Product differentiation
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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

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Product differentiation

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Product differentiation

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

Four brands of breakfast cereal

.

Which brand would be preferred by a consumer?

Crunchiness

A

B

C

D

Sweetness


Four brands of a refrigerator

Four brands of a refrigerator

.

Which brand would be preferred by a consumer?

Durability

A

B

C

D

Size


Trade offs in laptop computer

Trade-offs in laptop computer

.

Which brand would be preferred by a consumer?

What if B were not available?

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

Battery life

A

B

C

D

Computing power


Differentiation cost and entry

Differentiation, cost and entry

.

High

Unsuccessful entry

Uncertain success

Cost relative to competition

Successful entry

Low

High

Differentiation relative to competition


Competition in differentiated products

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

Hotelling’s model of horizontal differentiation

  • Two businesses on a line segment

  • Prices at L and R are and

  • Consider consumer at a fraction x of distance from L to R

  • Let c be cost of moving from L to R

L

R

Consumers of L

Consumers of R


Hotelling s model of horizontal differentiation1

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 marginal consumer that is indifferent between buying from L and R

  • This is given by

  • The optimal prices of both firms are = =c


Implications of the model of differentiation

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

Where should firms locate?

  • Let prices be held constant

  • The marginal consumer is at midpoint between L and 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

L

R


Spatial preemption

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 preemption1

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

  • Entry is profitable if


Implications of spatial preemption model

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

Sources of differentiation advantage

  • Creating synergies

  • Networks


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