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? Sweetness Crunchiness AB CD

Four brands of a refrigerator. Which brand would be preferred by a consumer? Size Durability AB CD

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!! Computing power Battery life AB CD

Differentiation, cost and entry. Differentiation relative to competition Cost relative to competition LowHigh Unsuccessful entry Successful entry Uncertain success

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 LR Consumers of LConsumers 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 LR

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 LR E d/2 E’s market has length 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