Outline

Hotelling Model with Entry

Salop Circle

Hotelling and Salop Models

Zhenyu Lai
Ec1642 (Adv. Industrial Organization) - Section 3

September 19, 2012

1 / 19

Outline

Hotelling Model with Entry

Salop Circle

Section Outline

Today we will solve the following two problems:

1. Hotelling Model with Entry Decision
2. Salop Circle with Endogenous Entry
Solution Concepts to understand:
1. Demand as determined by threshold type
2. Backwards induction
Math is your friend!
Focus on how to interpret math expressions.

2 / 19

Outline

Hotelling Model with Entry

Salop Circle

Hotelling Model with Entry Decision

Reference: Tirole, The Theory of Industrial Organization, p. 279-282

Unit mass of consumers located on linear city of unit length.

With quadratic travel costs, consumer purchase utility is

v t 2 p
Two Stage Game (how is this different from class?)
Stage 1: Two firms enter, simultaneously locate at a and b.
Stage 2: Both firms simultaneously choose prices pa and pb

Where will firms locate?

3 / 19

Outline

Hotelling Model with Entry

Salop Circle

Stage 2: Solve Consumer Demand

Use backwards induction, consider second period.

Given a and b, what is firm 1 and 2s demand?
Threshold type: Solve for indifferent consumer at x

Indifference condition:

v (x a)2 p1 = v (1 b x )2 p2
Solve for threshold x at which consumer is indifferent

x=

1+ab
p2 p1
+
2
2 (1 a b )
4 / 19

Outline

Hotelling Model with Entry

Salop Circle

Solving for indifferent consumer...

Details of derivation

Indifference condition:
v (x a)2 p1 = v (1 b x )2 p2
x 2 + a2 2xa + p1 = x 2 + (1 b )2 2x (1 b ) + p2


2x (1 a b ) = (1 b )2 a2 + p2 p1
p2 p1
(1 b )2 a2
Threshold x =
+
2 (1 a b )
2 (1 a b )
p2 p1
(1 a b ) (1 + a b )
=
+
2 (1 a b )
2 (1 a b )
1+ab
p2 p1
=
+
2
2 (1 a b )
5 / 19

Outline

Hotelling Model with Entry

Salop Circle

...yields Stage 2 demand

Given locations a and b, indifference threshold yields demand

1ab
p2 p1
+
2
2 (1 a b )
p1 p2
1ab
+
D 2 ( p1 , p2 ) = 1 x = b +
2
2 (1 a b )

D 1 ( p1 , p2 ) = x = a +

Interpreting demand equations:

D1 (p1 , p2 ) = x =

a
+
|{z}

Everything
to left

1a b
2

| {z }

Half the distance

between a and b

p2 p1
2 (1 a b )
|
{z
}

Gains from price competition

Equals 0 if p1 =p2

Higher consumers more sensitive to differentiated product

take less demand from other firm by lowering price

6 / 19

Outline

Hotelling Model with Entry

Salop Circle

Solve for Stage 2 equilibrium

Recall that firms choose price in Stage 2
Firms maximize profits. Consider firm 1:

max (p1 c ) D1 (p1 , p2 )

p1

First order condition:


1ab
p2 p1
1
a+
+
(p1 c )
=0
2
2 (1 a b )
2 (1 a b )

Policy functions for firm 1s optimal pricing

(1 a b )2 p2 + c
+
(p2 ; a, b ) = a (1 a b ) +
2
2
By symmetry,
P1

P2 (p1 ; a, b ) = b (1 a b ) +

(1 a b )2 p1 + c
+
2
2
7 / 19

Outline

Hotelling Model with Entry

Salop Circle

Interpreting equilibrium pricing

Solving system of equations, equilibrium prices are

p1
p2


ab
= c + (1 a b ) 1 +
3


ba
= c + (1 a b ) 1 +
3


Comparative statics
1. Less price competition when products are less substitutable


p1
ab
= (1 a b ) 1 +
>0

3
2. For given location a, movement of firm 2 towards the center
will decrease the price charged by firm 1.
 




p1
= 1 + a3 b 1a3b = 43 + 2b
<0
3
b
8 / 19

Outline

Hotelling Model with Entry

Salop Circle

Solve first stage for location choice

Intermediate microeconomics refresher

In Stage 1, firms choose location a and b knowing the result

of the second stage game

Consider firm 1. Profit function (given locations a and b) is

1 (p1 , p2 , a, b ) = (p1 c ) D1 (p1 , p2 , a, b )

By implicit function theorem,

1 (a, b ) = {p1 (a, b ) c } D1 (p1 (a, b ) , p2 (a, b ) , a, b )

First order condition


d 1
D1
1
= D1 dp
+
p

(
)
1
da
a +
da

D1 dp1
p1 da

D2 dp2
p2 da

=0

9 / 19

Outline

Hotelling Model with Entry

Salop Circle

Application of the envelope theorem

Intermediate microeconomics refresher

1
Recall in stage 2, firm 1 maximizes wrt price, so
p1 = 0
By the envelope theorem,


d 1
1
= (p1 c ) D
a +
da

D2 dp2
p2 da

h
1
+ dp

D1 + (p1 c )
da
|
{z

= p 1
1

D1
p1

i
}

which is 0

10 / 19

Outline

Hotelling Model with Entry

Salop Circle

How does changing location affect profits?

A change in a has a direct effect and an indirect effect

d 1
D1
D2 dp2
)
= (p1 c ) (
+
da
a
p da
|{z}
| 2{z }
Demand
effect

Strategic
effect

1. Direct effect (+ if a, b 12 ): moving a closer to b steals business

D1
a

1
2

p2 p1
2 (1a b )2

35ab
6(1a b )

>0

2. Strategic effect (): but causes firm 2 to price more aggressively


h 
i
D2 dp2
1
4 + 2a
=

= 3(12a+ab ) < 0
3
3
p2 da
2 (1a b )

11 / 19

Outline

Hotelling Model with Entry

Salop Circle

Interpreting Stage 1 result

How will choosing location impact profits?

Negative strategic effect dominates positive demand effect.

d 1
<0
da
What is the intuition? Does more demand more profit?
What is the difference between holding prices fixed, and

considering the competitors strategic response for pricing?

Where will firms choose to locate?

12 / 19

Outline

Hotelling Model with Entry

Salop Circle

Interpreting Stage 1 result

How will firms choose location?

Both firms locate at extreme pts. Max product differentiation.

a=b=0
Social planner minimizes average transport cost.

a=b=

1
4

Thus, product differentiation inefficiently high.

1. Welfare gains from lower transport cost not captured by firm.
2. Notice any welfare gains from lower prices hurts firm, but not
captured by social planner (because consumption is fixed).

13 / 19

Outline

Hotelling Model with Entry

Salop Circle

Salop Circle with Endogenous Entry

Reference: Tirole, The Theory of Industrial Organization, p. 282-285

Recall the Hotelling linear city model. Now, circular city.

Think of a tropical island with a mountain in the middle.

Suppose there are n identical ice-cream stands

Unit mass of consumers distributed evenly on beach
Consumers have linear travel costs, t
Market is covered (every consumer buys ice cream)
14 / 19

Outline

Hotelling Model with Entry

Salop Circle

Solving equilibrium for Circular City

Salop considers a two-stage game:

Stage 1: Firms choose whether or not to enter
Stage 2: Firms compete on price given location

Note: Salop assumes that when firms enter, they do not

choose location but are located equidistant from each other.

Q1: When will a firm enter?
Q2: What is the equilibrium price charged by entrants?

15 / 19

Outline

Hotelling Model with Entry

Salop Circle

Backwards Induction: Solve 2nd Stage First

Given firms locate symmetrically, what is equilibrium price?
Use indifference condition
Suppose neighbor chooses p, and firm i chooses pi


0, n1 from firm i is
indifferent between firm i and closest neighbor if


1
pi + tx = p + t
x
n

Consumer located at distance x

This is the indifference condition.

16 / 19

Outline

Hotelling Model with Entry

Salop Circle

What price will entrants set?

Firm i obtains demand from both sides

Di (pi , p ) = 2x =

p + t/n pi
t

To find equilibrium, set up optimization problem

Firm i maximizes profit





p + t/n pi
max (pi c )
f
p
t
i

First order condition: Differentiate wrt pi , and set pi = p

(since firms are symmetric)

p=c+

t
n

Note that profit margin (p c ) decreases with n

17 / 19

Outline

Hotelling Model with Entry

Salop Circle

Stage 1: When will firms enter?

Firms will enter when profits are positive.
Profits for each firm is

t  1
f
n n

Thus number of firms when profits are zero (with free entry)

n=

t/f

What happens to number of firms when fixed costs increase?

What happens to the profit margin p c when fixed costs

increase? How about when fixed costs tend to zero?

Is this the optimal n from a Social Planners perspective?

18 / 19

Outline

Hotelling Model with Entry

Salop Circle

Social Planners take on Circular City

Social planner would want to minimize sum of the firms fixed

costs and consumers transportation costs.

Price doesnt matter: Just a transfer from consumers to firms.

Social Planners objective function:

min nf + t 2n
n

Z 1/2n


xdx

Integrating, we get
min (nf + t/4n )
n

The solution here is nSP = 21 ft =

Too many firms enter in the market

1
2 n.

equilibrium. Intuition?
19 / 19