Product differentiation

• Two major forms of product differentiation - Quality - Variety • Differentiation by quality is Vertical differentiation - everyone agrees what is better or worse • Differentiation by variety is Horizontal differentiation - not everyone agrees what is better or worse

.

Four brands of breakfast cereal

Crunchiness A B C D Sweetness Which brand would be preferred by a consumer?

.

Four brands of a refrigerator

Durability A B C D Size Which brand would be preferred by a consumer?

.

Trade-offs in laptop computer

Battery life A B C D Computing power Which brand would be preferred by a consumer?

What if B were not available?

In the end, it’s all a matter of taste!!

.

Differentiation, cost and entry

High Unsuccessful entry Successful entry Low Differentiation relative to competition High

Competition in differentiated products • Pretzel vendor in NY can locate where most consumers are • But competition is very intense there • Or he can move a block away to reduce competition • • But he is distant from most consumers

What is the optimal location?

Hotelling’s model of horizontal differentiation • Two businesses on a line segment

L R

Consumers of L Consumers of R • Consider consumer at a fraction

x

from L to R

p R

of distance • Let

c

be cost of moving from L to R

Hotelling’s model of horizontal differentiation • Consumer’s total cost at L is +

cx

• Consumer’s total cost at R is +

c

(1

-x

) • Consumer buys from business where she has lower cost • This determines the

x



marginal consumer

that is indifferent between buying from L and R • This is given by

x

  1 2 

p R



p L

2

c

• The optimal prices of both firms are = =

c

Implications of the model of differentiation • If L decreases price its sales increase is proportional to 1/

c

• Business stealing is easy when

c

is small • Thus

c

is the measure of differentiation between the products of L and R • Profits are proportional to differentiation

c

• The length of interval between L and R is a measure of consumer heterogeneity

Where should firms locate?

• Let prices be held constant • The marginal consumer is at midpoint between L and R L R • So L has incentive to move to right to increase its market • • But then R has incentive to move to left

Thus, without consideration of prices, L and R wind up next to each other

Spatial preemption

• Suppose there is fixed cost F for creating a new location • How far apart must two products be to prevent admission of entrant E?

• If unit transportation cost is

t

and distance between L and R is

d

, then

c=td

E’s market has length d/2 E L R d/2 d/2

Spatial preemption

• Transportation cost from L (or R) to E is

dt

/2 • Thus E’s optimal price is the transportation cost,

dt

/2 • Size of E’s market is

d/2

• Therefore E’s profit, were it to enter is

d

4 2

t

• Entry is profitable if

d

 2

t F

Implications of spatial preemption model • One can preempt with substantially fewer products than would exist in competitive conditions • Preemptive distance

d

grows with fixed cost, but at a decreasing rate • Thus, increasing entrants fixed cost is not a cost effective strategy to preempt entry • It is better to fill up the product space • Market can accommodate firms that are much closer than level at which preemption occurs

Sources of differentiation advantage • Creating synergies • Networks