When we assess a market, we could analyse it by using static determination of prices. When firms optimally set endogenous variable(s) in order to maximise profit under a static competitive environment. This would help us understand why firms would set higher price in monopolistic market, earning positive profit, or setting price equals marginal cost in perfectly competitive market, earning zero profit.
However it is inadequate in explaining competitive interactions: which is why we should also consider strategic moves and firm's interactions. When we model the situation as an extensive game, where firms choose various settings in different stages of the game, it might help us understand what would happen in an ideal world.
Here, firms do not just simultaneously maximise profit by setting price or quantity, they would also pick a location as we assume products are differentiated. Product differentiation means that consumers do not view products as perfect substitutes, so that the product that is priced higher would not have zero demand.
In a horizontal differentiated industry, the market is scattered of consumers with different tastes. For example, in the carbonated drink industry, some would prefer Cola to Fanta, or Sprite taste to Red Bull taste. Firms would then have to locate themselves in the market before competing with other firms. For instance, in an industry with 2 firms (duopoly market), each of 2 firms in the industry would have to pick a location along consumer's preference set before competing against each other.
The game
So we split the entire game into 2 stages, firstly firms set to locate a point in the consumer's preference set. Then they would compete in the market by setting price.
To find out what firms would do, we have to see firstly what price they would set when they compete in the final stage, then work out how they would locate themselves in the market (using backward induction).
To set price, there are two effects that might affect their decisions. Firstly, the ability for each firm to extract consumer surplus from consumers depend on the market power each firm possess. Consumers would be more sensitive to price if they have elastic price elasticity of demand. Therefore, in this set-up, we can link this to consumer's preference. Assuming consumers in the market have the option to choose only between the 2 firms, if they derive huge dis-utility to a different 'taste' product, then firms would be equipped with market power, so that consumers are less tempted to switch from one firm to another. This would allow firms to extract more surplus by pricing higher with less compromise in quantity demand lost. Therefore, the stronger consumer's taste is, the higher prices firms would set.
Secondly, the decisions of pricing would also depend largely on the locations they have set in the initial stage of the game. The closer they are located within consumer's preference set, the more similar are their products, hence price competition is fiercer. Hence, they would undercut each other more aggressively.
To set locations, they would have to take into account 2 factors. Firstly, there is a market share effect, which states that if firm A locate closer, they would capture more of the market. Therefore making firm A wanting to set a location in the consumer's preference set in a closer proximity to firm B.
Secondly, there is the market power effect, which acts as a countervailing force to market share effect. It states that if firms are closer to each other, the price competition is greater, and they would have less market power (less ability to set high price and capture consumer surplus, and hence they would make less profit if they are located close to each other).
If market power effect dominate, such that it is best for firms to have maximal differentiation, they would select location furthest away from each other in equilibrium. If market share effect dominate, they would be close to each other and price would be lower in that case, keeping consumer's taste unchanged.
Under geographical constraint, if firms are constrained in a small geographical area, they would have to locate at close proximity to each other. Hence, there is greater price competition effect, and less market power of each firm as consumers can readily switch to rival firm. Whereas in larger markets, firms can obtain more market power, price would be higher and it could be exaggerated by consumers with higher taste (two products are not ready substitutes of each other). Therefore, changing geographic location would weaken the amount of market power each firm has in setting price, and this could explain the fierce price competition (result of the second stage) in places where firms are restrained (in the location setting stage) of this particular strategic game model.
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