ECO645

INDUSTRIAL ECONOMICS

INDUSTRIAL AND PRODUCT

DIFFERENTIATION
 6.1 DIFFERENTIATED PRODUCTS
• Product differentiation depends on consumers’
preferences.
• The objective of product differentiation is to
increase profits by increasing demand and decre
asing the price elasticity of demand.
• Common forms of product differentiation include
a) Location
b) Service
c) Physical characteristics
d) Subjective image differences
 6.1 DIFFERENTIATED PRODUCTS
a) Location
– Business success depends mostly on loc
ation – creates different perception
from buyers.
– Parkson Store at Wawasan Plaza versus
Parkson Store at One Borneo Hypermall.
b) Service
– High quality services (high prices) ve
rsus low quality services (low prices)
6.1 DIFFERENTIATED PRODUCTS
c) Physical characteristics
– Fresh-squeezed juice versus Hi-C frui
t drink with 10% fruit juice.
d) Subjective image differences
– Clorox bleach versus other liquid ble
ach.
– McDonald (great place for young child
ren and families)
 6.2 LOCATION MODELS
• Location models refers to any monopolistic or oligopol
istic competition model that demonstrates consumer pre
ference for particular brands of goods and their locat
ions.
• Three main location models:
i . Hotelling’s Location Model
i i . Salop’s Circle Model
i i i . Hybrid variations
• Consumers are heterogenous. They view certain brands a
s closer substitutes than other.
• Thus, brands compete more vigorously with brand that a
re considered as close substitutes.
6.2.1 HOTELLING’S LOCATION MOD
EL
• Harold Hotelling (1929) developed this m
odel to explain the location and pricing
behaviour of firms.
• In this model, location (spatial) model,
products differ in only one dimension, s
uch as the location of the stores that s
ell them.
6.2.1 HOTELLING’S LOCATION MOD
EL
• Consider two players in this game. Each player i
s a hot dog stand that competes for customers al
ong a street in a city.
• Stand 1 (S1) is located a miles from one end and
stand 2 (S2) is located b miles from the other e
nd.
• Consumers are uniformly distributed along the st
reet.
• All consumers are identical except for location
and each consumer buys 1 hotdog bun in each time
period.
6.2.1 HOTELLING’S LOCATION MOD
EL

a´

x y

S1 Alvin S2

a b
6.2.1 HOTELLING’S LOCATION MOD
EL
• Consumer have no preference for either s
tand except that consumer prefer to purc
hase from the nearest stand as each cons
umer faces a transportation cost, c per
mile.
• Now, consider a consumer, Alvin lives x
mile from S1 and y mile from S2.
• Because x is less than y, he goes to S1
to minimize transportation cost.
6.2.1 HOTELLING’S LOCATION MOD
EL
• Suppose the price of hotdog bun is set b
y the government, how could S1 choose it
s location to maximize its profits if S2
is already located b miles from the righ
t end of the city?
• Since consumer only care about how far t
hey must travel, S1 would want to be the
nearest stand for the greatest possible
number of consumers.
6.2.1 HOTELLING’S LOCATION MOD
EL
• S1 could maximize its profits by locating just t
o the left of S2, a´ miles, from left end of the
city.
• In this location, S1 gets all the customers to i
ts left, which is the majority.
• If S2 could relocate without additional cost aft
er S1 locates, S2 would move slightly to the lef
t of the S1’s location.
• This process would be repeated until both firms
were in the middle of the street – dividing hal
f the number of total customers.
 6.2.2 SALOP CIRCLE MODEL
• Steven C. Salop introduced this model in 1979 to p
rovide variations in the Hotelling’s basic model.
• This model is similar to the Hotelling’s model bu
t introduces two main differences;
i . Firms are located in a circle instead of a line.
i i . Consumers are allowed to choose a second/outside
goods.
E.g.: goods located around the circle is differen
tiated goods (brands/flavours of ice cream), and
the outside goods might be chocolate cake (undiff
erentiated).
6.2.2 SALOP CIRCLE MODEL
 6.2.2 SALOP CIRCLE MODEL
1) How consumers choose a product?
• All firms that offer the differentiated good
s are located on a circle of parameter 1, eq
uidistant from each other.
• It is an outside firm that offers the undiff
erentiated good.
• Consumers purchase goods by considering seve
ral factors:- preferred brand/distance-trans
portation cost, price and they will act acco
rdingly in order to maximize their utility.
 6.2.2 SALOP CIRCLE MODEL
• Each consumer attempt to maximize consumer sur
plus.
• For example, if your favourite flavour of ice
cream is vanilla, but chocolate ice cream cost
half as much, you might buy chocolate ice crea
m – the loss in taste (utility) is less than
the gain from buying the cheaper product.
• Thus, consumer will choose the product will gr
eater surplus – best combination of P & Q.
 6.2.2 SALOP CIRCLE MODEL
2) Firms’ behaviour
• Each firm wants to locate as far as possi
ble from its nearest competitor – the fu
rther away other store – the greater mar
ket power.
• The result – the stores locate equidista
nt from each other (1/n).
• If a firm keeps lowering its price it wil
l capture its competition’s customers. 
 6.2.3 HYBRID MODEL
• Deneckere and Rothschild (1986) developed
a more general hybrid model that includes
the Salop circle model and the hybrid mode
l just discussed as special cases.
• They use their model to explain why the ci
rcle model predicts that there are too man
y brands in monopolistic competition equil
ibrium, while the symmetric hybrid model p
redicts there can be too many or too few.
 6.2.3 HYBRID MODEL
• Their explanation is that there is much more
competition in the symmetric model than in t
he circle model (the point made above).
• As a result, all else the same, equilibrium
prices and short-run profits are lower in th
e symmetric model than in the circle model.
• When short-run profits are lower, it is hard
er to cover fixed costs, so there are fewer
stores or brands in the symmetric model's eq
uilibrium than in the circle model's.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
• The lemons model was introduced by George
Akerlof (1970).
• Shows the effect of asymmetric information
in a market with product differentiation.
• When buyers cannot judge a product’s qual
ity before purchasing it, low-quality prod
ucts (lemons) - may drive high-quality pro
ducts out of the market.
• Lemon problem
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
• Insurance companies are constantly faced with pr
oblems of adverse selection because they cannot
identify the true risks associated with insuring
an individual client.
• As a result, high-risk individuals are more like
ly to purchase insurance than low risk individua
l, and this drives up insurance rates.
• Thus, this eliminate the low-risk individuals fr
om the insurance pool.
• Another example – wine industry, used-car sales
.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
• The lemons model is an example of adverse selection, whe
re products of different qualities are sold at the same
price because buyers or sellers do not have sufficient i
nformation to determine the true quality of the products
.
• Akerlof’s lemons problem can be overcome by
1) Guarantees and warranties
2) Industry standards
3) External product certification
4) Consumer protection regulation
5) Liability law
6) Licensing
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
1. Guarantees and Warranties 
• Guarantees and warranties benefit both t
he firm, by attracting customers with an
assurance of higher quality goods and se
rvices, as well as consumers who, in the
case of receiving a faulty product, can
return the item or have it replaced.
• E.g: almost all electronic device makers
offer warranties.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
2. Industry Standards 
• Firms may set requirements to produce good
s and services that meet industry standard
s, thus attracting customers who might not
be able to properly evaluate the industr
y's products and services.
• This method is practiced most often by hig
h-quality producers of goods and services
who wish to differentiate themselves from
low-quality producers.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
3) External product certification
• Similar to creating industry standards, firms may at
tain external product certification so that consumer
s can rely on expert verification of the quality of
their goods and services.
4) Consumer protection regulation
• In many industries and governments act to address as
ymmetric information by implementing consumer protec
tion laws designed to set a standard by which all fi
rms must legally comply.
• E.g.: credit card issuers are subject to consumer pr
otection laws set forth by the government.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
5. Liability law
• Liability laws are a part of consumer protection
regulations as established by the government.
• Firms may be subject to penalties and fines if mi
nimum industry standards are not met.
6. Licensing
• Licensing falls under consumer protection regulat
ions as well.
• A firm, such as a public utility, might require a
license by the government to sell certain goods a
nd services.
6.4 PRODUCT DIFFERENTIATION WITH ASYMME
TRIC INFORMATION
7) Social regulation
• Social regulation is a significant measu
re taken by government when other consum
er protection laws fail to provide adequ
ate regulatory functions.
• Oversight (supervision) over banking ind
ustry is a type of social regulation des
igned to protect everyone.
THAT’S ALL FOR CHAPTER 6!

KOB KHUN KA!