Ann van Ackere, Universite de Lausanne, Lausanne, Switzerland
Erik R. Larsen, Aarhus University, Aarhus, Denmark

Abstract: We consider a stylized model of competition between two firms who provide a local service, for instance coffee-shops or hamburger chains. These firms are characterised by their quality of service, with one firm being high quality and the other being low quality. Quality impacts both the fixed and variable costs of the firms. The firms compete for customers in two areas, which are characterised by a different customer density. Firms decide in which area(s) to locate, and what price to charge. A firm entering both areas must charge the same price in both, i.e., price-discrimination is not allowed. We analyse the impact of cost levels and quality and density differences on the resulting market structure, prices, profits, customer surplus and social welfare. We show how the balance between fixed and variable cost determine the competitive conditions ranging from highly competitive markets to local monopolies under the same regulatory environment. Furthermore, in some areas with multiple equilibria the profitability of the firms is highly dependent on which of the possible equilibria is realised. The results can help explain some of the patterns observed in the location of chain outlets.

Keywords: game theory, market entry, heterogeneous customer, quality, cost