1. 1 Course outline II n Product differentiation n Advertising competition n Compatibility competition Heterogeneous goods

2. 2 Advertising competition I n Advertising and price competition for established products n Advertising and price competition for new products n Sequential advertising competition - entry and deterrence of entry n Executive summary

3. 3 Advertising competition II n Grossman & Shapiro (1984) n Two firms differ with regard to two aspects: – Information policy, – Horizontal differentiation (model “Hotelling“); here n We consider four groups of consumers: – Consumers are informed about both goods, – Consumers are informed about good 1 only, – Consumers are informed about good 2 only, – Consumers are not informed about any good.

4. 4 Brand demand with name recognition A 1 and A 2 1 0 1 no demand demand for good 1 demand for good 2 both products are known only good 1 is known only good 2 is known no good is known h

5. 5 The demand function Firm 1’s demand function: intensity of competition monopolistic part of demand price advantage demand in case of equal prices Assumption: price cap!

6. 6 Cost of advertising is called the cost rate of advertising.

7. 7 Exercise (fixed prices, simul- taneous vs. sequential competition) Consider two insurance companies being forced to sell their policies at a fixed price of 5. Find the equilibrium name recognitions in a simultaneous advertising competition assuming Now assume that one company is the advertising leader.

8. 8 How does the price elasticity depend on name recognition? Special case:

9. 9 Advertising and price competition for established products

10. 10 The simultaneous game n Firm 1’s profit function: n Firm 1’s “reaction functions”: scope for raising prices due to incomplete information

11. 11 Symmetric equilibrium Equilibrium:

12. 12 Advertising and price competition for new products

13. 13 Solving the pricing game (2 nd stage) n Firms’ reaction functions n Bertrand-Nash equilibrium n Effect of name recognition on prices:

14. 14 Analyzing the advertising competition (1 st stage) ??>0<0=0 direct effect strategic effect (optimal prices)

15. 15 Sequential versus simultaneous game n In the simultaneous game, optimal advertising levels are chosen according to : (the direct effect - the only effect in this case - should be zero) n In the sequential game, we found a negative strategic effect of advertising. n This yields:

16. 16 Exercise (advertising competition) Two tax consultants compete by fixing their level of advertising expenses, A 1 and A 2. The price of 10 for one consulting hour is given by regulation. Demand and profit functions are given by Calculate and interpret the reaction functions. Find the equilibria! How will the consultants feel about a law prohibiting advertising?

17. 17 Solution (advertising competition) graphically

18. 18 Advertising and price competition with advertising leader

19. 19 Entry deterrence Follower’s reduced profit function: =0, optimal prices at 3 rd stage =0, optimal advertising at 2 nd stage

20. 20 Executive summary n Incomplete information about the products (A i <1) increases the scope for raising prices. n High advertising costs may have positive effects on firm’s profits. n The advertising leader has the opportunity to build up a strategic entry barrier (limit adverti- sing expenditure or limit name recognition).