Lecture 3: PRODUCT DIFFERENTIATION

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Lecture 3 PRODUCT DIFFERENTIATION

• AEM 4160 Strategic Pricing
• Prof. Jura Liaukonyte

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Lecture Plan

• Market concentration
• What does it mean
• How to measure
• Why do we care?
• HHI, CR4-Ratio, Lerner Index
• Product differentiation
• Differentiation and market structure
• Implications for pricing
• Price Discrimination
• First Degree PD
• Second Degree PD

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Other Demand Elasticities

• Income Elasticity of Demand
• Measures how much quantity demanded changes with
  a change in income

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Values for Income Elasticity (EI)

• Sign indicates normal or inferior.
• EI?gt0 implies normal good.
• EI?lt0 implies inferior good.
• Normal goods may be necessity or luxury.

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Other Demand Elasticities

• Cross-Price Elasticity of Demand
• Measures the percentage change in the quantity
  demanded of one good that results from a one
  percent change in the price of another good

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Other Demand Elasticities

• Complements Cars and Tires
• Cross-price elasticity of demand is negative
• Price of cars increases, quantity demanded of
  tires decreases
• Substitutes Butter and Margarine
• Cross-price elasticity of demand is positive
• Price of butter increases, quantity of margarine
  demanded increases

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Example The Cross-Price Elasticity of Demand for
Cars

• Source Berry, Levinsohn and Pakes, "Automobile
  Price in Market Equilibrium," Econometrica 63
  (July 1995), 841-890.

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Magnitude Shows Size of Shift in Demand (Assume
Psubst Increases)

• EXYlt1

• EXYgt1

PX
PX
D
D
D
D
QX
QX
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Price Elasticity of Supply

• Measures the sensitivity of quantity supplied
  given a change in price
• Measures the percentage change in quantity
  supplied resulting from a 1 percent change in
  price

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MR MC

• Profit is p(q) TR(q) - TC(q)
• Profit maximization dp/dq 0
• This implies dTR(q)/dq - dTC(q)/dq 0
• But dTR(q)/dq marginal revenue
• dTC(q)/dq marginal cost
• So profit maximization implies MR MC

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Monopoly (Cont.)

• Derivation of the monopolists marginal revenue

/unit
Demand P A - B.Q
Total Revenue TR P.Q A.Q - B.Q2
A
Marginal Revenue MR dTR/dQ
MR A - 2B.Q
With linear demand the marginal revenue curve is
also linear with the same price intercept
Demand
but twice the slope of the demand curve
Quantity
MR
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Lerner Index

• Lerner Index
• L (p - MC)/p 1/EP
• The higher the number, the more pricing power the
  firm has.
• Mark-up power reflects monopoly power.
• PUNCHLINE If elasticity increases, mark-up will
  decline. If the product becomes less elastic,
  mark-up will increase.

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Market Concentration

• Industries have very different structures
• Numbers and size distributions of firms
• Ready-to-eat breakfast cereals high
  concentration
• Newspapers low concentration
• How best to measure market structure
• Concentration ratio,
• Herfindahl-Hirschman Index (HHI)
• Lerner Index (LI)
• Lets look at each of them

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Industry Concentration

• Four-Firm Concentration Ratio
• The sum of the market shares of the top four
  firms in the defined industry. Letting Si denote
  sales for firm i and ST denote total industry
  sales
• Herfindahl-Hirschman Index (HHI)
• The sum of the squared market shares of firms in
  a given industry, multiplied by 10,000 HHI
  10,000 ? S wi2, where wi Si/ST.

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Measure of concentration

• Compare two different measures of concentration

Firm Rank Market Share Squared
Market ()
Share
1 25
625
2 25
625
3 25
625
4 5
25
5 5
25
6 5
25
7 5
25
8 5
25
Concentration Index
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Measure of concentration

• Compare two different measures of concentration

Firm Rank Market Share Squared
Market ()
Share
1 25
25
625
2 25
25
625
3 25
25
625
4 5
5
25
5 5
25
6 5
25
7 5
25
8 5
25
H 2,000
CR4 80
Concentration Index
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Concentration index is affected by, e.g. merger
Firm Rank Market Share Squared
Market () Share
1 25
25
Market shares change
625
Assume that firms 4 and 5 decide to merge
2 25
25
625
3 25
25
625
4 5
5
25



5 5
25
6 5
25
7 5
25
8 5
25
CR4 80
Concentration Index
H 2,000
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Concentration index is affected by, e.g. merger
Firm Rank Market Share Squared
Market () Share
1 25
25
Market shares change
625
Assume that firms 4 and 5 decide to merge
2 25
25
625
3 25
25
625
4 5
5
25



100
10
5 5
25
6 5
25
7 5
25
8 5
25
CR4 80
Concentration Index
H 2,000
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Concentration index is affected by, e.g. merger
Firm Rank Market Share Squared
Market () Share
1 25
25
625
2 25
25
625
3 25
25
625
4 5
5
25



100
10
5 5
25
6 5
The Concentration Index changes
25
7 5
25
8 5
25
CR4 80
Concentration Index
H 2,000
85
2,050
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HHI

• The Herfindahl-Hirschman Index the square of
  the percentage market share of each firm summed
  over the largest 50 firms in the industry (or all
  of the firms if there is less than 50)
• In perfect competition, the HHI is small
• In monopoly, the HHI is 10,000 (100 squared)
• A popular measure with the Justice Dept in the
  1980s
• HHI lt 1000 characterized competitive markets
• HHI gt 1800 would bring Justice Dept challenge to
  proposed mergers
• E.g. The cigarette industry is highly
  concentrated with only 8 firms and a
  Herfindahl-Hirschman Index (HH1) of 2623

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Example Candy and Chocolate Industry
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Candy v. Chocolate
CANDY
HHI (for top 4) 1141 CR 4 59 Medium level
concentration -gtConcentration is increasing!
1,039 businesses overall!!
CHOCOLATE
HHI (for top 4) 2941.81 Cr 4 78.1 High level
of concentration
518 Businesses overall!!
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CR4 and HHI Candy Industry

• The HHI for just the top 4 companies in the
  industry is 2941.81.
• The CR 4 for the industry is 78.1.
• Therefore, the industry is highly concentrated
  with only a few major firms holding a majority of
  the market share.
• HHI 49.5²21.6²4²3²2941.81
• CR 4 49.5 21.6 4 3 78.1
• Hershey and Mars Inc. alone hold 71.1 of the
  market share.
• -Many mergers occur.

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Example Credit Card Industry
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Market Definition

• All Credit Lending Institutions with their own
  card
• 27.2 J.P. Morgan Chase Co.
• 19.2 Bank of America Corporation
• 18.9 Citigroup Inc.
• 17.2 American Express Company
• 4.0 Capital One
• CR4 83.2
• HHI 1810-1850
• Total Number of Companies 192

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What is a Market?

• No clear consensus
• the market for automobiles
• should we include light trucks pick-ups SUVs?
• the market for soft drinks
• what are the competitors for Coca Cola and Pepsi?
• With whom do McDonalds and Burger King compete?
• Presumably define a market by closeness in
  substitutability of the commodities involved
• how close is close?
• how homogeneous do commodities have to be?

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Fast-Food Outlets
Burger King
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Market Performance

• Market structure is often a guide to market
  performance
• But this is not a perfect measure
• Can have near competitive prices even with few
  firms
• Measure market performance using the Lerner Index

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Lerner Index

• L (p - MC)/p 1/EP
• Lerner Index is bound between (0,1)
• Closer to 1 the more pricing power the firm has.
• Mark-up power reflects monopoly power.
• PUNCHLINE If elasticity increases, mark-up will
  decline. If the product becomes less elastic,
  mark-up will increase.

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What are Sources of Monopoly Power?

• Low elasticity of demand
• We just showed this using Lerner Index.
• Possibly due to strong product differentiation.
• High barriers to entry
• e.g., ownership of necessary raw materials,
  patents and regulatory barriers, scale economies,
  product diff.
• Number of other competitors in market.
• Interactions between firms Compete or cooperate?

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Product Differentiation

• Products are different if there is some objective
  characteristic or property, real or perceived,
  that provides a basis for buyers to choose one
  over the other.
• Product differentiation may lead to reduced own
  -price elasticity. As the degree of
  differentiation increases, the price elasticity
  will decrease.

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Product Differentiation, cont.

• Ways in which products are differentiated.
• Product Brand
• Packaging
• Conditions of Sale
• Service Provided
• Location
• Product Differentiation as an Entry Strategy
• Product differentiation to create a niche market.
• Product differentiation to deter entry.

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Product Positions in Characteristics Space