PART III PRICE AND NON-PRICE STRATEGIES III.3 PRODUCT DIFFERENTIATION

PART III PRICE AND NON-PRICE STRATEGIES

III.3 PRODUCT DIFFERENTIATION

Example

Credit cards in the US - 4000 firms

- goods seem homogeneous - s

= 20%

- no significant entry barriers - national business

- no apparent collusion However

- specific interest rate do not vary with maket interest rate

- profitability is 3 to 5 x higher than in the bank sector in general during 1983-88.

Reasons?

- Switching costs

- Differentiated products

In the present chapter:

- Differentiated products

- Switching costs & imperfect information

III.3.1 HORIZONTAL AND VERTICAL DIFFERENTIATION

- “It takes all sorts to make a world”

- Horizontal differentiation: Consumer 1 prefers good A to good B while consumer 2 prefers prefers good B to good A.

- Instead, vertical differentiation refers to a situation where ALL consumers prefer

one good to another.

- In practice, almost all goods are both vertically and horizontally differentiated.

- Example: brand-name drugs versus generic drugs.

- The “characteristics” model:

! The consumers demand is about the characteristics of a product rather than about the product itself.

! Example: PC’s characteristics such as RAM, processor speed, screen

size, etc.

A simple illustration

- The demand by consumer i (i = A, B) for car k

Car characteristics HP/W Air Co Cons Size Price

GM Geo 0.3 0 64 0.9 4

Porsche 1 1 12 1.2 68

Valuation by i = A, B

By a student (A) 5 0.5 0.1 1 − ¹

By a CEO (B) 40 40 0 20 − ¹

Net utility: u

= b

c

+ … + b

c

− ^p

" u

= 4.8 u

= − ^{60.1 u}

= 26 u

= 36

- Advantages of the characteristics model:

! Vertical AND horizontal differentiation

! Used in marketing

III.3.2 DIFFERENTIATED PRODUCTS AND MARKET POWER

- What are the implications of product differentiation on the oligopolistic competition?

- Use a model of horizontal differentiation

Imagine:

- A beach that is 1 mile long, with icecream sellers at each end of the beach.

- Same product

- Even if the price is the same at both sellers, almost nobody on the beach is

indifferent between the sellers because of transport costs

We generalize:

- By analogy, products are different in terms of characteristics and consumers differ in their appreciation of these characteristics

- Consumers are distributed all along the line - “transport costs” = “differentiation costs”

- “spacial differentiation” transposed to the differentiation by product characteristics Very  sweet  

corn  flakes   No  sugar  

added  corn  

flakes  

Question:

- How do firms (sellers) compete in price when their products are horizontally differentiated?

HOTELLING MODEL

- Continuum of consumers uniformly distributed along a line of length equal to 1 - 2 sellers, A and B, located at each end of the line.

- Producers decide their price (p

, p

) as in a Bertrand model - Consumers choose where to buy one unit of the good

- t is the transport cost per unit of distance

- Timing: 1

, sellers choose prices and, 2

, consumers choose where to buy

- Backwards induction

Derivation of the equilibrium - Consumers problem

! Expenses for a consumer located at x who buys at A = p

+ t x

! Expenses for a consumer located at x who buys at B = p

+ t (1 – x)

! Indifferent consumer x’, with x’ such that p

+ t x’ = p

+ t (1 – x’)

!

€

x ʹ′ = 1

2 − p

− p

2t ^and

€

1 − ʹ′ x = 1

2 + p

− p

2t

! Demands: D

= x’ and D

= 1 − x’

! Graphically:

P

P

P’

A   B  

P’

x’

D

D

! Difference with the Bertrand model:

Even if p

> p

, D

> 0.

! This happens because consumers consider that the goods are not homogeneous because of the “transport costs”.

! If t is very low, we get closer to Bertrand: the seller selling at the lowest

price would get the whole market (see on graph)

- Sellers problem

! seller A:

€

Max

Π

= ( p

− c ) ^D

⁼ ( ^p

^{− c} ) ^{⎛ 1} ₂ ^{− p}

_2t ^{− p}

⎝ ⎜ ⎞

⎠ ⎟

! A’s best reply:

€

p

( p

) ≡ p

= c + t + p

2

! seller B:

€

Max

Π

= ( p

− c ) ^D

⁼ ( ^p

^{− c} ) ^{⎛ 1} ₂ ^{+ p}

_2t ^{− p}

⎝ ⎜ ⎞

⎠ ⎟

! A’s best reply:

€

p

( p

) ≡ p

= c + t + p

2

! Equilibrium: p

= p

= c + t > c

! Market power, increasing in t, that is, increasing with differentiation

- This is the third difference so far with respect to the Bertrand Paradox:

! Capacity constraints

! Repeated interactions

! Differentiated products

III.3.3 PRODUCT POSITIONING

- Another decision variable for firms: location - Equivalent to product positioning

- Timing

! 1. Location (long-term decision)

! 2. Price (short-term decision) - Equilibrium location?

- Stategic dimension because a firm’s profits do not only depend on its location but

also on its rivals locations.

! Graphically: let B’s location l’

be given.

P

P

P’

A   B  

P’

l’

D

D

l

x’

For A’s location choice l

, given l’

, we have 2 effects: a direct one and an indirect one.

- Direct effect

The closer is A to B, the higher the demand for A (indifferent consumer varies) and therefore, the higher A’s profits (see graph)

- Indirect effect

Price are not exogenous. Future prices are best replies to locations.

! if locations are too close, products are homegeneous from the consumers point of view. Back to Bertrand, even with transport costs: p = c

! if locations are further apart, as in the former section (l

= 0 and l

= 1), then firms obtain market power: p = c + t.

- Trade off between the direct effect and the indirect effect

III.3.4 IMPERFECT INFORMATION AND SWITCHING COSTS

- characteristics of differentiated goods are different or …

- can be a different perception of a good characteristics by the consumers

- can be the same good but consumers have imperfect information about prices and they have search costs

- can be switching costs