"Firms are usually proposing too few products." Discuss in the light of Harold Hotelling's Linear City Model and Richard Schmalensee's 1978 Paper on breakfast cereals.

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Industrial Economics: Topic 3

"Firms are usually proposing too few products." Discuss in the light of Harold Hotelling's Linear City Model and Richard Schmalensee's 1978 Paper on breakfast cereals.

Russell Manley: Tutorial Group

Many firms in industries face a downward sloping residual demand curve. They engage in monopolistic competition, they have market power and yet still, they make no economic profit. One of the most important reasons why this is the case is product differentiation. Consumers view the products in an industry as different, as imperfect substitutes. These goods are said to be differentiated or heterogeneous. I f customers view the products in an industry as different then it is possible for a firm to raise it's price above that of its competitors without losing all its customers. These industries are characterised by monopolistic as opposed to oligopolistic competition and therefore there is free entry and exit. The number of firms in an industry is determined within the model by entry behaviour rather than being decided exogenously. With firms producing differentiated goods the entry of a new firm helps to widen the choice of products for customers and it also helps lower price. There are essentially two types of monopolistic competition with differentiated products and free entry and exit; non-address and address/location models. The non-address or representative consumer model means that all firms are producing differentiated products but are targeting the same customers. The address or location model shows that some customers prefer products with certain characteristics or products that are sold by firms that are located close to them. Customers in this model are willing to Pay a premium for these preferred products and may not generally care about the price of some other goods in the market. These models differ in the type of demand that they face. In the non-address model demand varies almost continuously with the prices of all firms. In the location model demand for brands maybe independent from other products' prices because they are imperfect substitutes and generally the closer the substitutes they are the closer the responsiveness in price. As the title suggests it must be established if there are too few brands in the monopolistic competition equilibrium. The central issue revolve around the willingness of customers to Pay for greater variety. This centres on an optimum price-variety combination that compares the monopolistic competition equilibrium with the social optimum. Firstly the impact of product differentiation on the residual demand curve will be analysed and then further investigation will take place into the second of the two models, the location model, and more specifically Hotelling's linear city model. Also referenced will be Schmalensee's 1978 paper on the breakfast cereal industry.
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There are two central issues when analysing product differentiation. The first is that the customer is always right. If goods are identical but customers believe them to be different, e.g. brand names and supermarket's own products then the products are differentiated. Also if the products are different and customers believe them to be the same then they are homogenous. Secondly the closer the substitutes the greater the constraint that it exerts on another through change of price. Essentially an industry is differentiated if customers care about which brands they buy, and this will be determined by a number ...

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