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Strategic Management II
1. Product differentiation - Slides & Chapter 5
Differentiation reduces the substitutability of products for consumers and shapes the nature
of competitive interaction between firms. If the firm can develop dimensions in which to
effectively differentiate its product (e.g. horizontally and/or vertically), it can reduce the
intensity of competition and increase profits. Two products are differentiated if consumers
perceive different value from them. (That is, two products X and Y are differentiated if prices
exist at which some consumers prefer to purchase X and some consumers prefer to
- - Horizontal Differentiation: Two products are horizontally differentiated if neither of them attracts all demand when they are equally priced.
o Source of differentiation: Geographic distance. Consumers generally vary with respect to their ideal location, and thus differ on their valuation of firm locations.
Vertical Differentiation: Two products are vertically differentiated if one of them attracts (almost) all demand when they are equally priced.
o Source: Quality is a source of vertical differentiation. Consumers agree on positively valuing quality, but generally differ on how much they value it.
Effective differentiation reduces the intensity of competition. Two competing firms can sustain positive markups when their products are differentiated. (Consider pure price competition: Without differentiation, Bertrand paradox, zero profits; with differentiation: positive profits. Thus, product differentiation can be a source of competitive advantage).
- In the case of horizontal differentiation: Consumers vary with respect to their ideal location and price is not the only relevant factor when choosing among products.
In the case of vertical differentiation: Higher quality product can be sold at a higher price than a lower quality product, attracting consumers ready to pay more for superior quality.
Horizontal Differentiation 1 Linear city (Hotelling Model): provides the simplest instance of horizontal differentiation and explains its basic implications for consumer demand and product pricing.
Two firms A and B are located on the extremes of a segment of unit length (on 𝑥 = 0 and 𝑥 = 1), with unit cost c. Consumers are uniformly distributed over the segment (or ‘city’). Each consumer has a unit demand and obtains value s from the good (we assume all consumers purchase). Consumers incur a transportation cost 𝑡 ⋅ 𝑑, where 𝑑 is the distance travelled to purchase.
- Example: Consider the consumer located at 𝑥 = ¼.
Consumer utility if purchasing from firm A (at 𝑥 = 0): (𝐴) = 𝑠 – 𝑝𝑎 – 𝑡 ⋅ ¼.
Consumer utility if purchasing from firm B (at 𝑥 = 1): (𝐵) = 𝑠 – 𝑝𝑏 – 𝑡 ⋅ ¾.
If 𝑝𝑎 = 𝑝𝑏, she will prefer to purchase from firm A.
If 𝑝𝑏 = 𝑝𝑎 – 1/2 𝑡, she is indifferent between purchasing from both firms.
The location (demand) of the consumer indifferent between both is x.
𝑠 – 𝑝𝑎 – 𝑡𝑥 = 𝑠 – 𝑝𝑏 – 𝑡 (1-x) 𝑥 . All consumers with 𝑑i < 𝑥 will prefer to purchase from firm A (a mass of 𝑥 consumers), and all consumers with 𝑑i > 𝑥 will prefer to purchase from firm B (a mass of 1 − 𝑥 consumers).
The demand of firms is given by: 𝑝 𝑝 𝑡 𝑝 𝑝 𝑝 𝑝 𝑥 𝑡 𝑡 𝑝 𝑝 𝑡 𝑝 𝑝 𝑝 𝑝 𝑥 𝑡 𝑡 Profits (symmetric): = (𝑝 𝑝 )(𝑝 – 𝑐).
Firm 𝑖 sets price 𝑝 to maximize .
Reaction function of firm 𝑖: 𝑝 = 1/2 (𝑝 + 𝑐 + 𝑡).
There is a strategic complementarity in prices.
In equilibrium: pa=pb=c+t 𝑡 Markups and profits depend on 𝒕, which captures the degree of consumer preference for differentiation. When 𝑡 converges to zero, there is no differentiation and we obtain the Bertrand paradox.
You can increase the level of differentiation by: - By increasing transportation cost t: For example, by advertising brands, firms can create “nonexistent” differences among products-just with brand differentiation o Persuasive advertising: Generates dimensions of differentiation without providing information. Tends to soften competition.
o Informative advertising: Provides information about the product (characteristics, price, location). Tends to intensify competition.
- By increasing switching costs: Due to switching costs, a consumer may prefer to purchase the same product she consumed in the past, even in the presence of substitutes offered at a lower price. (For example, search costs to identify alternative 2 - - suppliers, transaction costs to initiate new contractual relationships, learning costs to use a new product).
Locating the firm far away from competitors. When a firm locates away from other firms, the global profits of the market increase Position can have: o Direct effect: The closer your product is to your competitor’s, for a given set of prices, the higher your demand will be.
o Strategic effect: The closer your product is to your competitor’s, the more intense will be price competition and thus the lower your price will be.
Circular city (Salop’s Model): formalizes the scope for differentiation and its basic implications for product variety and firm profits. In this model, firms locate on the perimeter of the circle, where the length is normalized to 1. There are n firms located over the perimeter, all with MC of c. Consumers obtain a utility s from buying the product, and are uniformly distributed over the circle. They incur a transportation cost of t*d, where d is the distance travelled in order to purchase the good.
In a symmetric equilibrium where all firms quote the same price, each firm attracts an equal share of consumers (Note that in practice each firm has only two competitors: the two firms surrounding it on the circle’s perimeter).
In equilibrium: 𝑝 𝑐 and . So as you can see, firm profits are decreasing in n.
The scope for differentiation is finite, and effective differentiation among firms is reduced as the number of competitors increases.
If firms can decide whether to enter or exit the market, how many firms will enter the market? =√ , Where F stands for the fixed cost of entry. It may seem clear that firms will enter the market until the profit of entry is zero (𝑝 ) − 𝐹 = 0.
The number of firms increases in t. That is, the more consumers wish differentiated products, the more firms cater to their needs. The higher the fixed cost of entry F is, the less firms there are (Equivalent to high entry barrier; If fixed cost is zero, the competition is perfect).
Vertical Differentiation In this model, firms 1 and 2 supply products of different quality, where 𝑠 𝑠 , and unit cost c. Consumers’ valuation of quality is uniformly distributed such that [ ], and the utility derived is 𝑖 𝑠 𝑝 . Consider that consumers have unit demand and they all purchase a product.
Consider a consumer , and that 𝑝 𝑝 , given that 𝑠 purchasing from firm 2 instead of firm 1 is: 𝑠 . The marginal utility of 3 ( 𝑠 𝑝 ) ( 𝑠 𝑝 ) 𝑠 𝑠 𝑝 𝑝 If is sufficiently low, the consumer doesn’t value quality much and prefers firm 1(low quality product).
If is sufficienctly high, the consumer does value quality and prefers firm 2 (high quality product).
To calculate the demand of firms 1 and 2, given prices: 𝑥 , all consumers with a high valuation of quality will purchase from firm 2 𝑥 consumers), ( 𝑝 𝑝 𝑥 and all consumers with lower valuation will purchase from firm 1 (𝑥 𝑝 𝑝 𝑥 Profits, which are asymmetric (𝑠 𝑠 , are: 𝑝 consumers), 𝑐 .
To sum up: - - Each firm sets prices to maximize profits, with reactions functions such like that: 𝑝 𝑝 𝑝 𝑐 𝑠 𝑠 𝑝 𝑝 𝑝 𝑐 𝑠 𝑠 There is a strategic complementarity in prices In equilibrium: 𝑝 - 𝑝 Markups and profits depend on the degree of vertical differentiation, this is, the difference in qualities.
When there is no differentiation (𝑠 𝑠 , we get the Bertrand result.
Strategic implication: A certain degree of differentiation softens price competition and increases profits Quality/price niches In general, maximum differentiation doesn’t maximize profits: 4 - If it is costly for firms to supply quality, that is 𝑐’(𝑠) > 0, the firm with the higher quality may choose not to offer the maximum feasible quality 𝑠 The firm with the lower quality will not choose zero quality,𝑠 , but will instead prefer an intermediate quality to distance its product from the competitor’s while generating value for consumers, 𝑠 𝑠 .
Network Effects Network effects are a source of vertical differentiation. They are present when the value of a good or service directly depends on the number of its users. A utility function with network effects: (𝑖) = 𝑠 + ( ) – 𝑝 • Where is the number of consumers (and maybe producers) of product i, and () is an increasing and concave function.
Price Discrimination A firm price discriminates when it charges different prices to different consumers that don’t reflect cost differences. By doing so, firms increase total revenues. Conditions needed: - At least two consumer group exist with different price elasticities (different demand curves).
The firm should be able to identify consumers in each group, and set prices differently for each group. That is, requires sufficient information and market power.
There must be no arbitrage, that is, the firm must prevent consumers in one group selling to consumers in the other.
There are three types of price discrimination: - - - First-degree price discrimination: Individual pricing, also referred as perfect discrimination. Allows for perfect discrimination. The price charged for each unit is the individual’s maximum willingness-to-pay for that unit. It’s kind of feasible now, using internet and big data.
Second-degree (indirect) price discrimination: Also referred to as non-linear pricing, quantity discounts, and versioning. Price depends on the number and type of units bought and sold, but not on the purchasing consumer. Indirect price discrimination uses consumer choice or ‘self-selection’, as a price discrimination tool. Coupons works as a price discrimination tool because they are difficult to use (people with low value of time or high price sensitivity will find coupons use beneficial). Quantity discounts and product bundling are also related with price discrimination mechanisms. The advantages of indirect price discrimination are: o It is unnecessary to observe the individual characteristic of the consumer.
o Arbitrage is prevented by self-selection.
o A disadvantage is that it is not easy to design optimal menus of contracts – a new tool is needed: Mechanism design.
Third-degree (direct) price discrimination: Different consumers are charged different prices for the same good. We separate consumers based on some observable and 5 fixed characteristics (by location, age, gender, employment…). For example, discount to students…etc o Selling additional output in elastic market (lower price).
o Reducing sales in the inelastic market (increase price).
The main problem is the possibility of resale (arbitrage): Individual services, large transportation costs, products protected by regulations…etc 6 7 ...