Product Differentiation

Product Differentiation

New Palgrave Dictionary contribution

Simon P. Anderson

Commonwealth Professor of Economics, University of Virginia,

PO Box 400182,

Charlottesville VA 22904-4128,

USA.

sa9w@virginia.edu

This version March 31st 2005. COMMENTS WELCOME

Abstract

Product differentiation is pervasive in markets. It is at the heart of structural empiricism and it smoothes jagged behavior that causes paradoxical outcomes in several theoretical models. Firms differentiate their products to avoid ruinous price competition. Representative consumer, discrete choice, and location models are not necessarily inconsistent, but performance depends crucially on the degree of localization of competition. With (symmetric) global competition, rents are typically small and market variety near optimal. With local competition, profits may be protected because entrants must find profitable niches. These rents lead firms to competitively dissipative them, and performance may be poor.

1. Overview

Consumer goods are available in a variety of styles and brands. Product differentiation refers to such variations within a product class that (some) consumers view as imperfect substitutes. The store Foods of all Nations in Charlottesville, VA (area population 120,000) carries 118 varieties of hot pepper sauce, 41 balsamic vinegars, and 121 different olive oils (these figures include variations such as flavorings and different package sizes from the same manufacturer). There are 82 other retail grocers listed in the area. Charlottesville is served by 23 rated radio stations which differ by format choices (18 are commercially operated).

Product differentiation offers firms market power. This enables them to transcend the Bertrand Paradox for pricing homogeneous products. In the Bertrand Paradox, two or more firms sell goods that consumers perceive as identical, so goods are perfect substitutes. Assume that marginal costs are common and constant, and market demand has a finite price intercept. Then one good cannot carry a price premium over another while retaining positive sales. Any lowest price above marginal cost would then profitably be undercut. This logic impels us to marginal cost pricing as the only equilibrium under Bertrand competition.

Product differentiation resolves the paradox naturally. When products are imperfect substitutes, a price-cutting firm cannot take all of its rivals' customers with an infinitesimally small price cut. This means that firms have some market power (due to the special features that distinguish them from their rivals' products); they can set prices without a completely elastic response by consumers. It also means that the product itself becomes a choice variable and firms differentiate to avoid the Bertrand outcome.

However, many models of product differentiation do not treat this choice explicitly, and instead assume a framework (representative consumer, discrete choice, and symmetric location models) that generates a demand system. It is not so much the framework used but rather the structure of product differentiation that is critical to the predictions and results. Indeed, common models of one type may be recast within another framework and be formally equivalent. Instead, the important feature for performance is whether each product is equally substitutable with all others or if each has only few close substitutes which are chain-linked to other products in the industry. Equal substitutability describes global competition where each firm competes with each other firm. Chain-linking corresponds to local competition. Local competition models naturally apply in geographical space since nearby stores are closer substitutes for consumers than distant ones. Likewise, in a characteristics setting, a consumer with a sweet tooth will find sugary products closer substitutes for any sweet product than for a saltier one.

The next section describes models of product location (in geographical space or its characteristics analogue) and distinguishes horizontal from vertical differentiation. Section 3 compares the common approaches to product differentiation used to analyze the market provision of variety. In these models, product decisions are suppressed and product selection is determined by entry. Section 4 describes how the market variety diverges from the equilibrium one. Section 5 elaborates on this theme for local competition. Section 6 indicates how product differentiation is used elsewhere in economics.

2. Product choice

Hotelling (1929) wrote the seminal paper treating the product specification as endogenous. Applications beyond Industrial Organization include marketing, economic geography (spatial competition), political science (the "Hotelling-Downs" model), and media economics. The basic paradigm is that consumers are differentiated by their locations ("addresses") and dislike distance. Products, too, are locations in this space (geographic, characteristics, etc.). When products are priced at marginal cost, consumers differ by which they like best, a situation known as horizontal differentiation. The simplest version of the model has two ice-cream sellers locating on a beach (with fixed prices). The Nash equilibrium is back-to-back pairing at the median of the consumer distribution, a result christened the Principle of Minimum Differentiation. It has been used to explain striking similarities in colas, gas station location, political parties' platforms, and the timing of television programs.

However, the Principle dissolves when firms locate in rational expectation of ensuing equilibrium prices (i.e., seeking a sub-game perfect equilibrium to a two stage price-then- location game). Indeed, if two products were collocated, Bertrand competition would

drive prices to marginal cost. Firms will avoid this ruinous result by differentiating to retain market power attributable to location advantage. The equilibrium trades off two opposing factors. Getting closer to a rival provokes more intense price competition so firms differentiate in order to relax price competition, but getting close to a rival attracts more customers.

The equilibrium locations are outside the optimum ones (which are at the quartiles for a uniform consumer density) for the central case of quadratic distance disutility costs, but otherwise there is no fundamental reason for excessive market differentiation. More elaborate models can rapidly become quite