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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
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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