Product differentiation

1
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

2
Four brands of breakfast cereal

• .

Crunchiness
A
B
C
D
Sweetness
3
Four brands of a refrigerator

• .

Durability
A
B
C
D
Size
4
Trade-offs in laptop computer

• .

Battery life
A
B
C
D
Computing power
5
Differentiation, cost and entry

• .

High
Unsuccessful entry
Uncertain success
Cost relative to competition
Successful entry
Low
High
Differentiation relative to competition
6
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?

7
Hotellings 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
8
Hotellings model of horizontal differentiation

• Consumers total cost at L is cx
• Consumers 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

9
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

10
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
11
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 ctd

Es market has length d/2
E
L
R
d/2
d/2
12
Spatial preemption

• Transportation cost from L (or R) to E is dt/2
• Thus Es optimal price is the transportation
  cost, dt/2
• Size of Es market is d/2
• Therefore Es profit, were it to enter is
• Entry is profitable if

13
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

14
Sources of differentiation advantage

• Creating synergies
• Networks