Multiple-Quality Cournot Oligopoly and the Role of Market Size

Miao, Zhuang and Long, Ngo Van (2017): Multiple-Quality Cournot Oligopoly and the Role of Market Size.

Abstract

We model an oligopoly where firms can choose the quality level of their products by incurring set-up costs that generally depend on quality level. If the set-up cost is independent of product quality, firms may choose to supply both types of quality.We focus on the long run equilibrium where free entry and exit ensure that the profit for each type of firm is zero. Using this framework, we study the implications of an increase in the market size. We show that for the existence of an equilibrium where some firms specialize in the low quality product it is necessary that the set-up cost for the lower quality product, adjusted for quality level, is lower than that for the higher quality product. In the case where the unit variable costs are zero, or they are proportional to quality level (so that unit variable costs, adjusted for quality, are the same), we show that an increase in the market size leads to (i) an increase in the fraction of firms that specialize in the high quality products, (ii) the market shares (both in value terms and in terms of volume of output) of high quality producers increases, and (iii) the prices of both types of product decrease. In the case where higher quality requires higher set-up cost (per unit of quality) but lower unit variable cost (per unit of quality), subject to certain bounds on the difference in unit variable costs, we obtain the result that an increase in the market size decreases the number of low quality firms, increases the number of high quality firms, and decreases the prices of both products. In the special case where the set up cost is independent of quality level, we find that all firms will produce both type of quality levels. In this case, an increase in the market size will reduce the value shares of low quality products, but will leave their volume share unchanged; and the market expansion induces a fall in the relative price of the low quality product, and in the prices of both products in terms of the numeraire good. We carry out an empirical test of a version of the model, where set-up costs now refer to set-up costs to establish an export market, and they vary according to the quality of product that the firm exports to that market. We show that the data supported the hypothesis that the average qualities of the product are higher for bigger export markets.

• Item Type: MPRA Paper
• Language: English
• Keywords: Multiproduct firms; Cournot competition; Vertical product differentiation; Cost structure; Market size.
• Subjects: L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L10 - General; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L13 - Oligopoly and Other Imperfect Markets; L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L19 - Other

References

Benasi, C., Chirco, A. and C. Colombo (2006). Vertical Differentiation and the Distribution of Income. Bulletin of Economic Research 58(4): 345-367.

Berry, S., J. Levinsohn, and A. Pakes (1995), “Automobile Prices in Market Equilibrium.” Econometrica 63(4): 841-90.

Berry, S., and J. Waldfogel (2010). Product Quality and Market Size. The Journal of Industrial Economics 58(1), pp. 1-31.

Bonanno, G. (1986), Vertical Differentiation with Cournot Competition. Economic Notes 15, pp. 68-91.

Champsaur, P. and Rochet, J.-C. (1989). Multiproduct Duopolists. Econometrica 57, pp. 533-557.

Choi, J. C. and Shin, H. S. (1992). A Comment on a Model of Vertical Product Differentiation. Journal of Industrial Economics, 40, pp. 229-231.

Di Comite, F., Thisse, J.-F. and Vandenbussche, H. (2014). Verti-zontal Differentiation in Export Markets. The Journal of Industrial Economics 93(1), pp. 50-66.

Fajgelbaum, P., G. M. Grossman, and E. Helpman (2011), “Income Distribution, Product Quality, and International Trade.” Journal of Political Economy, 119(4): 721-765.

Gabszewicz J. and Thisse, J.-F. (1979), Price Competition, Quality, and Income Disparities. Journal of Economic Theory, 20, pp. 340-359.

Gabszewicz, J. and Thisse, J.-F. (1980), Entry (and Exit) in a Differentiated Industry, Journal of Economic Theory, 22, 327-338.

Gal-Or, E. (1983), Quality and Quantity Competition. Bell Journal of Economics, 14, 590-600.

Gal-Or, E. (1985), Differentiated Industries without Entry Barriers. Journal of Economic Theory, 37, pp. 310-339.

Gal-Or, E. (1987), Strategic and Non-Strategic Differentiation. Canadian Journal of Economics 20, pp. 340-356.

Helpman, E. and Krugman, P. (1985) Market Structure and Foreign Trade, MIT Press.

Ireland, N. (1987), Product Differentiation and Non-Price Competition. Basil Blackwell.

Jappelli, T. and L. Pistaferri (2010). Does Consumption Inequality Track Income Inequality in Italy? Review of Economic Dynamics 13(1), 327-338.

Johnson, J. P. and D. P. Myatt (2006). Multiproduct Cournot Oligopoly. The Rand Journal of Economics 13(1) 133-153.

Krueger, D. and F. Perri (2006). Does Income Inequality Lead to Consumption Inequality? Evidence and Theory. Review of Economic Studies 73(1), pp 163-193.

Krugman, P. R. (1980), “Scale Economies, Product Differentiation, and the Pattern of Trade.” American Economic Review, 70 (5), 950-59.

Long, N. V., H. Raff, and F. Stähler (2011), Innovation and Trade with Heterogeneous Firms, Journal of International Economics, Vol 84(2) pp. 149-159.

McFadden, D. (1978), Modelling the Choice of Residential Location. In Spatial Interaction Theory and Planning Models, edited by A. Karlvist, L. Lundqvist, F. Snickars, and J. Weibull, pp 75-96 Amsterdam: North Holland.

Melitz, M. J. (2003), “The Impact of Trade on Intra-industry Reallocations and Aggregate Industry Productivity.” Econometrica, Vol 71(6), 2003, pp. 1695-1725.

Melitz, M. J. and D. Trefler (2012), “Gains from Trade when Firms Matter.” Journal of Economic Perspectives, 26, pp. 91-118.

Motta, M. (1992a), Sunk Costs and Trade Liberalization. Economic Journal 102, pp. 578-587.

Motta, M. (1992b), Cooperative R&D and Vertical Product Differentiation. International Journal of Industrial Organization. 10, pp 643-661.

Motta, M. (1993), Endogenous Quality Choice: Price vs. Quantity Competition. Journal of Industrial Economics, 41 (2), pp. 113-131.

Mussa, M. and Rosen, S. (1982). Monopoly and Product Quality, Journal of Economic Theory 18, 301-317.

Shaked, A. and Sutton, J. (1982). Relaxing Price Competition through Product Differentiation. Review of Economic Studies, 49, pp. 3-14.

Shaked, A. and Sutton, J. (1983). Natural Oligopolies. Econometrica 51, 1469-1483.

Shaked, A. and Sutton, J. (1984). Natural Oligopolies and International Trade. in H. Kierzkowski (ed.), Monopolistic Competition and International Trade (Clarendon, Oxford.)

Shaked, A. and Sutton, J. (1987), Product Differentiation and Industrial Structure. Journal of Industrial Economics 36, 131-146.

Singh, N. and Vives, X. (1984). Prices and Quality Competition in a Differentiated Duopoly. Rand Journal of Economics 4, pp. 546-554.

Tirole, J., (1988). The Theory of Industrial Organization. The MIT Press, Cambridge, MA.

Vives, X. (1985). On the Efficiency of Cournot and Bertrand Equilibria with Product Differentiation, Journal of Economic Theory, 36, pp. 166-175.

Yurko A. V. Does Income Inequality Affect Market Outcomes in Vertically Differentiated Market? International Journal of Industrial Organization 29(4), pp. 493-503.