Model Of Product Differentiation Research Articles

Estimating Substitution Patterns and Demand Curvature in Discrete-Choice Models of Product Differentiation

Abstract We extend BLP's aggregate discrete-choice model of product differentiation to create more flexibility in the price functional form. We apply a Box-Cox specification, which relaxes the typical unit demand assumption and creates flexibility on demand curvature. The model provides a unifying framework for mixed logit and mixed CES models, while remaining computationally tractable. We provide an illustrative application to the ready-to-eat cereals market. This shows that the cross-sectional relation between price elasticities and average prices per product is more in line with descriptive elasticity patterns, and that substitution between product pairs may be affected to some extent.

Crowding in Private Quality: The Equilibrium Effects of Public Spending in Education

Abstract We estimate the equilibrium effects of a public school grant program administered through school councils in Pakistani villages with multiple public and private schools and clearly defined catchment boundaries. The program was randomized at the village level, allowing us to estimate its causal impact on the market. Four years after the start of the program, test scores were 0.2 standard deviations higher in public schools. We find evidence of an education multiplier: test scores in private schools were also 0.2 standard deviations higher in treated markets. Consistent with standard models of product differentiation, the education multiplier is greater for those private schools that faced a greater threat to their market power. Accounting for private sector responses increases the program’s cost-effectiveness by 85% and affects how a policy maker would target spending. Given that markets with several public and private schools are now pervasive in low- and middle-income countries, prudent policy requires us to account for private sector responses to public policy, both in policies’ design and evaluation.

Allocating vehicle registration permits

We compare social welfare, consumer surplus and profits in two different institutional settings in which an item whose quantity is fixed and controlled (vehicle registration permit) is allocated to the buyers of a complementary good (car). In the first setting, which resembles the way in which vehicle registration permits are allocated in Singapore, the central planner runs a uniform price auction for permits in which the consumers who bid the highest receive the permits and pay the highest losing bid. Then each winning consumer purchases a car from a seller. In the alternative setting, the central planner first allocates the permits to sellers and then sellers offer to consumers bundles, each consisting of a car and a permit. For two different models of product differentiation, we find that social welfare is greater when permits are auctioned to consumers, but consumers and sellers generally prefer the alternative setting.

Competing to Sell the Reference Product

In a sequential model of vertical product differentiation in which consumers are loss-averse, I analyse how firms compete to sell the reference product when they set prices. I find that there are two subgame perfect equilibria: one where the reference point for all consumers is the higher-quality product; and the other where the reference point is the lower-quality product. However, applying the risk-dominance criterion, I obtain that the sole risk-dominant equilibrium is for the higher-quality firm to sell the reference product. Since the hedonic price of the higher-quality product is the highest, consumers do not suffer any psychological disutility in the risk-dominant equilibrium.

Close But Not Too Close? Optimal Copycat Strategies in the Light of Negative Publicity by the Original Product

Abstract This paper contributes to the understanding of how brand scandals related to a brand leader’s product affect the follower firm’s choice between copycatting and independent product development. In a model of vertical product differentiation, we show that it is optimal for the copycatter to follow a ‘safe distance’ strategy which guarantees a certain degree of protection against the negative spillovers associated with a brand scandal to the leader. Nevertheless, when the follower firm can choose between copycatting and decoupling, it chooses a higher quality for its copycat product because of the lower development costs. The decision for or against copycatting thus depends on a trade-off between development costs and the possibility of negative spillovers. Finally, we show that the threat of a scandal can lead to an additional indirect welfare cost because it diverts the follower’s choice away from a welfare-maximizing copycat strategy.

Market for artificial intelligence in health care and compensation for medical errors

We study the market for AI systems that are used to help to diagnose and treat diseases, reducing the risk of medical error. Based on a two-firm vertical product differentiation model, we examine how, in the event of patient harm, the amount of the compensation payment, and the division of this compensation between physicians and AI system producers affects both price competition between firms, and the accuracy (quality) of AI systems. One producer sells products with the best-available accuracy. The other sells a system with strictly lower accuracy at a lower price. Specifically, we show that both producers enjoy a positive market share, so long as some patients are diagnosed by physicians who do not use an AI system. Any transfer in compensation payment from the physician to the AI producer in the case of a diagnostic error will be passed on in full to the physician via the price of the AI system. The quality of the AI diagnosis system is independent of how any compensation payment to the patient is divided between physicians and producers. However, the magnitude of the compensation payment matters. An increase in compensation increases demand for both AI systems. In addition, the higher the compensation paid to the harmed patient, the higher the quality of the low-quality AI system. As the other firm continues to offer the highest accuracy level, any increase in compensation will decrease vertical differentiation, thereby increasing price competition between firms.

Dumping, antidumping duties, and price undertakings

This paper examines which types of firms, from a developed country (DC) or a less developed country (LDC), tend to practice dumping, using a two-market equilibrium analysis of trade in similar products. Specifically, we present a vertical product differentiation model of duopolistic competition between a DC firm and an LDC firm under free trade to show that the DC firm sells a higher-quality product without dumping. In contrast, the LDC firm sells a lower-quality product and practices dumping in the DC market by charging a price lower than the product's price in the LDC's local market. In response to the LDC dumping, the DC government's use of an optimal antidumping duty increases its domestic welfare. The LDC's social welfare may increase if its exporting firm accepts price undertaking rather than dumping. From the perspective of world welfare, defined by aggregating the welfare of the trading countries (DC and LDC), the trade damage measure through imposing antidumping fines on LDC dumping is Pareto-improving compared to free trade (under which dumping takes place) and price undertakings.

The effects of personal information on competition: Consumer privacy and partial price discrimination

This article studies the effects of consumer information on the intensity of competition. In a two dimensional duopoly model of horizontal product differentiation, firms use consumer information to price discriminate. I contrast a full privacy and a no privacy benchmark with intermediate regimes in which the firms can profile consumers only partially. I show that with partial privacy firms are always better-off with price discrimination: the relationship between information and profits is hump-shaped. In particular, competing firms prefer to target consumers with partial but asymmetric information about preferences. Instead, consumers prefer either no or full privacy in aggregate, but the effects of information on individual surplus are ambiguous: there are always winners and losers. Finally, I study the information acquisition incentives of the firms when there is an external data seller. When this upstream data broker holds partially informative data, an exclusive allocation arises. Instead, when data is fully informative, each competitor acquires consumer data but on a different dimension. These findings are relevant for the strategic decisions of firms active in digital markets and contribute to the policy debate surrounding privacy, exclusive access to data and competition.

Consumer loss aversion and scale-dependent psychological switching costs

We consider a model of product differentiation where consumers are uncertain about the qualities and prices of firms' products. They can inspect all products at zero cost. A share of consumers is expectation-based loss averse. For these consumers, buying products of varying quality and price creates disutility from gain-loss sensations. Even at modest degrees of loss aversion they may refrain from inspecting all products and choose an individual default that is strictly dominated in terms of surplus. Firms' strategic behavior exacerbates the scope for this effect. The model generates “scale-dependent psychological switching costs” that increase in the value of the transaction. They imply that making switching easier or costless for consumers would not motivate more switching.

Input price discrimination, pricing contract and social welfare

In this paper, we introduce input price discrimination into vertical product differentiation model to analyze the impact of input price discrimination on social welfare. We find that the input price discrimination improves the supply of high-quality products in the market, and lead to the increase of consumer surplus. The effect of input price discrimination on social welfare is influenced by the pricing contract of input. When the price of input is determined by upstream firm, the input price discrimination reduces social welfare. While the input price discrimination increases social welfare when the price of input is determined by bargaining of upstream and downstream firms.

The value of energy efficiency in residential buildings – a matter of heterogeneity?!

Energy efficiency ratings of residential buildings are intended to remove assessment errors from real estate markets to increase energy efficiency – the key to fully decarbonizing the building sector. Price premiums of rated buildings should reflect capitalized future energy savings, but instead are nonlinear (1), can exceed savings (2) and are correlated with buyer's characteristics (3). We explore these anomalies with a hedonic model of product differentiation, which is adapted to efficiency valuation in the housing market. The model implies that buyers with high willingness to pay for efficiency “sort” themselves to efficient buildings (and vice versa) and drive their premiums above average discounted energy expenditures - if the market share of the efficient buildings is below average. In this sense a non-linear scarcity premium explains findings (1) and (2). Furthermore, it is revealed that the results from (3) require average buyer's characteristics to vary spatially, but neither their variance nor the variance of buildings stocks efficiency – strong assumptions. The model explains measured premiums of the UK well and shows that as well as buyer heterogeneity and supply structure, the prebound effect - the overestimation of energy costs in inefficient buildings by ratings – also plays an important role in determining efficiency premiums.

Limited perception and price discrimination in a model of horizontal product differentiation

We analyze the implications of consumers' limited perception in a model of horizontal product differentiation. Consumers with limited perception do not necessarily notice all goods in the market. Limited perception thus offers a market segmentation into consumers who notice only one good and consumers who notice all goods. Our objective is to analyze whether less perception is harmful to consumers when firms use this segmentation to price discriminate. We show that product differentiation under limited perception is less extreme than under full perception. Consequently, despite firms' ability to price discriminate, average prices may be lower under limited than under full perception. In addition, we show that consumer surplus and welfare are not maximized under full perception but increase for some degree of limited perception.

Is it rational for a large-retailer to sell an own-brand product similar to the branded product of a large manufacturer? A Vertical Product Differentiation Model

A theoretical model was constructed to investigate the conditions that a large retailer must satisfy to increase the quality of the retailer-owned brands towards a greater number of groceries. The key result shows that the restraint given by a vertical integration scheme (producer-distributor) is relaxed for a higher quality-production cost ratio under the assumption of modelling with endogenous quality. Another finding is that the national brand´s production is not altered, which is explained by the fact that this brand is demanded by consumers with high willingness to pay for it. However, the wholesale price decreases and hence the manufacturer’s profit always falls as the quality of own brands rises. This is consistent with the argument that the retailer improves its negotiation capacity with the private manufacturer when it sells an own brand that is a close substitute for the manufacturer’s label, which always forces the wholesale price of the branded product down.

Quality Competition and Market-Share Leadership in Network Industries

Abstract This paper incorporates network externalities into a model of vertical product differentiation to examine how firms determine product quality and network size. We show that, with significant network benefits from quality improvement, the effects of network externalities differ depending on the type of competition. In response to an increase in network externalities, vertical product differentiation enlarges under price competition but shrinks under quantity competition. Moreover, under price competition, the network size of a high-quality product increases, whereas that of a low-quality product decreases for a sufficiently large extent of network externalities, resulting in a reversal in the leading position in terms of network size from the low- to the high-quality product. By contrast, the network sizes of high- and low-quality products both increase under quantity competition; moreover, the gap between their network sizes shrinks for a sufficiently large extent of network externalities.

Revenge consumption, government‐led voucher, and social welfare

This paper considers revenge consumption and government vouchers directly provided to the consumers in a duopoly model of vertical product differentiation. We find that revenge consumption will raise consumer surplus and social welfare. The government issuing vouchers will further push up consumer surplus and social welfare; however, facing the wave of revenge consumption, the government purposely want to recover the slowdown economy caused by the pandemic spread-out, should fully consider the quality difference of products and issue different discount rate voucher. For the producer, whether the government issuing vouchers increase firm's profit depends on the degree of revenge consumption and product differentiation.

Games with switching costs and endogenous references

We introduce a game‐theoretic model with switching costs and endogenous references. An agent endogenizes his reference strategy, and then taking switching costs into account, he selects a strategy from which there is no profitable deviation. We axiomatically characterize this selection procedure in one‐player games. We then extend this procedure to multiplayer simultaneous games by defining a Switching Cost Nash Equilibrium (SNE) notion, and prove that (i) an SNE always exists; (ii) there are sets of SNE, which can never be a set of Nash equilibrium for any standard game; and (iii) SNE with a specific cost structure exactly characterizes the Nash equilibrium of nearby games, in contrast to Radner's (1980) ε‐equilibrium. Subsequently, we apply our SNE notion to a product differentiation model, and reach the opposite conclusion of Radner (1980): switching costs for firms may benefit consumers. Finally, we compare our model with others, especially Köszegi and Rabin's (2006) personal equilibrium.

FDI and quality-enhancing technology spillovers

When Northern firms undertake FDI in the South, their superior technology spills over to Southern firms and enables Southern firms to enhance their product quality. This paper explores quality-enhancing technology spillovers in an international duopoly model of vertical product differentiation. We find that the Northern firm strategically reduces its product quality to limit the amount of technology spillovers upon FDI. The trade-off between the Northern firm’s endogenous product quality choice and technology spillovers—similar to that between R&D and technology spillovers as discussed previously–plays a critical role in welfare consequences and policy implications of quality-enhancing technology spillovers.

Public monopoly versus mixed oligopoly: product differentiation and social efficiency

In this paper, we consider a mixed oligopoly market in which a public firm and private firms compete, in particular, in which private entrants are allowed to enter a monopoly market by a public incumbent who maximizes social welfare. It has been widely believed that the public firm has advantage over private firms because the former who maximizes social welfare can charge a lower price than the latter who maximizes its own profit. However, in a Hotelling model of product differentiation, we obtain the results that both the public firm and private firms charge the same price in equilibrium, and more importantly, that the equilibrium prices may rise as a result of competition, thereby lowering the consumer surplus, if the transportation cost is high enough. We also show that if a private firm enters the market by choosing its own degree of differentiation, it will prefer neither maximum differentiation nor minimum differentiation in the case that the public incumbent is myopic in the sense that it cannot anticipate entry as well as in the case that it is far-sighted enough to anticipate entry. This draws an important policy implication in the market of Korean housing guarantee services.

Revenge consumption, product quality, and welfare

Revenge consumption, the situation in which the demand for specific goods and services suddenly skyrockets and remains high for an extended period of time, is a relatively new economic phenomenon observed recently in many cities around the world after the easing of restrictions associated with the coronavirus pandemic in 2020 and 2021. We study welfare implications of revenge consumption in a model of vertical product differentiation. We show that revenge consumption induces producing firms to enhance the quality levels and raise prices on their products. As the level of revenge consumption increases, social welfare initially increases but it eventually declines. Results, which hold across monopoly, duopolistic competition, and national brand-private label competition models, provide useful information for public policy.

Strategic outsourcing and quality choice: Is a vertical integration model sustainable?

This paper uses two versions of a vertical product differentiation model with price competition to investigate how strategic behavior between rival firms influences which organizational production mode each firm adopts: that is, either vertical integration or outsourcing. We show that not only a symmetric configuration, where both high‐ and low‐quality firms outsource, but also an asymmetric configuration, where the high‐quality firm produces in‐house whereas the low‐quality firm outsources, are acceptable as a subgame‐perfect equilibrium outcome. We explore the implications of these results in light of the recent slump in business of Japanese electronics enterprises in the flat‐panel television industry.