Lecture 3

Product differentiation

• Competing firms differentiate their products in such way that products fulfilling the same need typically do not have identical features.

• The differentiation of goods along key features and minor details is an important strategy for firms to defend from intensive price competiton and gain market power.

Horizontal Differentiation (variety)

• Horizontal differentiation occurs in a market when products are different according to features that make them more attractive for certain groups of customers and less attractive for others groups of customers.

• Those features cannot be ordered.

• Ex:Redcarsarenot“better”thanbluecars.Intermsof Nespresso coffee, “Ristretto” is not better than “Volluto” or “Roma”

• With the same price, different consumers buy different products.

Vertical Differentiation (quality)

• Vertical differentiation: products can be ordered according to their objective quality.

– Ex: Mercedes and Fiat, Prada and Zara

• Firms that succeed in increasing perceived quality of their goods can set higher prices because some consumers are willing to pay more for additional quality.

• If prices were identical all consumers would prefer to buy the product with higher quality.

Basic Concept:

The Hotelling model typically involves a scenario where two sellers (or firms) are deciding where to locate along a linear market (often represented as a line segment, like a street or a beach). The consumers are evenly distributed along this market. The two main assumptions of the model are:

1. Consumers buy from the nearest seller: This is to minimize travel costs or inconvenience.

2. Sellers want to maximize their market share: Each seller aims to attract the most customers.

Classic Example:

Imagine a beach that is 1 km long. Two ice cream vendors (Vendor A and Vendor B) are deciding where to place their stands along the beach. Beachgoers are evenly spread along the length of the beach and will buy ice cream from the nearest vendor.

Scenario:

1. Both vendors at the ends of the beach: If Vendor A sets up at one end (0 km mark) and Vendor B at the other end (1 km mark), they each capture half the market. However, this is not a stable equilibrium, as each vendor can increase their market share by moving closer to the center.

2. Both vendors in the middle: If both vendors move towards the center, they continue to share the market equally, but with reduced travel distance for customers. The model predicts that both vendors will end up back-to-back in the center of the beach. This is the Nash Equilibrium of this model - a stable state where neither vendor can improve their position by moving.

Key Insights:

• Principle of Minimum Differentiation: The model suggests that firms often end up very similar to each other (e.g., location, products) in an attempt to capture the largest market share. This leads to less variety for consumers.

• Trade-offs: The model highlights the trade-offs between competition (for market share) and customer convenience.

direct cost: bus ticket

indirect cost: opportunity cost of time

Nash Equilibrium for a price game

Is a pair (PA*, PB*) such that PA* is the best response against PB* and vice-versa.

Suppose that a=1-b, that is, assume that both firms are located on the same position.

In this case the model is equivalent to the Bertrand model and there exists a unique equilibrium given by:

PA*= PB*= MC There is no differentiation.

The market center: a=1-b=1/2

• If there is no competition in prices firms tend to locate in the center of the variety space with a minimal product differentiation.

MINIMUM DIFFERENTIATION PRINCIPLE

The Quadratic Transportation Costs Case

• If we consider quadratic transportation costs we can show that each firm will choose to locate in one end of the market.

MAXIMUM DIFFERENTIATION PRINCIPLE

• Intuition: when firms are located far apart they reduce the intensity of price competition and gain market power.