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Product Differentiation. Horizontal product differentiation: Consumers have different preferences along one dimension of a good. Example: some consumers prefer hot salsa, some prefer mild.

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## Product Differentiation

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**Product Differentiation**• Horizontal product differentiation: Consumers have different preferences along one dimension of a good. • Example: some consumers prefer hot salsa, some prefer mild. • Vertical product differentiation: Consumers have the same ordinal preferences, but not the same cardinal preferences. • Example: all consumers prefer better fuel efficiency, but their willingness to pay will differ.**Product Differentiation as a Competitive Strategy**• Firms seek to be unique along some dimension that is valued by consumers. • Differentiation can be based on the product itself, the delivery system, or the marketing approach. • If the firm/product is unique in some respect, the firm can command a price greater than cost.**Price Competition and Product Differentiation**• Model of Bertrand competition combined with “location” choice • Firms choose “location” along a spectrum • Can think of this as the same product in different location, or • Can think of this as different products**Chili Peppers -- Hotness measured in Scoville Units***Habanero = 100K Sweet Italian = 0 Cayenne = 30K Jalapeno = 2.5K Thai = 50K *Source: http://www.cybersauce.com/knowldge.htm#scoville**Firm A at location 0**Firm B at location 1 0 1 • Assumptions on firms in the model • Both firms have the same marginal cost, c • Each firm located at a specific point of the spectrum • Firms set prices pA and pB**Firm A at location 0**Firm B at location 1 0 X 1 • Assumptions on consumers in the model • Each consumer has a gross value for the good, V • Consumers buy from firm that provides highest net value • Each consumer located at certain point on the spectrum • Consumer must transport the good from firm • Net value = V - p - t*(distance between firm & consumer) • Will not purchase if net value < 0**Firm A at location 0**Firm B at location 1 0 X 1 • Example • Consumer at X compares net value from each firm • If [V - pA - tX] > [V - pB - t(1-X) ], buy from firm A • Rearrange to get: pB - t(2X-1) > pA • So, if X .5, pA must be less than pB • If X < .5, pA can be higher than pB**Z**Firm A at location 0 Firm B at location 1 0 X 1 • Nash Equilibrium • Look for NE where all consumers buy (requires a high V) • Step 1: Figure out each firm’s profit • First, need to get a handle on demand • If person at X buys from A, so will everyone to his left • Find consumer, Z, who is indifferent between A and B • Then demand for A = ZN and for B = (1-Z)N • (N = size of market)**Z**Firm A at location 0 Firm B at location 1 0 1 • Nash Equilibrium, con’t • Find Z so that: [V - pA - tZ] = [V - pB - t(1-Z)] • This simplifies to: pA + tZ = pB + t(1-Z) • Or: Z = (pB - pA + t)/2t • Then demand of firm A = ZN = N(pB - pA + t)/2t • And profit of A = (pA- c)*N(pB - pA + t)/2t • By symmetry, profit of B = (pB- c)*N(pA - pB + t)/2t)**Z**Firm A at location 0 Firm B at location 1 0 1 • Nash Equilibrium, con’t • Next step: Derive Best Response • Take derivative of profit w.r.t. Price • Profit of A = (pA- c)*N(pB - pA + t)/2t • Or: N/2t*(pApB - pA2 + pAt - c pB + c pA - ct ) • So derivative = N/2t*(pB - 2pA + t + c) • Set = 0: N/2t*(pB - 2pA + t + c) = 0 • Solve: pA = (pB + t + c)/2**Z**Firm A at location 0 Firm B at location 1 0 1 • Nash Equilibrium, con’t • Final step: Use BR’s to find NE • BR for firm A: pA = (pB + t + c)/2 • By symmetry, BR for firm B: pB = (pA + t + c)/2 • Substitute BR for firm B into BR for firm A: • pA = (pB+t+c)/2 = [(pA+t+c)/2+t+ c]/2 = pA/4+3t/4+3c/4 • 3/4 pA = 3/4[t + c] • So, pA* = t + c, and by symmetry pB* = t + c,**So.....**• With differentiated products, Bertrand competition does not collapse to zero profits • Firms price above marginal cost and make profit • Note that the higher t is, the higher are prices and the more profit the firms make • t is a measure of the degree of product differentiation • Why? • Demand for each firm’s product is downward sloping: qA = a - bpA + dpb**Product Positioning**• How do firms choose where to “position” their products? • Previous model explains competition once position determined, but position is not exogenous. • Two stage game: Position selected first, then price.**Product Positioning, con’t**• The closer your product is to your competitor’s, for a given set of prices, the higher your demand will be, “the direct effect”. • The closer your product is to your competitor’s, the more intense will be price competition and thus the lower your demand will be, “the strategic effect”.**Firm A’s new location**Firm A at location 0 Firm B at location 1 0 0.5 0.66 0.33 1 • The “Direct Effect” • Assume both firms set the same price • If located at either end of the spectrum, they split demand. • If firm A moves closer to Firm B, Firm A’s demand (and thus profit) will increase, assuming no change in price.**But if Firm A moves to 0.33, Firm B will also want to**relocate to get closer to Firm A. • How do you find a NE in locations? It becomes very complicated. • If both locate in the same place, products are identical and competition drives price to MC so firms have an incentive to differentiate. • However both firms want to maximize demand and thus are driven towards the middle. • The end result depends on consumer’s value for the product, the “transportation costs” and the firms’ costs.**Search Costs**• Consumers often lack information about a product’s characteristics or price related to the characteristics or price of other goods. • To gain information, the consumer must “search” i.e. incur a cost of acquiring the information. • Consumers should search as long as the benefit from search (increase in consumer surplus either because higher value product or lower price) is greater than the cost of search. • Firms can take advantage of the fact that consumers limit search and price above cost.**Switching Costs**• Consumers often must incur a cost to switch from one product to another. • For example, changing word processing software or finding a new insurance company. • Consumers will only switch when the benefit (increase in CS from higher value product or lower price) is greater than the cost of switching. • Since consumers don’t switch instantaneously, firms may be able to price above cost. • Firms may lower switching costs to compete: • Example: Sprint will switch you for free.

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