This week in my ECONS101 class, we are covering the decision-making of firms with market power. When firms have market power that means that they have some control over the price of their product. Some firms gain market power through barriers to entry into their market - there is something that keeps competitors out of the market. However, most firms don't benefit from barriers to entry. Instead, most firms derive market power from differentiating their product from the products sold by their competitors. In this post, I'll demonstrate why it is that firms differentiate their product, using the consumer choice model, and assuming that there are only two firms (one firm selling Good X, and one firm selling Good Y).
Before we get that far though, let's consider what would happen if we had two firms selling identical products (what we refer to as perfect substitutes). In that case, the consumer is indifferent between the two firms' products. Since they are identical, the consumer doesn't care which firm they buy from. In that case, the consumer will obviously buy from whichever firm is selling their product for a lower price, and will buy nothing from the firm that has the higher price.
This situation is shown in the diagram below. The consumer's indifference curves are shown by the two red lines, I0 and I1 (with I1 representing a higher level of utility, or satisfaction, for the consumer). The indifference curves are straight lines when the two goods are perfect substitutes (so the consumer doesn't care about how many of each good they have, only how much they have of both goods in total). The consumer's budget constraint is shown by the black line. The budget constraint is relatively steep, which means that the price of Good Y is relatively lower than the price of Good X. The consumer's best affordable choice (the consumer's optimum) is the bundle of goods E0, (it's on the highest indifference curve that they can reach, I1), where the consumer spends all of their income on Good Y, and spends nothing on Good X. This makes sense, given that Good Y and Good X are exactly the same good, and Good Y is relatively less expensive than Good X.
Obviously, the situation in the diagram above is not good for the seller of Good X. How could they respond? One thing that they could do is lower their price to match the price of Good Y. That would cause the consumer's budget constraint to pivot outwards and become flatter (just like in this example). They could even make their price lower than the price of Good Y, capturing all of the market. Of course, there is little to stop the seller of Good Y from then lowering their price as well. This sort of a price war is not good for either seller, and could continue until neither seller is able to make any profit at all (which is the case in a perfectly competitive market).
A better option for the seller of Good X arises when they recognise that the real problem here is that the two goods are identical in the mind of the consumer. The two goods are perfect substitutes. If the seller of Good X can somehow convince the consumer that the two goods are different rather than identical, then they may be able to keep some sales, even if the price of Good X is higher than the price of Good Y.
This situation is shown in the diagram below. When the goods are differentiated, the consumer's indifference curves are curves (not straight lines - straight line indifference curves only happen when the goods are perfect substitutes). The highest indifference curve that the consumer can get to is I1'. They will buy the bundle of goods E1, which contains Y1 of Good Y, and X1 of Good X. Even though Good X is relatively more expensive, the consumer chooses to buy some of it.
So, how do firms differentiate their products? There are many ways, but one of the most common is through branding. By branding their product, firms demonstrate that their product is different in at least a superficial way to the products of their competitors, setting it apart in the minds of consumers. For example, petrol sold by petrol stations from different chains is the same good, regardless of which chain it is purchased from. The petrol stations are differentiated from each other by their branding (as well as by their locations, and by the additional services that they offer in addition to petrol). Supermarket brand cornflakes are often the same cornflakes that are in the boxes of leading brands, just in a different coloured box. And so on.
There are lots of examples. Some firms are good at differentiating themselves, while others are not so good. Ceteris paribus (holding all else constant), the more differentiated a firm's product is from its competitors, the more market power it will have. And that makes the example in the photo below difficult to understand. This photo was taken at the Chapel Downs shopping centre in Flat Bush in January (although the situation there has been the same for many years [*]). You may need to zoom in to see the detail in the photo. However, let me explain what is going on. I've circled the names of three stores. The one on the left is called No 1 Supavalue Supermarket. The one in the middle is called Supavalue Supermarket. The one on the right is called Super Value Supermarket. To be clear, all three stores are in the same shopping centre. This is NOT how you differentiate yourself from your competitors.
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[*] I took this photo during fieldwork, that I have been repeating in January each year for the last fifteen-plus years. The situation I describe here has been present for most of that time. I only captured it in a photo this year.
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