Slide.

2ème année de la Grande Ecole de l’Institut de Rabat

Semestre 3

Industrial Organization
Ch5:
Differentiation

1st Term 2017-2018

Slide.2

Plan for today

• Understand that product differentiation involves two conflicting
forces: it relaxes price competition, but it may reduce the demand that
the firm faces.
• Be able to distinguish between horizontal and vertical product
differentiation.
• Reconsider the question of entry into product market.
• Be exposed to some basic approaches to estimate differentiated
product markets.

Industrial Organization
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Product differentiation
• Product differentiation can be viewed as the ability of producers to
create distinctions (in a physical or in a psychological sense) between
goods that are close substitutes.
• Consumers no longer regard them as identical or near-identical.
• Products are differentiated by their characteristics or attributes.
• Product differentiation depends on consumers’ preferences.
• Characteristics approach
• Preferences are specified on the underlying characteristics space
– Discrete choice approach
• Consumers have heterogeneous preferences and choose one
(and only one) product among the available products
• e.g., Hotelling model
– Representative consumer approach
• Consumers are assumed to be identical and have a variable
demand for all products
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Horizontal Vs. Vertical differentiation

• Horizontal product differentiation
– Each product would be preferred by some consumers.
– If, at equal prices, consumers do not agree on which product is the
preferred one.
• Vertical product differentiation
– Everybody would prefer one over the other product.
– If, at equal prices, all consumers prefer one over the other product

– NB: Sometimes, it is not easy to draw the distinction in practice.

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Horizontal differentiation

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Vertical differentiation

• Vertical product differentiation : consumers prefer one over the other

product .

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Natural Vs. Strategic Differentiation

• The distinguishing characteristics of differentiated products and services
may be classified as either natural or strategic.
– Natural product differentiation: the distinguishing characteristics
arise from natural attributes or characteristics, rather than having
been created through the actions of suppliers.
– Strategic product differentiation: the distinguishing characteristics
are consciously created by suppliers: for example, through a decision
to create a new brand and promote it by means of advertising or other
types of marketing activity.

Industrial Organization
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Sources of natural product differentiation

• Geographic variation: the location of a seller automatically
differentiates a product or service in the minds of consumers.
• New technology: it can be used to differentiate a product. i.e Retina for
apple.
• Brands and trademarks: are used widely to differentiate similar
products.
• Community or national differences: Here the country or community of
origin is the defining attribute that differentiates goods and services (i.e
Swiss watches, Italian designer clothes, Hollywood movies).
• Consumer tastes and preferences: Consumers themselves have
different attributes, tastes and preferences. Examples include the color of
cars and the style of clothes.

Industrial Organization
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Sources of strategic product differentiation

• Factor variations: Factor inputs such as labor and capital are rarely
homogeneous. Final outputs to be marketed as distinct from those of other
firms.
• Additional services: can often be used to differentiate products. Even if
the same product is available from two suppliers, the conditions
surrounding the sale might be different (cheaper credit, faster delivery
times or a more comprehensive after-sales service.)
• Rate of change of product differentiation: Products with a short natural
lifespan can be subjected to planned obsolescence (Intentional physical
obsolescence ; Style obsolescence; Technical obsolescence; postponed
obsolescence).
• Consumer ignorance: Ignorance on the part of consumers can allow
firms to exaggerate the extent of differentiation of their products and
services (misleading advertising). Sometimes suppliers attempt to
convince consumers that higher prices reflect higher quality.

Industrial Organization
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Common approaches in horizontal differentiation

• There are two common approaches to the specification of consumers’
preferences when products are horizontally differentiated.
– The goods branch (Representative consumer models) assumes that
consumers have preferences over goods and a taste for variety. Firms
compete to attract consumers by differentiating the goods or services
they offer.
– The address branch (Spatial or location models) assumes that
consumers have preferences over the characteristics of products.
consumer demand for a particular firm’s product might be highly
dependent on small changes in the price set by another firm whose
product embodies a very similar bundle of characteristics; but
independent of small changes in the price set by a third firm, whose
product characteristics are further removed (McDonald’s, Burger King
and Pizza Hut).
• These different approaches to specifying the preferences of consumers
give rise to different modeling approaches, address models and
monopolistic competition.
Industrial Organization
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Monopolistic competition
• Two key assumptions typically underlie the specification of preferences
in models of monopolistic competition:
– There is a very large set of possible differentiated products over
which the preferences of consumers are defined.
– The preferences of consumers over the set of all possible
differentiated brands are symmetric.
• Symmetric preferences mean that the representative consumer views all
products within the set of differentiated products as close substitutes for
each other (and as relatively poor substitutes for products outside of the
group)
• Cross-elasticities of demand within the group are significant and equal,
but insignificant with products outside the group.

Industrial Organization
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Monopolistic competition
Preferences of consumers are defined over all possible differentiated products
and that these products are imperfect substitutes is that consumers have a taste
for variety
A Taste for Variety

Indifference curve

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Monopolistic Competition: Equilibrium

• The assumption of symmetry and consumers’ taste for variety imply the
essential feature of monopolistic competition: every brand is in
competition with every other brand.
Monopolistically Competitive Equilibrium for firm i
Two conditions must be satisfied
for a free-entry equilibrium:
1. Profit Maximization: Firms in
the industry must be profit
maximizing
2. Free-Entry Condition: There
must not be an incentive for
firms to enter or exit. (the
profits of firms in the industry
must be zero.
DD : demand for i if all firms in the industry change their price simultaneously.
dd: demand for i if all other firms keep their price constant as firm i changes its pric
Why demand curve is not perfectly elastic?

Industrial Organization
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Determinants of the Monopolistic Competition Equilibrium

• The equilibrium number of firms depends on the extent of scale
economies and the elasticity of substitution.
– ↑ the elasticity of substitution increases ⇉ the markup and the price ↓
– ↑ in the extent of scale economies ⇉ ↓ the number of firms and hence varieties.
The Excess-Capacity Result
• The equilibrium two interesting characteristics:
– Price exceeds marginal cost, so that firms are exercising market power.
– Firms are not producing where their average costs are minimized.
• Does the free-entry equilibrium results in the optimal extent of
product diversity?

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Determinants of the Monopolistic Competition Equilibrium

• Does the free-entry equilibrium results in the optimal extent of product
diversity?
• Trade-off between variety benefits and the decrease in cost efficiency.
– Welfare could be improved if the number of firms or products were reduced
(decrease in average industry cost as the remaining firms exploit available
economies of scale and move down their average cost curves, arguably
leading to lower prices and increased consumption).
– This argument ignores the consumers’ love of variety. Reducing the number
of varieties available reduces the welfare of consumers (Decreasing the
number of products reduces variety, average costs, and prices).
• Two effects to consider:
– Business stealing or trade diversion: Incumbents accommodate entry by reducing
their output. This provides excessive incentives for entry and contributes to an
excessive number of firms ( ) f: fixed costs of entry
– Nonappropriability of Total Surplus: When a firm introduces a new product its
profits do not equal total surplus. Instead some of the benefits from the introduction
of a new product are captured by consumers. ( )
Industrial Organization
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Monopolistic Competition: Equilibrium

Asymmetric Preferences
• Consumers view the products within the set of differentiated products as
NOT close substitutes for each other.
• Suppose that there are only two substitute products that could be
produced.
• The producer will have a bias against products with relatively inelastic
demands since it captures more of the gross surplus of the good with
relatively elastic demands.
• Dixit and Stiglitz (1977) inelastically demanded commodities will be the
ones which are intensively desired by a few consumers. Thus we have an
“economic” reason why the market will lead to a bias against opera
relative to football matches, . . .
• The market will also be biased against the introduction of products that
have greater fixed costs.

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Address Models
• Address models of product differentiation assume that consumers have
preferences defined over the characteristics or attributes of products.
• The set of all possible products is called the product space and the total
number of attributes defines the dimension of the product space.
• The address of a product or brand corresponds to the point product
space determined by its bundle of attributes.
Breakfast Cereal Example of an Address Model
Consider a stylized view of the market
for breakfast cereals and assume that
consumers have preferences only over
two product attributes, crunchiness and
fruitiness.
The address of a brand is determined by
its crunchiness and fruitiness.

Industrial Organization
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Address Models
• In general, let θi be the address of brand i .
• Depending on the number of attributes, θi can be either a number or a
vector. then an address model of product differentiation is identical to a
model of firm location in physical or geographic space
Consumer Preferences
• Address models assume that consumer preferences are distributed in the
same product space.
• The address of a consumer represents their most preferred product.
• Tastes are asymmetric since different consumers have different addresses.
Consumers have completely inelastic demands in that they will purchase
a single unit of only one brand. The utility of a consumer located at
address θ* who purchases brand i is :
D = |θ∗ − θi | is the distance between the
address of the consumer and the address of
brand i.
pi is the price of brand i,
V is the consumption benefit of the consumer’s
Brands that are closer to the consumer’ s ideal are preferred. ideal product
However, a more distant— less preferred— brand might be purchased T(D): transportation, mismatch costs or
if it has a lower price. (dis)utility costs.
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Address Models
• Mismatch and transportation costs are assumed to be strictly increasing in distance.
• Common specifications for these costs are :
– (a) linear in distance, in which case T (D) = kD where k is the transport
cost per unit of distance;
– (b) quadratic in distance, in which case T (D) = kD2 .

• Address models also require that we specify how consumers are distributed
in product space.
• What is the density of consumers at each location? That is, relatively how
many have the same address?
• Suppose that products are differentiated only along a single dimension and
that the measure of the attribute is between 0 and 1.
• If the preferences of consumers are uniformly distributed, then their
location is evenly distributed along this unit interval.

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A Simple Address Model: Hotelling’s Linear City

It is a model developed by Hotelling (1929).
• Suppose initially there is a fixed number of firms, equal to N .
Assume that marginal production costs are c for all products and
less than the price (p ).
• Since we have fixed prices, competition between firms will be over
locations or product specification.
• Firms maximize their profits by maximizing sales.
• Maximizing sales requires that firms maximize their market lengths.
• Our objective is to identify the equilibrium set of locations or
products.

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A Simple Address Model: Hotelling’s Linear City

Mass of
consumers
1

0 x 1

Location of firm B
Location of firm A

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A Simple Address Model: Hotelling’s Linear City

Locations endogenous, price exogenous (fixed)
• Suppose that prices are fixed exogenously and equal.
• Products are differentiated in only a single dimension on the unit interval,
between 0 and 1.
• Consumers’ tastes are distributed uniformly.
• As prices are fixed and equal, utility-maximizing consumers will purchase
the product with the smallest transportation costs— they will purchase
from the firm whose location is closest to theirs.
• At which addresses (on the scale 0 to 1) should the two firms locate?
firm i is located at θi
Linear Address Model

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A Simple Address Model: Hotelling’s Linear City

where li is the market length, or interval, served by

firm i .
M: the density of consumers,
Mli is total sales of firm i .

Given that prices are fixed and > c,

firms maximize their profits by maximizing Let x be the location of the consumer
sales. Maximizing sales requires that firms between firm i and i − 1 who is just
maximize their market lengths. indifferent between the two firms.

Linear Address Model

firm i is located at θi

Industrial Organization
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A Simple Address Model: Hotelling’s Linear City

The address of the marginal consumer x is defined by:

Similarly, if y defines the location of the consumer between firm i and

i +1 who is just indifferent between the products of i and i +1, then
li = x + y , or:

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A Simple Address Model: Hotelling’s Linear City

• The market share, or length, of a peripheral firm increases as it moves closer to
its interior competitor. It gains sales in the interior, without losing sales on the
periphery.
• Define a firm’ s half-market length by its market length on one side. Then if
locations are chosen simultaneously, two conditions must be satisfied for a
Nash equilibrium in location:
– No firm’ s market length is less than any other firm’ s half-market length.
– The two peripheral firms must be paired. The peripheral firms must be
adjacent to an interior firm.
The equilibrium when there are 2 firms suggested to Hotelling that “ Buyers
are confronted everywhere with an excessive sameness”. The result that 2 firms
in either product or geographic space will locate in the middle is often referred
to as the principle of minimum differentiation.

firms 1 and 2 are located at .25 and .75 and they both serve half
of the market. The largest half-market length of either firm is .25, To avoid any risk, firms 1 and 2 choose to be located at .50
so the first condition is satisfied. However, either firm could
Insufficient differentiation from social
increase its profits by moving closer to the other.
viewpoint to minimize total transport
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A Simple Address Model: Hotelling’s Linear City

Free Entry into the Linear City
• We assume that each firm is restricted to producing a single product (or
locating at a single location).
• Determining the free-entry number of firms is equivalent to determining
the number of varieties offered in the market.
• In order to produce product θi a firm must first incur design and setup
costs specific to θi equal to 𝑓 (fixed cost). They are sunk due to their
location specificity.
• We suppose the magnitudes of the setup costs for each product are the
same.
• Firms enter the market sequentially.
• Prior to entry 𝑓 is not a sunk cost and hence the firm will only enter if it
anticipates that its profits are nonnegative.

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A Simple Address Model: Hotelling’s Linear City

Free Entry into the Linear City
• If we denote v as the length of the largest peripheral interval or market length
and w as the length of the largest interior interval.
• We assume (p − c) = 1, so that the profitability of an interval simply equals its
density (M) multiplied by its length (li ).
• Then in order for there not to be an incentive for an additional firm to enter as
an interior firm :

• and for there to be no incentive for an additional firm to enter as a peripheral

firm:

• The largest market length that an incumbent can capture without inviting entry
is:

• If every successful entrant has a market length of 2𝑓/M , then the minimum
number of firms in a market of unit length is :

Industrial Organization
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Exogenous location of firms

Locations fixed (exogenous), prices endogenous
• Suppose that firm A is located at the left-end point on the unit
interval and firm B is at the right-end point.

A B

0 1
marginal consumer

The address of consumers (𝜃̅) just indifferent (so-called marginal consumers) between
the products of firms A and B.
Industrial Organization
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Exogenous location of firms

• To derive the demands we need to derive the consumer (𝜃̅) that

is just indifferent between buying from A or from B:

• If (pB=pA) then the indifferent consumer is at half the distance

between A and B. If (pB-pA)↑ the indifferent consumers moves to
the left, that is the demand for firm A increases and the demand
for firm B decreases.

And

Industrial Organization
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Exogenous location of firms

• To derive the demands we need to derive the consumer (𝜃̅) that

is just indifferent between buying from A or from B:

• If (pB=pA) then the indifferent consumer is at half the distance

between A and B. If (pB-pA)↑ the indifferent consumers moves to
the left, that is the demand for firm A increases and the demand
for firm B decreases.
θ = 0 if 𝑝+ > 𝑝- + 𝑡
0 23 425
θ = + if |𝑝+ − 𝑝- | ≤ 𝑡
1 16
θ = 1 if 𝑝+ < 𝑝- + 𝑡
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Exogenous location of firms

• Demands : Profits

𝐷+ (𝑝+ , 𝑝- ) = θC 𝜋+ (𝑝+ , 𝑝- ) = 𝑝+ − 𝐶+ 𝐷+ (𝑝+ , 𝑝- )

𝐷- (𝑝- , 𝑝+ ) = 1 − θC 𝜋- (𝑝- , 𝑝+ ) = 𝑝- − 𝐶- 𝐷𝐵(𝑝- , 𝑝+ )

1 𝑃- − 𝑃+
𝜋+ (𝑝+ , 𝑝- ) = 𝑝+ − 𝐶+ ( + )
2 2𝑡
0 25 423
𝜋- (𝑝- , 𝑝+ ) = 𝑝- − 𝐶- ( + )
1 16

• Firm i maximizes its profit by taking the price pj as given.

• FOC gives the optimal price for firm i as a function of the price pj .
– the reaction function of firm i (or the best-response function).
0 1
𝑝+∗ 𝑝- = 𝐶+ + 𝑡 + 𝑝- 𝑝-∗ 𝑝+ = 𝐶 + 𝑡 + 𝑝+
1 2 -

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Exogenous location of firms

• Solving simultaneously the 2 functions yiels the Nash Equilibrium :
0 0 0 0
• 𝑝+ = 𝑡 + (𝐶+ + 𝑡 + 𝐶- + 𝑡 + 𝑝+ )
1 1 1 1
𝟏 𝟏
• 𝒑𝑨 = 𝒕 + (𝟐𝑪𝑨 + 𝑪𝑩 ) et 𝒑𝑩 = 𝒕 + (𝟐𝑪𝑩 + 𝑪𝑨 )
𝟑 𝟑
• If 𝐶+ = 𝐶- = 𝐶 we have : 𝒑=𝒕+𝑪
• When firms’ locations are fixed, a greater value of t corresponds to a
greater degree of product differentiation.
Conclusion:
• The greater the degree of product differentiation, the greater the
degree of market power.
– The higher is t , the more differentiated are the goods from the point of view
of the consumers, the highest is the market power (the closest consumers are
more captive since it is more expensive to turn to the competition) which
allows the firms to increase prices and therefore profits. When t=0 (no
differentiation) we go back to Bertrand

Industrial Organization
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Endogenous location of firms

When firms choose locations:
2 periods:
– In the first period, firms choose location
– In the second period firms compete in prices given their locations
• We solve the game backwards, starting from the second period.
• Assuming that firms anticipate that the price competition equilibrium
will prevail in the second stage.

• We assume that firm 1 is located at x1 of the left end and firm 2 at x2

of the right end.

Industrial Organization
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Endogenous location of firms

• marginal consumer :

• Fonctions de demandes:
– 𝐷+ (𝑝+ , 𝑝- ) = θC
– 𝐷- (𝑝- , 𝑝+ ) = 1 − θC

Industrial Organization
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Endogenous location of firms

• Profits :

• FOC gives the optimal price for firm i as a function of the price pj .
– the reaction function of firm i (or the best-response function).

If CA = CB= c : Profits

Industrial Organization
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Endogenous location of firms

• 1st period, simultaneous choice of a and b
Profits are functions of (a, b) alone:
P A (a, b) = ( p*A (a, b) - c ) DA (a, b, p*A (a, b), pB* (a, b))
P B (a, b) = ( pB* (a, b) - c ) DB (a, b, p*A (a, b), pB* (a, b))
• Replace p (a, b), p (a, b), D (a, b), D (a, b) and we get a function of a and b alone.
*
A
*
B
*
A
*
B

• Take the FOC as always with respect to a and b.

𝑡
𝛱+ = −𝑎1 𝑏 + 𝑏 S + 𝑎𝑏 1 + 4𝑏 + 4𝑏 1 − 𝑎S − 4𝑎 − 4𝑎1
18
YZ
– S𝑖𝑛𝑐𝑒 0 ≤ 𝑎 ≤ 𝑏 ≤ 1, 5 < 0
Y[
– As a augmente decreases, A’s Profit increases. A should choose a=0.
YZ3
• Ditto: > 0.
Y`
• As B increases, B’s Profit increases. B should choose b=1.

Industrial Organization
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Endogenous location of firms

Conclusion:
In a game with several stages, we potentially have
• (Indirect effect) Strategic or competition effect : Firms choose to be in the
extremes i.e. they choose maximum differentiation.
• Direct effect: For firm A, for example, an increase in a (movement to the right)
has a positive effect because it moves towards where the demand is (demand
effect), but has a negative effect (competition effect).
• If transportation costs (or mismatching cost) are quadratic, the competition effect
is stronger than the demand effect and firms prefer maximum differentiation.
• Within a context of price competition, firms have strong incentives to di
differentiate themselves in order to soften the competition intensity. Even though
they also have an incentive to "mimetism" in order to capture their rival’s market
share.
• The social optimum solution is the one that minimizes costs (or maximizes utility)
and it would be a=1/4 and b=3/4.
• Therefore, from a social point of view the market solution leads to too much
differentiation.

Industrial Organization