Monopoly: Hotelling Model And Relationship Between Market Power And Firms’ Advertising Expenditures

1) Why does a monopolist have more stores than would be socially optimal in the Hotelling model? Explain how this result is derived

Economists explored the theoretical subject of the hotelling model with product differentiation by creating various location models. The author of this model created the product differentiation theory that has been influential for a period of 80 years. However, in his development, Harold Hotelling mentioned the fact that his analysis had consequences for other forms of product differentiation. This being said, this essay will explore his model by analysing why a monopolist have more stores than would be socially optimal in the hotelling model through making different assumptions and explaining the results later.

First and foremost, differing from Hoteling who commenced his analysis by assuming two stores at fixed locations, the monopolist supplier assumed there is one store. Due to the single store assumption by the monopolist, the supplier has to worry about identifying a perfect location for the store. According to this assumption, the monopolist is only bound to increase sales by lowering price for the supplier to be able to serve all the consumers. Nevertheless, the monopolist can acquire mores stores through product differentiation. More stores will be characterized by location and transportation costs by consumers through applying product differentiation. Having more stores in a precise location, allows the monopolist to supply more goods in variety.

Secondly, when the number of stores increases, this allows the monopolist to increase the price and still sell to all the consumers. This is triggered by the need to maximize profits through maximizing locations of the store along the major street. For the monopolist to achieve this, its advised that he/she spaces the stores out uniformly over the length of the precise location. For the monopolist to maximize the price it can charge with two, three, four-plus stores located at the mile marks along the major street, it has to locate the store at ¼,3/4, 1/6,1/2 mile mark along the major street. For example, if a precise selected street has 10 stores then the monopolist’s locations along the major street will be calculated using a pattern to the store locations simple function; ½(10),3/2(10),5/2(10) to reduce the travelling distance any consumer must take while heading to the store. When the monopolist is aware of the number of consumers he/she is supplying to, the monopolist will be able to compute his profit by including; the transportation cost, reservation price, fixed costs of an extra store and the number of the stores. Therefore, for the monopolist to maximize their profits, it requires the monopolist to develop more stores or in Hotelling’s language, to generate more variety of a similar product.

Whereas, Socially optimal in the Hotelling model is known as the number of stores that maximizes total social surplus which is slightly different from the number of stores that maximizes the monopolist’s profit. Using an example to illustrate this theory further, according to the social perception the monopolist develops too many stores or recommends new selection of chocolates. In addition, the monopolist only considers how the increase in price will boost total revenue and relates that to the fixed costs of developing the new store or forming the new chocolate. Unfortunately, a boost in total revenue barely adds anything to the Total Social Surplus since it is considered as nothing more than a move of surplus from consumers to the monopolist. Conversely, the monopolist tends to disregard the true social value of developing the new store which decreases transportation expenses. Based on the social value perspective, a decrease in transportation expenses is the only advantage associated with developing an extra store.

Although the monopolist relates the boost in profits to the increase in fixed costs, society should also relate the decrease in transportation expenses to the rise in fixed costs. The growth in the firm’s profits linked to developing an extra store or producing a new variety of chocolates is bound to be greater than the decrease in transportation expenses linked with the extra store. So based on the social perspective, the monopolist has so much to gain through enticement to develop extra stores.

Last but not least, to further elaborate on how the results are derived, as mentioned earlier, the monopolist includes the fixed cost of an additional store, the number of stores, transportation costs, number of consumers and reservation price when calculating the profit. Earnings are solely equal to total revenue minus total cost, for any number of stores. Whereas the social optimum is computed by putting into consideration the total value of the number units sold to consumers in situations where all the number of buyers acquire exactly one unit of the good from one of the store. When the reservation price is included,the total worth of the number of units purchased is NR. To establish the Total Social Surplus, they deduct from the total worth, (NR), the total variable costs of manufacturing, (Nc), the fixed costs of developing a number of shops (Nf) and total transportation costs; TSS=NR-Nc-Nf-(total transportation costs). Total transportation expense hinge on the number of shops and transportation cost per unit of distance.

In conclusion, monopolist have more stores than would be socially optimal in the Hotelling model because their able to increase their prices and profits. Due to an increase in the number of stores this leads to an increase in price. Whereas an increase in transportation costs reduces the price. All in all, the number of stores tend to surpass the socially optimal number of stores.

2) What does economic modelling tell us about the relationship between market power and firms’ advertising expenditures? How do incentives to advertise differ for oligopoly firms as compared to a monopolist?

Advertising can be identified as a major tool used by firms to boost their sales, share information about product and prices with the public to attract new customers or retain the existing customers. Besides boosting their sales through advertising, advertising can have major negative and positive economic/social effect. However, this essay will discuss economic modelling such as the Dorfman-Steiner Model role in advancing a relationship between market power and firm’s advertising expenditures, and how incentives to advertise differ for oligopoly firms as compared to a monopolist.

Relationship between market power and firms advertising expenditure; Dorfman-Steiner model curated the model that illustrated the relationship between market structure and advertising. They considered the monopolist demand function to be characterized by the following ; Q=Q(P,A). In their model, quantity was considered to be the function of advertising and price was independent of the level of advertising expenditures. Since Dorfman and Steiner model returns states that the advertising to sales ratio, is advertising divide by price multiply by quantity has a direct relationship with price cost margin, inversely related to the price elasticity of demand, and directly related to the advertising elasticity of demand. The advertising elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in advertising expenditures. Therefore, due to the advertising sales ratio function that develops a conjectural link between market structure and advertising due to the Lerner Index of market power. For instance, if the monopolist encounters competition from the substitute products, price elasticity of demand will be huge, price cost margin will be low and the advertising to sales ratio will be tiny, whereas as the elasticity of demand reduces, the price cost margin grows, and the advertising-to-sales ratio rises. . Therefore, for the case of monopoly, this model indicates a positive link between advertising and market power. As the Lerner Index of market power grows, so does the advertising to sales ratio. However, due to the limited impact of the model, it only applies to the monopoly behaviour.

To illustrate this further the below graph shows the expected relationship between market power and advertising expenditures. The relationship is nonlinear. According to the model, the advertising-to-sales ratio grows with a rise in the concentration ratio ( concentration ratio is computed by summing up the first four firms with the highest market shares) and reduces with a rise in concentration beyond that level. The monopolist advertising is significantly greater than the perfectly competitive level of advertising. Graph 1: Relation between CR and Advertising-to-Sales Ratio

With regards to how incentives to advertise differ for oligopoly firms as compared to a monopolist, its best to further understand the oligopoly behaviour. This can be done by making an assumption of the Cournot behaviour in relation to advertising expenditures. If we are using two identical firms ( Apple and Samsung), both firms are likely to assume that their competitors will preserve its existing level of advertising. The advertising for Apple can be illustrated as follows;

Equation 1:

M: represents market share. The first term of the equation represents the industry output effect, meaning Apple’s growth in advertising rises the demand for the generic industry product not just its own brand. Whereas, the right side of equation 2 represents the market share effect. If Apple rises its advertising, its market share will grow relative to that of Samsung . Whereas, the below equation

Equation2:

This equation implies that oligopolists have extra incentive to advertise. To explain this equation further, besides the fact that advertising boosts the total demand for products, it also contributes to the growth of firms market share.

Therefore, both equation 1 and 2 implies that for any provided price-cost margin, the advertising-to-sales ratio is likely going to be much bigger in oligopoly than monopoly, due to the fact that the advertising elasticity of demand is considered to be bigger under the oligopoly market structure than monopoly. Also, increasing the advertising expenditure has zero impact on the monopolist’s market share of 100%, which leads to the reduction of the monopolist’s motivation to advertise. Its also key to note that as a firm’s price cost margin grows, it should have a positive impact on the advertising-to-sales ratio. Also, as other factors remain constant, oligopolists are expected to have a huge advertising-sales-to-ratios than monopolists. In addition, sometimes oligopolists may tend to participate in extreme advertising.

In summary, advertising is likely to be used purposefully to pre-empt entry and maintain market power. A rising cost in advertising can be used to increase rivals expenditures and stop entry.