Product Differentiation in a Regulated Market: A Welfare Analysis

Abstract

This article analyzes a regulated spatial differentiation model. An objective function is specified for the regulator as a linear combination of the profit of firms and the disutility of consumers in order to perform a social welfare analysis. It is shown that social welfare is positive and maximum product differentiation takes place if the regulator is clearly biased towards firms. By contrast, when the regulator is consumer-biased, minimum differentiation holds and social welfare is negative. Interestingly, the latter result is a common feature in market planned economies, whereas the former corresponds to liberal market economies.The rationale and significance of this is model is premised on the observation of a high number of cases where the election of the product characteristics space is limited by regulatory action due to health, technological, or environmental reasons. For instance, several pharmaceutical products do not contain the ideal drug amount for any consumer's height or weight, alcohol content in drinks and nicotine levels in cigarettes are restricted, a car's color or speed range is limited, and polluting substances in petrol are controlled.This research studies two markets, linear and circular, where available space for the location of firms is restricted by a regulator. Both models are formalized as a three-stage game in which the regulator chooses the commercial area size in the first instance. Firms locate simultaneously in a second stage and, lastly, they set up prices. The game is solved by backward induction.