Product differentiation and entry games : Simulating dynamic oligopoly games

Abstract

The aim for this thesis is to make an analysis of entry in industries with differentiated products. We will attempt to achieve this task by presenting a game. Studying thoroughly this game will make it possible at the same time to discover a framework. The framework will consist of a full derivation and presentation of a theoretical model, as well as a numerical method. We will concentrate on the case of oligopolies, and develop our framework to be able to solve dynamic problems. The model will rest on discrete choice theory, and in order to illustrate the dynamics we will in our derivations make use of the Bellman equation and Markov processes. The firms in the industries in question will, as stated, be able to differentiate their product from other firms’ product. We will present two different types of industries. First of all industries where firms are global players, and secondly industries where firms are local players. With global players we mean firms that have the opportunity of being active in different markets at the same time. In this setup the firm differentiates itself from the competitors by location. The choice of which market to enter into will decide its location, and thus how differentiated its product will be to competing products. We also mentioned local players. By them we mean players present exclusively in one local market. These players differentiate themselves from competitors with the price and quality of the product. In each case we will see that the equilibrium is found by solving a game. The firms will maximize their value function and build best response functions. The first part of our thesis will concentrate on a static set up. This is done in order to have a foundation on which to support the analysis of the dynamic models. The analysis of the dynamic models, takes place in our second part, when we introduce the event of entry. We will present a dynamic model, both for the case where firms are global players and for the case where firms are local players. Finally, in the third part, we implement both the static model and the global player model and use the global player implementation to perform a simulation with Matlab. The simulation will attempt to shed some light on different issues regarding entry in the Norwegian airline industry.