and 2.
B) which firm sells to who
C) output expression for each firm
Where u1=u2 so
bv1 - p1 = bv2 - p2
rearrange to find b* (indifferent consumer)
b* = p2-p2/v2-v1
B)
Firm 1 sells to consumers with low values of b,
Firm 2 sells to high
C)
q1 = p2-p1/ v2-v1 - blowbar
q2 = bhighbar - p2-p1/ v2-v1
Blowbar: people wanting low quality (below b)
Bhighbar: people wanting high quality (above b)
Now do profit max problems for each firm, to find their best responses
(Assume common MC, no fixed cost)
Steps: (ive provided maximisation for firm 1 to start, but then can solve myself using steps)
π₁ = (P1 - C)q1 = (p1-c) (p2-p1/v2-v1 -blowbar)
FOC and rearrange to make p1 subject
(So same process for firm 2 too)
Then sub BR2 (p2) into BR1 (p1) to get adjusted BR1.
And then sub adjusted BR1 into BR2 to get adjusted BR2.
Result: is bertrand paradox (no profits) solved under vertical PD?
Yes!
Price for both firms is P>MC , so just like with bertrand with HORIZONTAL (where we found pa=pb=c+t)
Which firm sets higher price?
B) How do we find profit of each firm?
C) which firm makes more profit
Firm 2 as higher quality (recall V2>V1)
B) sub into each firm’s initial profit max expression
C) higher quality with its higher price earns more profit (firm 2)
π1 = (bhighbar - 2blowbar)²(v2-v1) / 9
π2 = (2bhighbar - blowbar)²(v2-v1) / 9
2bhighbar - blowbar > bhighbar - 2blowbar
Shows firm 2 profit > firm 1
This assumed quality is fixed. Now let firms choose their quality levels.
(Essentially 2 stage game. Choose quality then price!)
Recall profits, the only difference was
2bhighbar - blowbar > bhighbar - 2blowbar
Shows higher quality of firm 2 earns more profit.
So would both choose higher quality?
No, as that means no differentiation thus price would drive down till P=MC
So when can Bertrand paradox be avoided
They can charge P>MC only if firms choose different quality levels (if pick the same quality, no differentiation so price gets driven down!)
So if quality was a sequential game. Who picks what
First to pick will choose high quality (since more profit), other chooses low quality (still P>MC so better than standard bertrand)
Direct and strategic effects of quality
B) Which one dominates
Direct: higher quality more desirable for both firms (increased demand so more profit)
Strategic: wider quality differences is basically more differentiation and higher profits
B) strategic dominates, hence why we see differentiation in terms of quality!
Search goods vs experience goods
Search goods:
When we are sure of a their features (and utility from consuming it) before buying
Experience goods:
Reuire us to experience them to understand their features e.g ready meals
Informative vs persuasive advertising
Informative describes the good features
Persuasive just tries to convince a product is good
Consider horizontally differentiated product (cannot observe features to tell which is better)
E.g cornflakes with different sweetness
Informative advertising can make consumers aware of differences.
Who does advertising help
consumers: buy right brand (their welfare rises)
producers: advertising makes product appears more differentiated so price comp reduces (higher prices)
What about vertical PD and informative advertising for that
Similar effects for consumers and producers- recall vertical PD refers to quality diffs
So informative advertising highlights quality gaps.
High and low quality firms benefit from making the gap in quality visible (increased differentiation soften price comp)
(But do low quality rlly wanna advertise low quality…)
So in vertical PD firms benefit from advertising making the gap in quality clearer to soften price comp and establish PD.
But do low quality rlly wanna advertise low quality…? Ratners example
Ratners famouslt mocked own products as bad - and it backfired
So branding dilemma - want to differentiate but not harm their brand
Persuasive advertising effects on consumer and producer
Effects can be similar, but more risks to consumer e.g if perceptions become misleading creating false expectations
(bad for consumers, may pay more or choose wrong)
Can advertising or branding increase consumer utility
Yes - if the advertising makes product seem more desirable
E.g i get utility from jumper being Acne
So if we pay for a product with identicial characteristics and quality, just because of the brand.
Is this rational choice?
Yes, can still be, as we include branding into our utility function (get utility from branding)
Does advertising signal quality
No - persuasive advertising says little about product (think about it! Advertising in general does not mean quality)
Yes - advertising can signal quality e.g if consumers believe the producer can afford to waste money on advert, they may think product is good enough too.
So an argument is - advertising CAN signal quality e.g if consumers believe the producer can afford to waste money on advert, they may think product is good enough too.
Why is this a danger
As a low quality product can gain by falsely signalling quality by advertising!
Why is this ‘false signalling of quality’ from low quality firms unlikely in reality tho:
Since recall vertical PD, firms benefit from wider gap in quality (to soften price competition). So a low-quality advertising as high quality is counter productive
Advertising to get consumers to over-estimate the value of a good can be a profitable strategy when?
When only purchasing good once (no repeat purchases).
Repeat purchases this strategy wouldnt work since people disappointed by quality
With repeat purchases, what is the best approach to advertising
Advertise truthfully to attract consumers to buy again.
So far considered advertising real (informative) or perceived differences in products.
Producers can also advertise price
Consider a market where a few sellers and prices not easily observed.
Easy for sellers to avoid price competition. However what if one starts to advertise price
Can lead to undercutting to steal sales, leading to price competition P=MC bad for all firms
Why else is price advertising bad (2)
Could increase risk of collusion: if that leading firm sets a high price, could send signal to firms ‘follow us’
Further incentive to collude on price if they advertise through meet the competition clauses e.g refund difference removes incentive to compete on price
