Environmental Externality and Horizontal Product Differentiation

1
Environmental Externality and Horizontal Product
Differentiation

• George Deltas
• Madhu Khanna
• Donna Theresa Ramirez
• program in Environmental and Resource Economics
• University of Illinois at Urbana-Champaign
• 23 September 2004

2
Consumption of green goods

• Consumers have preferences for green products
  Gallup study
• 57 of Americans avoid environmentally harmful
  products
• 65 of Americans willing to pay a premium for
  eco-safe products
• Willingness to pay for greener commodities may be
  due to
• private benefits - cost savings
• social benefits - lower pollution
• However, consumers do not seem to fully
  internalize the externality when making
  consumption choices
• low-efficiency cars
• non-recyclable containers

3
Preference for other attributes

• Consumers also have preferences for other product
  attributes
• other attributes that define quality intrinsic
  product quality
• reliability, durability
• overall performance
• brand and the attributes that define the brand
  for which ranking across consumers may not be
  uniform
• style
• design
• There may be some trade-offs in choosing
  horizontal and vertical attributes
• Size of cars and fuel efficiency
• Convenience of gas station location and brand
  loyalty

4
Firm response

• Firms respond to such consumer preferences by
  differentiating each other according to brand,
  intrinsic quality, and greeness
• The extent to which firms increase the greeness
  of a product depend on
• consumer valuation for green goods
• substitutability between green and ordinary goods
• inherent product quality
• how its rival responds
• reduce price
• market greener products

5
Evidence of firm response to green preferences

• Toyota
• manufacture high fuel efficiency vehicles
• manufacture hybrid vehicles
• McDonalds
• use paper/cardboard instead of styrofoam
• Procter and Gamble
• use recyclable and refillable packaging for
  detergents
• IBM
• inform consumers of proper disposal of hardware

6
Objectives

• To determine which types of firms would choose to
  manufacture greener products
• To determine whether market pressure in the form
  of consumer preferences for environmental
  attributes is sufficient to achieve socially
  optimal level of environmental quality
• If not, what types of instruments can achieve
  social optimum
• To assess the welfare impacts of these instruments

7
General Framework

• Extension of the standard Hotelling model of
  horizontal differentiation
• recognize that products are both vertically and
  horizontally differentiated
• greeness is only one of the many attributes
  consumers care about
• firms can choose greeness of products, while
  other attributes are constant
• firms compete for consumers in prices
• consumers choose products that give them highest
  net utility

8
Differences with current literature

• Differs from vertical product differentiation
  (VPD) models in the following ways
• valuation or MWTP for quality that is uniform
  across consumers
• differentiates between private and social
  valuation for product quality
• recognizes preference for brand
• Differs from horizontal product differentiation
  (HPD) models in the following ways
• takes extent of horizontal differentiation as
  fixed
• asymmetric firms firms do not just vary
  according to brand but also according to
  intrinsic quality

9
The Model Consumer preferences

• The utility function of a representative consumer
  i, consuming a good produced by firm jA,B is
• where
• Vj is utility from product js intrinsic quality,
  VA VB
• Sj is greeness of the product
• pj is price
• dij is consumer i s distance from most preferred
  brand, by purchasing product j
• q is extent of brand loyalty
• l is private valuation for environmental quality,
  less than lS
• lS is social valuation for environmental quality

10
The indifferent consumer

• The consumer indifferent between buying from A
  and from B , xc is the one who equates
• The indifferent consumer is
• So that firm market shares are

11
The Model Firm competition

• Firms compete in 2 stages
• Stage 1 Choose environmental quality
• Stage 2 Choose prices
• to maximize profits
• where qj is defined by consumer preferences
• Quadratic cost of environmental quality
  improvement, marginal cost of quality same across
  both firms, zero production costs

12
Who undertakes higher environmental quality
investment?

• The firm with higher intrinsic quality undertake
  higher environmental quality investment
• The firm with higher intrinsic quality has higher
  market share and charges higher prices
• The firm with higher intrinsic quality earns
  higher profit

13
Features of the Nash solution

• The higher the intrinsic quality differential,
  the higher the differential in quality, price,
  market share and profits
• The higher the private valuation for
  environmental quality, the greater the difference
  in environmental quality levels, prices and
  market shares
• The higher the extent of brand loyalty, the less
  the advantage of the high quality firm in terms
  of
• environmental quality
• market share

14
Social Welfare

• Consumer surplus from purchasing good from firm A
• Consumer surplus from purchasing good from firm B
• Total cost of investing in environmental quality
• Transportation cost

15
Is Nash solution welfare-maximizing?

• The firm with higher intrinsic quality has higher
  welfare maximizing level of S than the low
  quality rival
• If firms are asymmetric,
• the intrinsically high quality firm always
  underinvests in environmental quality relative to
  welfare maximizing level
• the intrinsically low quality firm
• overinvests in environmental quality if the
  inherent quality differential is high
• underinvests in environmental quality if the
  inherent quality differential is low
• If firms are symmetric, even if consumers fully
  internalize the externality, Nash choices will
  always be sub-optimal

16
What instrument can achieve welfare-maximizing
environmental quality level?

• Profit function with a differentiated subsidy is
• The subsidy for the high quality firm is higher
  than the subsidy level for the low quality firm
• The subsidy differential
• increases with the social valuation for
  environmental quality and the inherent quality
  differential
• falls with the extent of brand loyalty

17
How will a uniform environmental quality subsidy
perform?

• Profit function with a uniform subsidy is
• A uniform subsidy causes both firms to choose
  quality levels higher than their Nash choices
• The uniform subsidy is lower (higher) than the
  optimal differentiated subsidy for the high (low)
  quality firm
• Causing the high (low) quality firm to under
  (over) invest than is welfare-maximizing

18
What about a MQS?

• We model a welfare-maximizing MQS that binds for
  the low quality firm
• that satisfies
• We find that the high quality firms choice of
  environmental quality FALLS with the level of MQS

19
Illustrating the MQS
20
How will MQS perform relative to welfare
maximizing levels?

• If intrinsic quality differential is
• higher than some low critical value
• lower than some maximum value
• Then
• the high quality firm chooses S level that
  exceeds the MQS
• MQS will be above (below) the socially optimal
  choice of the low (high) quality firm

21
Are these instruments welfare enhancing relative
to Nash?

• A uniform subsidy is welfare-enhancing if
  marginal benefit from environmental quality
  improvement is higher than marginal cost for both
  firms
• Marginal benefit is higher if the social value
  for environmental quality, lS is high, and
• Marginal cost falls if K is low, r is low, and if
  degree of brand loyalty is low, i.e., low q,
• A MQS is welfare-improving if
• Brand loyalty is strong and
• Positive net revenue effect on the low quality
  firm offsets the negative net revenue effect on
  the high quality firm

22
Conclusions

• Market leaders tend to be the environmental
  leaders.
• Consumer pressure is not sufficient for firms to
  choose the socially optimal level of
  environmental quality even if consumers fully
  internalize the positive externality.
• A differentiated subsidy which is higher for the
  intrinsically high quality firm is sufficient to
  achieve welfare-maximizing levels.
• A uniform subsidy will make the high (low)
  quality firm under(over) invest on environmental
  quality investment relative to social optimum.
• The high quality firm responds negatively to an
  increase in a minimum quality standard.
• The extent of brand loyalty has a significant
  role in determining whether uniform subsidy and
  the MQS are welfare-enhancing.

23
What can the results say about some
goods/industries in the real world?

• 1. Market leaders tend to be environmental
  leaders
• Automobile manufacturing industry
• Toyota has always been ranked highly in ratings
  by JD Power Associates, and by consumers
• Toyota has higher mpg than corresponding cars in
  the rivals fleet
• Toyota has been leading in developments for
  hybrid vehicles, rivals
• Petroleum manufacturing
• BP Amoco is an industry leader
• BP Amoco led its rivals in in advancements in use
  of cleaner alternative fuels such as natural gas
  and in supporting the Kyoto Protocol
• Personal consumer goods
• Procter and Gamble is the industry leader
• Procter and Gamble paved the way for developing
  more environmental-friendly packaging

24
Examples(contd)

• 2. Subsidy on hybrid vehicles
• There is a 2,000 tax break for those who
  purchase hybrid vehicles - this is like a uniform
  subsidy
• Those already producing hybrid vehicles such as
  Toyota and Honda (assumed to be high V firms),
  are selling them below their unit cost
• While for the low V firms such as GM and Ford,
  they have delayed manufacture of hybrid vehicles
  until 2005 and 2007, respectively.
• These imply that the 2000 subsidy is not enough
  for the high quality firm to encourage consumers
  to buy hybrid vehicles if sold at true cost,
  while at the same time, too low for the low
  quality firms to start manufacturing them

25
Examples(contd)

• 3. MQS Is the CAFÉ standard a good example of
  such an MQS?
• Tightening of current CAFÉ standards are under
  deliberations (Source Greenwire February 2003)
• Opposed by Ford and GM
• Supported by Toyota and Honda (proposed standards
  are not stringent enough)
• This might be an indication that the proposed MQS
  is
• higher than what Ford and GM would privately
  choose to remain profitable
• lower than what Toyota and Honda would privately
  choose
• If consumers are loyal to their brands (assuming
  MBMC for all firms), then the proposed MQS will
  be welfare-improving
• those loyal to GM and Ford will experience higher
  environmental quality
• those loyal to Toyota and Honda will keep on
  consuming cars cleaner than the other consumers