1. 20 E-commerce 5 Aaron Schiff ECON 204 2009

2. Introduction Product differentiation is another strategy used extensively by firms in addition to or instead of price discrimination. Objectives of this lecture: Understand the basic principles of product differentiation, the Hotelling model, and discuss the implications for e-commerce.

3. Product Differentiation Perfect competition = zero profits. Firms would prefer to make higher profits, if they can. One way firms can do this is to differentiate their product from others, so that all products are no longer homogeneous. In this case, consumers won’t just simply buy from the cheapest firm, but will also care about their preferences across the different products.

4. Product Differentiation With differentiated products, consumers who really like the product offered by a particular firm will be reluctant to change to another firm even if the price increases a little. –“Brand loyalty”. Product differentiation aims to make the demand that a firm faces less elastic. Ultimately, product differentiation allows firms to increase prices and profits compared to perfect competition.

5. Product Differentiation and E-commerce Recall that some aspects of e-commerce increase the intensity of competition among firms. Product differentiation can help to offset this. –Important for e-commerce firms. Implementing product differentiation requires knowledge about consumer tastes. –E-commerce firms have good opportunities to collect and use this information. Product differentiation requires customising a standard good or service. –Maybe easier to do with online services or digital goods.

6. Product Characteristics We imagine every good or service as having a set of characteristics that consumers can observe. –Colour / size / quality / location / support etc. Characteristics are chosen by the firms. –Firms compete in product design as well as by setting prices. Think of products as being points in a characteristics space. Quality Flavour

7. Vertical vs Horizontal Differentiation Vertical differentiation: Products differ according to a characteristic such that all consumers agree which product is better or worse. –Examples: Quality, energy efficiency. Horizontal differentiation: Different consumers have different preferences over characteristics. –Examples: Flavour, crunchiness. We will concentrate on horizontal differentiation.

8. Horizontal Differentiation We will examine the “Hotelling” model of horizontal product differentiation. Two firms are differentiated along a single dimension in a product characteristics space. Consumers tastes are uniformly distributed along this dimension. Firms compete by setting prices, given their product characteristics.

9. Hotelling Model Consumers are uniformly distributed along a line between 0 and 1. A consumer’s location x represents her ideal preference for the single product characteristic. Examples: 01 MildHot Chili sauce: 01 West EndEast End Icecream vendors on a beach:

10. Hotelling Model Ideally, a consumer would like a product to be exactly at her ‘location’. But each product exists only at a single point along the line. Consumers experience disutility from consuming a less- than ideal product. Disutility is proportional to the distance between the consumer’s location and the product’s location.

11. Hotelling Model Each consumer wants to buy one unit of one product, which gives some utility v. Disutility for a consumer located at x from consuming at product located at y is given by t × |x – y|, where |x – y| is the absolute distance between the consumer’s location and the product’s location. The parameter t measures the degree of horizontal differentiation between the products, from consumers’ point of view. –No differentiation: t = 0 –Very differentiated: Large t.

12. Hotelling Model A consumer also pays a price p i to buy from firm i. –Assume that v is large enough so that all consumers buy one of the two products. Thus the net utility of a consumer located at x from buying the product of firm i located at y i is: u i = v – t × |x – y i | – p i Each consumer chooses the product that gives them the highest net utility out of the two.

13. Hotelling Model Assume that the products’ locations are fixed at y 1 = 0 and y 2 = 1. This gives net utilities: u 1 = v – tx – p 1 u 2 = v – t(1 – x) – p 2

14. Hotelling Model Illustration: 01 v – p 1 u1u1 u2u2 v – p 2 Buy product 1Buy product 2

15. Hotelling Model Consumer who is indifferent between the two products is located at x* where: v – tx* – p 1 = v – t(1 – x*) – p 2 Which gives: x* = ½ + (p 2 – p 1 )/(2t) Demands (market shares) for the two products are: D 1 = x* = ½ + (p 2 – p 1 )/(2t) D 2 = 1 – x* = ½ + (p 1 – p 2 )/(2t) Note each firm’s market share is increasing in its rival’s price and decreasing in its own price.

16. Example 1 Suppose in the Hotelling model that v = 10 and t = 2. Questions: –Find the demands for the two products when p 1 = p 2 = 5 and illustrate graphically. –Show what happens when p 1 reduces to 4.

17. Hotelling Model Suppose marginal cost is c for both firms. Profit functions:  1 = (p 1 – c)D 1 = (p 1 – c)[½ + (p 2 – p 1 )/(2t)]  2 = (p 2 – c)D 2 = (p 2 – c)[½ + (p 1 – p 2 )/(2t)] Each firm’s profit depends on its own price and its rival’s price.

18. Hotelling Model Each firm chooses its price to maximise its profit taking its rival’s price as given. This gives (need to use calculus): p 1 = ½(c + t + p 2 ) p 2 = ½(c + t + p 1 ) We then solve simultaneously to get the equilibrium prices: p 1 = p 2 = c + t

19. Hotelling Model Observations: –Price equals marginal cost plus a mark-up that depends on the degree of product differentiation (t). –Stronger differentiation = higher mark-up = higher prices. –No differentiation (t = 0) gives perfect competition (p = c). Profits at equilibrium prices:  1 =  2 = t / 2. Stronger product differentiation equals higher profits. –Stronger differentiation makes consumers more ‘loyal’ to a product in the face of a price increase. –Firms can increase prices with less fear of losing customers to their rival (makes each firm’s demand less elastic).

20. Example 2 Repeat the previous example for t = 4 and compare. Suppose c = 1. Calculate equilibrium prices and profits in the Hotelling model for t = 2 and t = 4 and compare.

21. Implications for E-commerce Product differentiation can increase profits and help to offset pro-competitive effects of e- commerce such as freer entry and exit. E-commerce stores are easier to customise, and can be customised to every individual consumer. Use information about customer’s past purchases and activity to customise the web store for them.

22. Implications for E-commerce Example: Amazon customisation

23. Implications for E-commerce Recommendations explicitly based on purchase history.

24. Implications for E-commerce Amazon uses my purchase history to customise its website for me. Its ability to do this makes Amazon more valuable to me than a competitor that I have never used before. This differentiates Amazon from its rivals and makes it less likely that I will switch if Amazon raises its prices a little. Differentiation based on customer data.