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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

- not everyone agrees what is better or worse

Four brands of breakfast cereal

.

Which brand would be preferred by a consumer?

Crunchiness

A

B

C

D

Sweetness

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

.

High

Unsuccessful entry

Uncertain success

Cost relative to competition

Successful entry

Low

High

Differentiation relative to competition

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
- 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 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

- 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
- 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

- 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
- Entry is profitable if

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

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