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
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 pL and pR
• 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 pL +cx
• Consumer’s total cost at R is pR +c(1-x)
• Consumer buys from business where she has
lower cost
• This determines the marginal consumer x  that
is indifferent between buying from L and R
1 pR  pL
• This is given by x  
2
2c



p
p
• The optimal prices of both firms are L = H =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
d 2t
• Therefore E’s profit, were it to enter is
4
F
• Entry is profitable if d  2
t
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