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In economics, a location model or spatial model refers to any monopolistic competition model that demonstrates consumer preference for particular brands of goods and their locations. Examples of location models include Hotelling's Location Model, Salop's Circle Model, and hybrid variations.
In traditional economic models, consumers display preference given the constraints of a product characteristic space. Consumers perceive certain brands with common characteristics to be close substitutes, and differentiate these products from their unique characteristics. For example, there are many brands of chocolate with nuts and others without them. Hence, the chocolate with nuts is a constraint of its product characteristic space.
On the other hand, consumers in location models display preference for both the utility gained from a particular brand's characteristics as well as its geographic location; these two factors form an enhanced “product characteristic space.” Consumers are now willing to sacrifice pleasure from products for a closer geographic location, and vice versa. For example, consumers realize high costs for products that are located far from their spatial point (e.g. transportation costs, time, etc.) and also for products that deviate from their ideal features. Firms have greater market power when they satisfy the consumer's demand for products at closer distance or preferred products.
In 1929, Hotelling developed a location model that demonstrates the relationship between location and pricing behavior of firms. [1] He represented this notion through a line of fixed length. Assuming all consumers are identical (except for location) and consumers are evenly dispersed along the line, both the firms and consumer respond to changes in demand and the economic environment.
In Hotelling's Location Model, firms do not exercise variations in product characteristics; firms compete and price their products in only one dimension, geographic location. Therefore, traditional usage of this model should be used for consumers who perceive products to be perfect substitutes or as a foundation for modern location models.
Assume that the line in Hotelling's location model is actually a street with fixed length.
All consumers are identical, except they are uniformly located at two equal quadrants and , which is divided in the center by point . Consumers face a transportation/time cost for reaching a firm, denoted by ; they have no preferences for the firms.
There are two firms in this scenario, Firm x and Firm y; each one is located at a different end of the street, is fixed in location and sells an identical product.
Given the assumptions of the Hotelling model, consumers will choose either firm as long as the combined price and transportation cost of the product is less than the competitive firm.
For example, if both firms sell the product at the same price , consumers in quadrants and will pick the firm closest to them. The price realized by the consumer is
, where is the price of the product including the cost of transportation.
As long as for Firm x is greater than Firm y, consumers will travel to Firm y to purchase their product; this minimizes . Only the consumers who live at point , the halfway point between the two firms, will be indifferent between the two product locations.
Assume that the line in Hotelling's location model is actually a street with fixed length.
All consumers are identical, except they are uniformly located in four quadrants , , , and ; the halfway point between the endpoints is point . Consumers face an equal transportation/time cost for reaching a firm, denoted by ; they have no preferences for the firms.
There are two firms in this scenario, Firm x and Firm y; each one is located at a different end of the street, is able to relocate at no cost, and sells an identical product.
In this example, Firm x and Firm y will maximize their profit by increasing their consumer pool. Firm x will move slightly toward Firm y, in order to gain Firm y's customers. In response, Firm y will move slightly toward Firm x to re-establish its loss, and increase the pool from its competitor. The cycle repeats until both firms are at point , the halfway point of the street where each firm has the same number of customers. This result is known as Hotelling's law, however it was invalidated in 1979 by d'Aspremont, J. Jaskold Gabszewicz and J.-F. Thisse. [2] Consider that quick (short run) price adjustment and slow (long run) location adjustment is modelled as a repeated two-stage game, where in the first stage firms will make an incremental relocation and in the second period, having observed each other's new locations, they will simultaneously choose prices. d'Aspremont et al. (1979) prove that when firms are sufficiently close together (but not located in the same place) no Nash equilibrium price pair (in pure strategies) exists for the second stage subgame (because there is an incentive to undercut the rival firm's price and gain the entire market). For example, when firms are equidistant from the centre of the street, no equilibrium price pair exists for locations 1/4 or closer than 1/4 of the length of the street from the centre. The non-existence of a Cournot equilibrium precludes the ending of the game, and so it is not repeated. Thus, although both firms at the halfway point itself is an equilibrium, there is no tendency for firms to agglomerate here.
If only Firm x can relocate without costs and Firm y is fixed, Firm x will move to the side of Firm y where the consumer pool is maximized. Consequently, the profits for Firm X significantly increase, while the profits for Firm Y significantly decrease.
One of the most famous variations of Hotelling's location model is Salop's circle model. [3] Similar to the previous spatial representations, the circle model examines consumer preference with regards to geographic location. However, Salop introduces two significant factors: 1) firms are located around a circle with no end-points, and 2) it allows the consumer to choose a second, heterogeneous good.
Assume that the consumers are equidistant from one another around the circle. The model will occur for one time period, in which only one product is purchased. The consumer will have a choice of purchasing variations of Product A (a differentiated product) or Product B (an outside good; undifferentiated product).
There are two firms also located equidistant around the circle. Each firm offers a variation of Product A, and an outside firm offers a good, Product B.
In this example, the consumer wants to purchase their ideal variation of Product A. They are willing to purchase the product, given that it is within the constraint of their utility, transportation/distance costs, and price.
The utility for a particular product at distance is represented in the following equation:
Where is the utility from a superior brand, denotes the rate at which an inferior brand lowers the utility from the superior brand, is the location of the superior brand, and is the location of the consumer. The distance between the brand and the consumer is thereby given in .
The consumer's primary goal is to maximize consumer surplus, i.e. purchase the product that best satisfies any combination of price and quality. Although the consumer may receive more pleasure from their superior brand, the inferior brand may maximize the surplus which is given by:
, where the difference is between the utility of a product at location and the price .
Now suppose the consumer also has the option to purchase an outside, undifferentiated Product B. The consumer surplus gained from Product B is denoted by .
Therefore, for a given amount of money, the consumer will purchase the superior variation of Product A over Product B as long as
, where the consumer surplus from the superior variation of Product A is greater than the consumer surplus gained from Product B.
Alternatively, the consumer only purchases the superior variation of product A as long as
, where the difference between the surplus of the superior variation of Product A and the surplus gained from Product B is positive.
A monopoly, as described by Irving Fisher, is a market with the "absence of competition", creating a situation where a specific person or enterprise is the only supplier of a particular thing. This contrasts with a monopsony which relates to a single entity's control of a market to purchase a good or service, and with oligopoly and duopoly which consists of a few sellers dominating a market. Monopolies are thus characterised by a lack of economic competition to produce the good or service, a lack of viable substitute goods, and the possibility of a high monopoly price well above the seller's marginal cost that leads to a high monopoly profit. The verb monopolise or monopolize refers to the process by which a company gains the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a business entity that has significant market power, that is, the power to charge overly high prices, which is associated with a decrease in social surplus. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A small business may still have the power to raise prices in a small industry.
As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a consumer's ordinal preferences over a choice set, but is not necessarily comparable across consumers or possessing a cardinal interpretation. This concept of utility is personal and based on choice rather than on pleasure received, and so requires fewer behavioral assumptions than the original concept.
In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent. That is, any combinations of two products indicated by the curve will provide the consumer with equal levels of utility, and the consumer has no preference for one combination or bundle of goods over a different combination on the same curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. In other words, an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.
In mainstream economics, economic surplus, also known as total welfare or total social welfare or Marshallian surplus, is either of two related quantities:
Price discrimination is a microeconomic pricing strategy where identical or largely similar goods or services are sold at different prices by the same provider in different market segments. Price discrimination is distinguished from product differentiation by the more substantial difference in production cost for the differently priced products involved in the latter strategy. Price differentiation essentially relies on the variation in the customers' willingness to pay and in the elasticity of their demand. For price discrimination to succeed, a firm must have market power, such as a dominant market share, product uniqueness, sole pricing power, etc. All prices under price discrimination are higher than the equilibrium price in a perfectly competitive market. However, some prices under price discrimination may be lower than the price charged by a single-price monopolist. Price discrimination is utilised by the monopolist to recapture some deadweight loss. This Pricing strategy enables firms to capture additional consumer surplus and maximize their profits while benefiting some consumers at lower prices. Price discrimination can take many forms and is prevalent in many industries, from education and telecommunications to healthcare.
The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption, by maximizing utility subject to a consumer budget constraint. Factors influencing consumers' evaluation of the utility of goods include: income level, cultural factors, product information and physio-psychological factors.
In economics and marketing, product differentiation is the process of distinguishing a product or service from others to make it more attractive to a particular target market. This involves differentiating it from competitors' products as well as from a firm's other products. The concept was proposed by Edward Chamberlin in his 1933 book, The Theory of Monopolistic Competition.
In economics, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. Consumer theory uses the concepts of a budget constraint and a preference map as tools to examine the parameters of consumer choices. Both concepts have a ready graphical representation in the two-good case. The consumer can only purchase as much as their income will allow, hence they are constrained by their budget. The equation of a budget constraint is where is the price of good X, and is the price of good Y, and m is income.
In microeconomics, two goods are substitutes if the products could be used for the same purpose by the consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to complementary goods and independent goods, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is Coca-Cola and Pepsi; the interchangeable aspect of these goods is due to the similarity of the purpose they serve, i.e fulfilling customers' desire for a soft drink. These types of substitutes can be referred to as close substitutes.
The classical general equilibrium model aims to describe the economy by aggregating the behavior of individuals and firms. Note that the classical general equilibrium model is unrelated to classical economics, and was instead developed within neoclassical economics beginning in the late 19th century.
Utility maximization was first developed by utilitarian philosophers Jeremy Bentham and John Stuart Mill. In microeconomics, the utility maximization problem is the problem consumers face: "How should I spend my money in order to maximize my utility?" It is a type of optimal decision problem. It consists of choosing how much of each available good or service to consume, taking into account a constraint on total spending (income), the prices of the goods and their preferences.
In microeconomics, a consumer's Marshallian demand function is the quantity they demand of a particular good as a function of its price, their income, and the prices of other goods, a more technical exposition of the standard demand function. It is a solution to the utility maximization problem of how the consumer can maximize their utility for given income and prices. A synonymous term is uncompensated demand function, because when the price rises the consumer is not compensated with higher nominal income for the fall in their real income, unlike in the Hicksian demand function. Thus the change in quantity demanded is a combination of a substitution effect and a wealth effect. Although Marshallian demand is in the context of partial equilibrium theory, it is sometimes called Walrasian demand as used in general equilibrium theory.
Bertrand competition is a model of competition used in economics, named after Joseph Louis François Bertrand (1822–1900). It describes interactions among firms (sellers) that set prices and their customers (buyers) that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a review of Antoine Augustin Cournot's book Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838) in which Cournot had put forward the Cournot model. Cournot's model argued that each firm should maximise its profit by selecting a quantity level and then adjusting price level to sell that quantity. The outcome of the model equilibrium involved firms pricing above marginal cost; hence, the competitive price. In his review, Bertrand argued that each firm should instead maximise its profits by selecting a price level that undercuts its competitors' prices, when their prices exceed marginal cost. The model was not formalized by Bertrand; however, the idea was developed into a mathematical model by Francis Ysidro Edgeworth in 1889.
Revealed preference theory, pioneered by economist Paul Anthony Samuelson in 1938, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.
In economics, compensating variation (CV) is a measure of utility change introduced by John Hicks (1939). 'Compensating variation' refers to the amount of additional money an agent would need to reach their initial utility after a change in prices, a change in product quality, or the introduction of new products. Compensating variation can be used to find the effect of a price change on an agent's net welfare. CV reflects new prices and the old utility level. It is often written using an expenditure function, e(p,u):
In economics, discrete choice models, or qualitative choice models, describe, explain, and predict choices between two or more discrete alternatives, such as entering or not entering the labor market, or choosing between modes of transport. Such choices contrast with standard consumption models in which the quantity of each good consumed is assumed to be a continuous variable. In the continuous case, calculus methods can be used to determine the optimum amount chosen, and demand can be modeled empirically using regression analysis. On the other hand, discrete choice analysis examines situations in which the potential outcomes are discrete, such that the optimum is not characterized by standard first-order conditions. Thus, instead of examining "how much" as in problems with continuous choice variables, discrete choice analysis examines "which one". However, discrete choice analysis can also be used to examine the chosen quantity when only a few distinct quantities must be chosen from, such as the number of vehicles a household chooses to own and the number of minutes of telecommunications service a customer decides to purchase. Techniques such as logistic regression and probit regression can be used for empirical analysis of discrete choice.
In economics and consumer theory, quasilinear utility functions are linear in one argument, generally the numeraire. Quasilinear preferences can be represented by the utility function where is strictly concave. A useful property of the quasilinear utility function is that the Marshallian/Walrasian demand for does not depend on wealth and is thus not subject to a wealth effect; The absence of a wealth effect simplifies analysis and makes quasilinear utility functions a common choice for modelling. Furthermore, when utility is quasilinear, compensating variation (CV), equivalent variation (EV), and consumer surplus are algebraically equivalent. In mechanism design, quasilinear utility ensures that agents can compensate each other with side payments.
The Brander–Spencer model is an economic model in international trade originally developed by James Brander and Barbara Spencer in the early 1980s. The model illustrates a situation where, under certain assumptions, a government can subsidize domestic firms to help them in their competition against foreign producers and in doing so enhances national welfare. This conclusion stands in contrast to results from most international trade models, in which government non-interference is socially optimal.
In economics and other social sciences, preference refers to the order in which an agent ranks alternatives based on their relative utility. The process results in an "optimal choice". Preferences are evaluations and concern matter of value, typically in relation to practical reasoning. An individual's preferences are determined purely by a person's tastes as opposed to the good's prices, personal income, and the availability of goods. However, people are still expected to act in their best (rational) interest. In this context, rationality would dictate that an individual will select the option that maximizes self-interest when given a choice. Moreover, in every set of alternatives, preferences arise.
This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.
