Welfare economics are a part of normative economics which objective is to evaluate different situations of a given economic system, in order to choose the best one.

Its study can be traced back to Adam Smith, who related an increase of welfare with an increase on production, and to Jeremy Bentham, whose utilitarian views made him think that welfare was equal to the sum of individuals utilities or, in other words, to a “social” utility.

Traditional welfare economics is based on the work of three neoclassical economists. Alfred Marshall stated that consumer’s welfare was the consumer’s surplus, and therefore was measurable in monetary units. Vilfredo Pareto would criticize this cardinal view, and would be the economist who built a true theory of welfare economics in his book “Manual of Political Economy”, 1906: based on the principles of unanimity and individualism, he designed what nowadays is known as the Pareto Optimality, which would become the core of welfare economics. Later, Pigou wrote “The Economics of Welfare”, 1920, stating that a definition of social welfare must include both efficiency and equity.

During the XXth century, welfare economics developed quickly. Nicholas Kaldor and John Hicks’ compensation criteria, and its following critics by Scitovsky, Little and Paul Samuelson, which aim was to find some way of classification of different optima. Also Bergson’s social welfare function, and Kenneth Arrow’s impossibility theorem, proving the former could not be identified. The theory of second best, developed by Lipsey and Lancaster, aimed at finding an optimum when Pareto optimality could not be found. Finally, the increasing use of cost-benefit analysis marks the validity of welfare economics nowadays.

The Shaked-Sutton model derives from a series of papers written by Avner Shaked and John Sutton. This model is centred in studying vertical differentiation and its role when discriminating the market, in order for firms to absorb as many consumers’ surplus as they can and the consequences this has for the market.

Vertical differentiation between products means discriminating goods as a result of their different qualities. Quality is a characteristic that all consumers want. Given the same price, higher quality products will always be chosen. However due to different income levels that vary from a to b, consumers will have different willingness to pay. This way, individuals with higher incomes will buy goods of higher quality paying a higher price, while lower income individuals purchase lower quality goods at a lower price. Given a higher spread of income between consumers, there will be a higher number of firms in the market each producing a different quality, and thus, making the number of firms in the market subject to the dispersion of incomes.

Firms will have to go through two key decision stages. In the first stage firms will have to choose the quality of their products, taking into consideration that higher quality goods have associated a higher production cost but are also preferred by consumers. Due to this firms are encouraged to produce higher quality goods as it will increase the competitiveness of their product. On the second stage firms will set their prices. Once the quality of the product is determined, firms will want to maintain the greatest differentiation for their product in order to raise their market power.

In markets with a great number of firms, competition between firms will be translated into a lower price for higher quality goods and will end up driving lower quality goods out of the market. A finite number of firms will exist in equilibrium depending on the size of the market and of the cost function associated to the firm.  If the market is in equilibrium it will only allow as many firms as different demands of quality are.

Salop’s circular city model is a variant of the Hotelling’s linear city model. Developed by Steven C. Salop in his article “Monopolistic Competition with Outside Goods”, 1979, this locational model is similar to its predecessor´s, but introduces two main differences: firms are located in a circle instead of a line and consumers are allowed to choose a second commodity. Consumers will have to choose between buying one or none of the differentiated goods, and spending the rest of their income in the second, non-differentiated good.

In this circular model all firms that offer the differentiated goods are located on a circle of perimeter 1, equidistant from each other, and it is an outside firm that offers the undifferentiated good. Consumers purchase goods taking into consideration several aspects such as their preferred brand specification, the distance and transportation cost and their price, and so will act accordingly in order to maximize their utility.

We will designate x’ as the consumer’s preferred good, and x will be the least valued good. Consumers enjoy a surplus S when x’ is consumed instead of x. Knowing that consumers can buy x at location x_i for a price of p_i, we can equate a decision formula:

Taking into consideration transportation cost,

where x_i-x’ is the shortest arc length between x_i and x’. If we reformulate the first equation,

This way the effective reservation price v is given by,

Changing now our attention towards the firm’s perspective, there is a total of n firms, and we know that they are at an equidistant distance of 1/n from each other, spread around in a circle. Suppose firm A charged p while the rest of firms charged p*. In the absence of competition the maximum distance consumers are willing to travel T, which is equal to:

However competition is a condition that is given in this market and consumers will consume from the firm that reports the highest surplus. The quantity sold by firm A will be equal to,

It is a logical outcome that firms that have their price set above v will not sell their goods. Only when they lower prices below v will they start attracting consumers.

There will be a point where the price is low enough to overlap with neighbouring firms. If a firm keeps lowering its price it will even capture its competition’s customers. 

The choice amongst firms is indifferent to client when the price is equal to,

To sum up, the number of firms in this market will depend on the degree of differentiation between goods, as well as price. We have here similar conclusions to those seen in the linear city model: there are two opposite effects. On one hand, there is an incentive for both stands to locate at the centre of the beach in order to increase their market share by reaching out to the greatest amount of customers, in what is known as the demand effect. And, on the other hand, there is an incentive for both stands to locate at opposite extremes in what is considered to be the strategic effect. While the first effect will reduce differentiation between the stands, the second one will increase it.

This model constitutes an important development from its predecessor, since it can be used to understand contestable markets and entry and exit barriers. It is considered, along with Harold Hotelling’s model, an important part of monopolistic competition theory.

Hotelling’s linear city model was developed by Harold Hotelling in his article “Stability in Competition”, in 1929. In this model he introduced the notions of locational equilibrium in a duopoly in which two firms have to choose their location taking into consideration consumers’ distribution and transportation costs. Hotelling’s model has been source of inspiration for a great amount of fruitful literature which does not only constrain to industrial organization theory but also to other sciences, such as politics, as some of its conclusion can be directly applied to them.

Initially the model was developed as a game in which firms first chose a location and after a selling price for their products. In order to set their business in the best location to maximize profits, the firms will have to evaluate three key variables: competitors’ location, customers’ distribution and transportation costs.

However, this model includes two different approaches, the first one being a static model consisting of a single stage were firms choose their location and prices simultaneously, and a dynamic model in which price is set after determining the location. The model is based on a linear city that consists of only a single straight street. For a better comprehension, Hotelling’s model is sometimes explained by using the example of a beach were two ice cream stands are trying to decide the best location.

Static model

In a beach going from west to east, of size [0,1] where consumers are distributed evenly, two identical ice cream stands (A and B) with a marginal cost of production, c > 0, try to determine their best location. A is located at a distance a from point 0, while B is located at a distance b from point 1.

It is indifferent for customers whether to go to one or the other stand, as long as their utility is maximized. For this reason, we must assume that both ice cream stands offer the exact same ice creams, and therefore consumers’ utility will be given only by the price of the ice cream and the distance to the stand. Despite differences in prices, the stand with the lowest prices will not necessary attract all the demand since consumers will also consider the distance to the stand.

If both stands’ prices were equal, the differential factor would be how close consumers are to each stand. All consumers located to the left of a would go to stand A, and all consumers located to the right of 1-b would go to stand B. The remaining consumers, located between both stands would go to whichever is the closest. In this first model,  is the exact middle of that beach, so consumers to its left would go to stand A while consumers to its right would go to stand B.

Two conditions are necessary for profits to be positive and maximized in both stands:

-Selling prices must be higher than marginal costs

–

This second condition implies that both stands can’t be located at the same point exactly in the middle of the beach. If this were the case it would be indifferent for the customers to go to either one. Each stand would decrease its prices in order to attract customers, and thus they would enter into what is referred to as a price war. If they had different marginal costs, the stand with the highest marginal cost would be in a clear disadvantage and would end up exiting the market, as the other stand would be able to push the prices further down, and so attract all customers. Depending on how prices are set it could lead to a Bertrand’s solution, in which the prices of both stands are equal to their marginal costs, thus achieving zero profits.

We can conclude by saying that in this model the key factor for product differentiation is location. Each stand will therefore set prices that will be higher than their marginal costs, and will choose a location other than the middle of the beach.

Dynamic model

In this case, the model has two stages. During the first stage, the stands chose their location and on the second stage prices are set.  With regards to the previous model there are two additional assumptions:

Both stands have equal marginal production cost.

Total cost for consumers depends both on the price of the goods and the distance to its location (t).

The point of division between the areas served by these two stands is determined by the condition that at a certain point it is indifferent for consumers between consuming in one stand or the other. Equating and equalising we get 

By solving, the demand function for each stand will be: 

By using backwards induction we can find the subgame perfect Nash equilibrium where both firms maximize their profits.

Stage 2: having already determined a location the stands will now have to set the price that will report the highest possible profits. This will lead us once again to the static model result, in which each stand sets its own price.

Stage 1: the stands anticipate and choose their location. Profits will be higher the less distance there is to the extremes, therefore maximum differentiation between stands will be given when A locates at 0 and the B at 1.

The conclusions that can be drawn from this model are two opposite effects. On one hand, there is an incentive for both stands to locate at the centre of the beach in order to increase their market share by reaching out to the greatest amount of customers, in what is known as the demand effect. And, on the other hand, there is an incentive for both stands to locate at opposite extremes in what is considered to be the strategic effect. While the first effect will reduce differentiation between the stands, the second one will increase it.

In politics we can observe how candidates follows this demand effect, as they tend to come from a specific ideology but tend to convey towards a moderate ideology with the objective of attracting as many voters as possible.

Product differentiation is a marketing process that has the objective of making customers perceive the product of a specific firm as unique or superior to any other product belonging to the same group, and so creating a sense of value. Differentiation does not always imply changing the product, sometimes it is enough just by simply creating a new advertising campaign or by changing its packaging. This term was introduced in economics by Edward H. Chamberlin in his book “Theory of Monopolistic Competition”, 1933.

What a firm achieves by differentiating its product from competitors is to create a market in which it can act as a monopoly, enabling them to have price-making power. However, since products are also similar enough and there are plenty of customers, this type of market structure is also considered as perfect competition. This market is therefore characterized by a group of related products that can be considered to be close substitutes amongst each other which is reflected by their high crossed elasticity. Nevertheless, product differentiation can also be a way to avoid or to create entry barriers and thus become a source of competitive advantage. As a product becomes more differentiated and unique for consumers, it will become more difficult to compare it to other products and it will move competition with other products to non-pricing factors.

There is an important distinction to be made between different differentiation strategies. Product differentiation can be subject to subjective or objective preferences. Two categories are distinguished from this division, horizontal and vertical differentiation. The former is given when consumers base their purchasing decision on subjective preferences when comparing products, e.g. colours or flavours. The latter occurs when a product can be evaluated against the other ones in terms of measurable and qualitative factors, e.g. technological differences or technical properties in engines. Several models have been developed to analyse these two strategies, the most famous being Hotelling’s linear city model and its extension, the Salop’s circular city model, for horizontal differentiation and the Shaked-Sutton’s model for vertical differentiation.

Characteristics demand theory states that consumers derive utility not from the actual contents of the basket but from the characteristics of the goods in it. This theory was developed by Kelvin Lancaster in 1966 in his working paper “A New Approach to Consumer Theory”.

This approach allows us to predict how preferences will change when we change the options or baskets presented to consumers by studying how these vary according to the change in the characteristics that make them up. With conventional theory, the introduction of a new option meant that we could not reliably predict how this would slot into the consumer’s preference map. However, by relying on a study of the characteristics rather than the goods or service involved, we can predict how changes will affect a consumer’s behaviour without needing to start once again empirically.

This allows us to calculate ‘shadow prices’ for different attributes without having a price for the good itself by associating utility to the characteristics that make up the good rather than the good itself. With these ‘shadow prices’, we can solve utility maximisation problems for baskets or options for which we do not have empirical evidence, as Lancaster demand also lends itself to building utility functions (based on the amount of each type of characteristic rather than the amount of each type of good in a particular basket).

Characteristic demand theory also helps justify the existence of brands. Luxury brands are able to charge a surprice for their products by differentiating themselves from competitors that sell similar goods. In the first diagram, if we suppose that both brands have the same characteristics and are perfect competitors, then we will choose the basket that maximises our total consumption. This means will tend to opt for the cheaper brand, which allows us to reach the highest utility curve: for a given amount of money, we are able to buy either a certain amount of brand 1 (point B) or a certain amount of brand 2 (point A). We choose A since it’s on a higher indifference curve. Point C represents a higher utility curve achieved by a drop in the price of brand 1. However, even though brand 1 got cheaper, we’ll still consume A, since it remains on a higher indifference curve.

In the second diagram, if we look at Lancaster demand, our utility functions will be based on the characteristics that each basket contains rather than on the amount of each type of good. Here, it is no longer ‘all or nothing’- we can allow for convex demand curves that represent our preference for variety in consumption: point C. This time, if the price of one brand drops, we will change our outcome: we can opt for point D.

Video – Characteristics demand:

The Chamberlin´s model analyses and explains the short and long run equilibriums that occur under monopolistic competition, a market structure consisting of multiple producers acting as monopolists even though the market as a whole resembles a perfectly competitive one. The economist Edward H. Chamberlin gives name to this model, which he developed in his book “Theory of Monopolistic Competition”, 1933.

Assumptions

Chamberlin made a set of assumptions that were necessary for this market to perform properly. These assumptions include:

The existence of a set of products that the consumers perceive to be close substitutes. The crossed elasticity of these products is high but never infinite.

Each firm monopolises a product, although it shares the market with the rest of the industry.

There are a great number of firms in the market.

No entry or exit barriers to the market.

Full mobility of factors.

There is some degree of agent myopia in the sense that they do not learn from past errors.

Perceived vs actual demand

Chamberlin introduced in his model a distinction between perceived and effective demand curves. On the one hand, perceived demand, d in the adjacent figure, is the demand the firm is planning to supply or, in other words, how the firm believes customers will act to respect of its product. On the other hand, effective demand, D, is the way in which the market will act, in other words, how customers will act based on their perceptions on the market. However, consumers will always choose the best price and the greatest possible quantity, hence choosing always to be on what is called actual demand (green).

Equilibrium in the short-run

In the short-run, as shown in the second figure, each firm will act as a monopolist in its market. Given their demand and cost curves they will maximize profits by producing the level of output at which marginal cost equals marginal revenue. Whether they make profits or not will depend on the cost structure. In our example, there are no profits. 

Equilibrium in the long-run

In the long run, the cost structure of the firm varies, allowing it to lower its prices in order to attract more customers. Lets start analysing the equilibrium in the long run considering the firm is in this situation of equilibrium (A), and because of its profits, it has no incentives for changing its price. However, the extraordinary profits that the firm is making will attract new competitors to the market. Although aggregate demand in the market is maintained, the entrance of new firms will translate into a fall of the effective demand of the firm. This drop in the demand of the firm is illustrated by the shift of the demand curve to the left, from D to Dˈ and a new equilibrium point will be reached at B.

However the firm will want to recover its previous profits levels and will therefore lower its price seeking to attract customers. The rest of firms will follow the same strategy so no customers are lost, and therefore the changes in its competitors and own strategies will change the perceived demand of the firm, from d to d’. A new equilibrium will be reached at C but this time firms will be incurring in losses, as price will be below average cost. This loss of profits will cause the exit of firms from the market, displacing effective demand rightwards and perceived demand downwards, as each firm that remains in the market will increase their individual demand.  This process will be repeated until the equilibrium point is reached, from D to D*. At this equilibrium point, E*, the demand curve will be tangent to average cost in the long-run and price set at this level. Profits will be equal to zero and hence no entry or exit of firms will occur.

Main conclusions

Chamberlin’s monopolistic competition model analyses a whole new market structure, apart from the classic monopoly and perfect competition. It demonstrates that in a market the number of firms can be irrelevant, and perfectly competitive results can be reached. In fact, in terms of welfare and product differentiation, monopolistic competition is desirable.

It’s worth mentioning that these results are similar to those of William Baumol’s contestable markets, since the number of firms in the market does not necessarily determine how competitive it is. Also, the results are contrary to the results found in Bertrand’s duopoly model.

Monopolistic competition is a market structure defined by four main characteristics: large numbers of buyers and sellers; perfect information; low entry and exit barriers; similar but differentiated goods. This last one is key to distinguish monopolistic competition from perfect competition since in the latter all products are homogenous. This product differentiation leads consumers to perceive products in this market as unique, providing firms with a monopolistic-like property that enables them having price-making power. There is a distinction to be made between horizontally and vertically differentiated products in order to be able to understand different strategies that monopolistic firms might adopt. The former is given when consumers base their purchasing decision on subjective preferences when comparing products, e.g. colours or flavours. The latter occurs when the product can be evaluated with another one in terms of measurable and qualitative factors, e.g. technological differences or technical properties in engines.

The extent to which each firm can take advantage of their monopoly condition depends on the flexibility of their demand curve. If it is too rigid (steeper), in order for the monopolist to achieve a higher price, it has only to reduce some of its production. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices. Naturally, every monopolist in an imperfect market tries to expand the size of the market in which its product dominates. For this they have to compete with other monopolists leading them to a series of costs other than production (manufacturing and transportation costs), which are defined as selling expenses. These expenses are incurred with the aim of modifying the demand curve so quantities demanded for the product increase for each level of prices.

If a firm fails to have its product differentiated, the market would be shared with other firms, turning into a duopoly, oligopoly or even, if other conditions are met, a perfectly competitive market.

Within the field and existing research of monopolistic competition, the most prominent model is the one devised by Edward H. Chamberlin (the Chamberlin model), which he developed from monopoly models. Even though there are other models and theories, most have followed Chamberlin’s model, being this the most widely used and recognized in economics.

Contestable markets are those in which the short-term threats from potential competitors exert such a degree of pressure over the incumbents, that their behaviour is conditioned. Contestable markets are therefore in a competitive equilibrium even though the market can be considered to have a relatively small number of firms, meaning these could as well behave as in imperfect competition.  In any case, the amount supplied by the industry and the prices of the goods are held at perfect competition levels and therefore maintain a desirable welfare outcome.

This threat of new entrants is real, these should be able to enter the market without any complications and have the same advantages as the incumbent firms, once inside the market. This theory pays special attention not only to barriers of entry but also to exit barriers. Firms that want to enter should know they can enter and exit the market without inquiring into high costs, which would otherwise restrain their incentives to enter.

For a market to be considered a contestable market a series of requisites must be met:

-potential entrants should have access to the same technology as incumbents. If this is not the case entrants would be in a disadvantage position compared to incumbents.

– sunk costsshould not exist. Firms that enter the market must be able to recover their investments.

-the reaction time to changes for an incumbent firm should be longer than the time for a new firm to enter the market. This gives entrants the possibility to enter markets and perform hit-and-run strategies.

The theory was proposed by William J. Baumol in his “Contestable Markets and the Theory of Industrial Structure” 1982. As he argued, perfectly contestable markets would always result in a competitive equilibrium independently of the number of firms in the market, as the threat of potential rivals would guarantee it. Nevertheless these conditions are subject to important limitations. Demand should be significantly sensitive to price, for the threat of entrants charging lower prices and attracting consumers to be real one. Technology should have constant returns so incumbents do not have an advantageous position over entrants. Due to all these restrictive assumptions perfectly contestable markets are of a rare nature.

Exit barriers (or barriers to exit) are obstacles that stop or prevent the exit of a firm from a specific market. It is associated with firms that are incurring in some form of losses, but cannot exit the market as a result of exit barriers that would further increase their level of loss. In Michael Porter’s model of competitive analysis, barriers are a fundamental element to gauge the level of competition in a sector, and defines the market structure in that industry. He identified the following exit barriers:

Non-transferable assets: when a firm invests on specialised assets, which cannot be used in other industries, exiting the market implies losing those assets.

Fixed exit costs: such as indemnities paid to employees, cancelation costs in contracts with suppliers, etc.;

Synergies: when producing one good allows for lower costs in the production of other goods, exiting an industry may imply higher costs when producing that good.

Although barriers may have negative consequences for some firms, for others they will be positive. Where some firms loose other win, it can be regarded as a zero-sum game. For abnormal profits to occur in a market, barriers have to exist. Using Joe Bain’s definition, “barriers give firms the power to maintain in the long-term prices higher than average cost”.