Product differentiation Two major forms of 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. 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 Cost relative to competition Unsuccessful entry s es Un in rta c uc s ce 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 L R Consumers of L Consumers of R • 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

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 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 d/2 R 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 costeffective 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