Production Function

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Discussion Papers

Pricing and Market Structure
Mats Godenhielm
University of Helsinki and HECER
and
Klaus Kultti
University of Helsinki and HECER

Discussion Paper No. 338
September 2011
ISSN 1795-0562

HECER – Helsinki Center of Economic Research, P.O. Box 17 (Arkadiankatu 7), FI-00014 University of Helsinki, FINLAND, Tel +358-9-191-28780, Fax +358-9-191-28781, E-mail info-hecer@helsinki.fi, Internet www.hecer.fi

HECER
Discussion Paper No. 338

Pricing and Market Structure*
Abstract
We derive the equilibrium pricing strategies under three often observed market structures in a model with one large firm and a competitive fringe of small capacity constrained firms under uncertain demand. The pricing strategies reflect the varying levels of frictions and within-location competition induced by the market structures. An implication of the complexity of the pricing strategies is that a sample of posted prices and a simple index based on these is not enough for comparing the market structures in terms of expected prices paid. Knowledge of the market structure and expected demand is needed as well. JEL Classification: D43, L10, L13

Keywords: firm location, market structure, firm size.

Mats Godenhielm

Klaus Kultti

Department of Political and Economic
Studies
University of Helsinki
P.O. Box 17 (Arkadiankatu 7)
FI-00014
FINLAND

Department of Political and Economic
Studies
University of Helsinki
P.O. Box 17 (Arkadiankatu 7)
FI-00014
FINLAND

e-mail: mats.godenhielm@helsinki.fi

e-mail: klaus.kultti@helsinki.fi

* Mats Godenhielm wishes to thank Matti Liski and Tanja Saxell for usefull comments. Financial support from the Academy of Finland and the Yrjö Jahnsson Foundation is greatly acknowledged.

1

Introduction

It is often observed that sellers of similar goods, say outdoor equipment, locate close to each other and that several smaller retailers are found near a larger one. Another frequently observed market structure is one with several small sellers in the city centre and large retailers in the outskirts of the city. We analyze the e¤ect that di¤erent market structures have on expected prices and expected utilities and pro…ts. This can be seen as investigating the e¤ects of price competition between locations versus price competition within a location.

In our model aggregate supply is much larger than aggregate demand. If there were only one …rm it could charge the monopoly price, whereas if there were two …rms (still with enough capacity to satisfy the whole market) they would engage in Bertrand competition and drive the price down to zero. We model a market with one large …rm (without capacity restrictions) and a competitive fringe of small capacity constrained …rms and analyze the e¤ect these …rms have on the prices. Key assumptions are capacity constraints of the small …rms and uncertain demand,1 as they induce the small sellers to use a mixed pricing strategy whenever they are together at a location2 . We de…ne market structure as the locational distribution of …rms and analyze how market structure a¤ects average posted prices, expected utilities, pro…ts as well as the prices actually paid. The settings that we consider are

(A) All …rms are in the same location, this setting can be interpreted as describing a city centre. (B) The large …rm is in one location and all the small …rms are in a second location. This setting can be seen as corresponding to a city center with small …rms and a large retailer at the outskirts of the city.

(C) All …rms are at separate locations.
The ordering of the di¤erent market structures by average price and by expected price paid is often very di¤erent. There are several reasons for this. Firstly, when the small sellers are together in a location (as in market structures (A) and (B)) they use mixed pricing strategies3 . The cheapest goods are then bought …rst,...
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