7. Differentiation in quality

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En provenance du cours de National Research University Higher School of Economics

Industrial Organization: Strategy and Competition in Business

6 notes

National Research University Higher School of Economics

Industrial Organization: Strategy and Competition in Business

6 notes

Industrial Organization is the area of economics that studies the markets as institutions, the state of competition and strategic interaction among firms, the industrial policy and the business decisions firms make within the market framework. The course looks at the markets from three different perspectives: the economic theory, the applied business perspective and the institutional and legal perspective. The focus of the course is split equally between the economic theory and business perspective but there is a significant legal component incorporated in various topics. The course includes economic modeling, game theory, numerous real life examples and several case studies. We explore interesting topics of market organization such as negotiations, antitrust, networks, platforms, electronic markets, intellectual property, business strategies, predation, entry deterrence and many others. The basic objective of the course is to enable the student to understand the structure of markets and the nature of strategic competition. Knowledge in this course will be valuable for the students in acquiring managing and governance skills, enriching their understanding of the institutional framework of business, and improve their analytical ability in negotiations. Prerequisites: The course requires understanding of basic economic modeling, knowledge of intermediate microeconomics (especially production/cost theory), knowledge of basic concepts and methodologies of game theory, intermediate econometrics and basic calculus.

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Product differentiation

In our previous lectures we have come to the conclusion that when firms compete with price, the Bertrand paradox leads those firms to lose their entire market power. In today’s lecture we will try to resolve this paradox assuming that the firms can differentiate their products. Differentiation has two dimensions. The horizontal, where beliefs for the quality of the product are subjective; and the vertical, where beliefs for quality are objective. We will present two models for horizontal differentiation: the linear and the circular city. We will also cover the Nobel award winning model of differentiation in quality. We will talk about brand proliferation and will examine how it can be effective as a deterrence mechanism. Additionally, we will have two entertaining case studies on the costs of withdrawal and rebranding.

7. Differentiation in quality14:40

Rencontrer les enseignants

Kosmas Marinakis
Assistant Professor
ICEF and Faculty of Economics Sciences, HSE

Now, we will come to the cases that there are

some vertical differentiation of the products.

So, assume that products are differentiated in a way that everyone

understand that if price is not a factor they will prefer a specific product,

meaning that everyone is able to recognize which is

the better product and if all products have the same prices,

all consumers will pick the same exact product.

Vertical differentiation is what we usually call quality,

meaning that quality have different meanings,

so different people consider different things to be quality in different products.

However, in some products,

we have an objective opinion that one product is better than the other.

Like the example that I gave you in the beginning of

the lesson with their Rolls-Royce and the Kia cars.

The most important aspect of vertical differentiation is that

the buyer interprets the asking price as the signal for quality.

This is very important for you to understand because it has two implications.

The first implication is that when we have vertical differentiation,

there is no interest in this kind of models because everyone will pick the best product,

if price is not a factor.

The problem is that usually,

we do not have perfect information for that,

we have asymmetry of information.

Sellers will tell you, "Oh,

get our product because it's better," and the other competitor will tell you,

"No, get ours because ours is better."

So you have these asymmetry of information that

the seller knows more about the quality of the product

than the buyer and this asymmetry of information is what makes the consumer,

the buyer, to look for signals about what the actual quality is.

This was all founded by Akerlof,

a Nobel Prize economist,

who created the model that shows exactly this thing,

what happens with asymmetry of information when you

have products that they are differentiated vertically.

We have one seller and one buyer and we have a single product that will

be transacted from the seller to the buyer if they both agree with respect to the price.

Now, this product can be either a high quality product,

so the quality which we denote by S,

will be equal to SH,

this means that the product is high quality.

SH is the quality index for this product,

or it can be as we call in economic slang,

a lemon, a product of bad quality,

and in this case, S will be equal to SL, low quality.

The seller knows the exact S,

knows the exact quality of the product.

The buyer knows only the probability that the product is going to be high quality,

so we denote this probability with a Greek letter pi or as sometimes I call it

p. And this probability can give us

also the probability of the product to be low quality,

this will be one minus pi.

So, let's look at the payoffs now

of the possible cases that what might happen in this model.

First of all, if trade occurs seller receives the price of the product p,

you sell the product, you get the money,

you get p and this is what your payoff should be

if you're the seller of this product, if trade occurs.

The buyer valuates this product according to a constant theta,

theta is how much the buyer appreciates the product and this

is multiplied by the actual quality of this product,

S, where S can be either SH or SL,

and then from the payoff of the buyer,

we have to subtract p because this is how

much the buyer paid to the seller in order to acquire the product.

We also have the case that trade doesn't occur.

These two guys they do not come into an agreement about the price,

and trade never occurs.

In this case, sellers stays with a product which appreciates at a value beta times S,

in a similar manner like the buyer,

but with a different constant that time and the buyer gets no benefit,

its initial state, it doesn't really have

any change to the buyer's utility and therefore,

we get a payoff of a zero in this case.

Now, beta and theta,

the preference for the product,

the valuation for the product by the two different parties is common knowledge,

they both know how much they valuate the product

and how much the other party is valuating the product.

And we also assume here that beta is smaller or equal than theta.

Why do we do that? Because this is necessary for any transaction to occur.

If I go, for example,

to Gap and I want to buy a T-shirt,

if Gap valuates this T-shirt to $20,

but my valuation for the same T-shirt is that it's $10,

then I'm not the right candidate to buy this shirt,

this is because I valuated less,

it's less useful to me than it is due to the company that is selling it.

So they are going to sell it only to someone who valuates

it more than what they valuated.

So, beta has to be smaller or equal to theta in order for any model of trade to work.

Let's take the two markets now separately.

Let's assume that the product is indeed a bad quality product,

the product is a lemon.

So, this means that the object is of quality SL,

and the seller will not sell it unless there is a price

that these greater or equal to beta times SL,

this is how much this product is worth to the seller,

it's not going to sell it unless it gets at least beta times SL.

The buyer will not buy unless the price is smaller or equal than theta,

share preference factor times the quality,

but no, she doesn't know the quality,

so she will use the expectation for quality,

expectation for S because the product is

indeed of low quality but the buyer doesn't know that.

So what the buyer does,

he says that, "Oh, okay.

The product has a pi probability to be SH and one minus pi probability to be SL.

Let me take the expected value of these two in order to be able to understand,

to have an assessment about how much this product may cost."

Therefore, we can say that according to these two conditions,

for the seller and for the buyer-.

If the good is a lemon,

there is always room between

the asking price by the seller and the price offered by the buyer.

And therefore, a transaction will occur.

These markets will never fail.

These two guys can sit down and discuss it,

and there is a price for which both of these conditions will be satisfied.

So, both the condition of the seller and the condition of the buyer will be satisfied,

and they can actually find the price for which a transaction will occur.

So the market of lemons will never fail.

Let's see what happens in the opposite case where the good is a high quality good.

It's not a lemon anymore.

So what happens in the market of high quality goods?

If the object is high quality,

the seller will not sell unless the price is higher or equal to beta times SH now.

Because the good is higher quality,

this means that the price will be higher than before.

However, the buyer doesn't have any more information.

He's in the same condition,

the same situation that he was before.

So, again, we'll have the same condition.

Price has to be smaller or equal than theta times the expected value of the product,

the expected quality of their product, for this consumer.

For trade to occur in this case,

beta must be much smaller than theta.

This is because now the price that the seller will

accept has gone up because the good is high quality,

and there is much less room.

If beta is not much smaller than theta,

if you see these two conditions,

there is no P that will satisfy both conditions at the same time.

This means that unless the buyer needs the product much more than the seller,

this market will fail.

There is a transaction to be done.

This transaction is efficient,

but because of the expectation of the buyer,

this trade will never occur.

That is, again, there is no room for P to be between these two conditions,

to make these two conditions there to be satisfied at the same time.

Let's see an example.

Assume that beta is equal to one,

theta is higher, one and a half,

then low quality good has a quality of two,

high quality good has a quality of 10,

and the probability is just half,

the probability of the good being high quality.

And therefore, the probability of the good being low quality is also

one half since these two probabilities have to complement to one.

In this case, if we do the calculations that we have above,

we see that the seller requires that the price will be higher than 10.

However, the buyer requires that the price will be smaller than nine.

So, no matter how much they will discuss,

since these are the preferences,

they are not going to find

the common ground for the price and transaction will not occur.

What is very important in this model is that the market failure in

the case of the good quality goods happens because of their symmetry.

Not necessarily because the seller knows more than the buyer,

just because one party knows more than the other party.

If you have the case that both of the parties ignored the actual quality of the product,

so you didn't have a symmetry,

you just have worse information to both of them,

not only bad information for the buyer,

but now you have not full information for the seller also,

so in this case, failure might not be happening.

So, if both parties are equally uninformed,

the expectation for quality will be the same for both of them.

So, price has to be between beta times expectation and theta times expectation,

and this will will exist.

There will exist a room for negotiation between the two.

In our previous example,

we had that price should be greater than 10 if the seller knows.

Now price, if the seller doesn't know,

has to be greater than six.

And then still, the buyer would require that the price will be less than nine.

So, every price between six and nine would be a price that both of the two would

agree to have trade because they would both get a positive surplus from this trade.

This is the third and our last model.

This model was one of the fundamental models in asymmetry of information in economics,

and it was very useful also for differentiation.

Differentiation is very important.

It can give you power.

And what kind of power?

The best kind of power in markets, market power.

It can give you the ability to charge your product

more than competition and even have your customers to be

happy for paying more just because they are getting a product that

makes them to be more satisfied than the products of the competition.

I will leave you for today with a quote that the man

who changed more industries than anybody else once said,

has to do with Microsoft and Apple altercation with respect to who imitated whom.

Some people believe that Apple was imitated by Microsoft.

Some other people say that they both imitated the program of Xerox.

But no matter what,

Steve Jobs just understood where the problem was.

The problem was that Apple's differentiation had evaporated.

So, considered that having a different product,

having a product that consumers consider better than the competition,

is the key of success.

So, dare to be different. See you soon.

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