pic Economics for all: Product Differentiation

Saturday, 1 November 2008

Product Differentiation

Suppose now there are 3 firms instead of 2. Assume that prices are fixed so the competition is purely for location and that firms all move simultaneously. There is no equilibrium that results from this as firms tend to locate as a cluster in the centre of the market and the demand is shared equally between each firm so each firm gets a third of the demand. Alternatively firms are located at quartiles, and there is still no stable equilibrium. On the other hand, if we switch from simultaneous decision making to sequential decision making there is an equilibrium where firms locate at 0.25, 0.5, 0.75. So what is important here is whether or not decisions are made simultaneously or sequentially. When firm one enters it can chose freely from the available locations on the street but when firm 2 enters the market it has to take into consideration the location of firm one.

The demand proximity effect is where firms tend to locate near to the high areas of demand which is where there are most consumers. Suppose consumers are split into two groups of equal size and that the consumers are located so that one group is at one end of the market and the other group is located at the other end of the market. Assume the prices are fixed so competition is purely about location and there are two firms. The firms will locate one at each end of the market, hence firms locate where the demand is, and this is referred to as the demand proximity effect.

Product proliferation is where firms make many different varieties of products and flood the markets with them. The effect of product proliferation can be that the proliferating firms gain a larger share of the market demand from consumers and thus restrict demand for potential entrants. The effect is that firms considering entering the market cannot expect to get enough profits in order to cover their costs and so the potential entrants decide not to enter the market.
For product proliferation to be a credible strategy firms must have sufficiently high sunken costs in order for potential entrants to know it is unlikely for the firms to move location as the costs of moving location are high enough to provide incentives for firms to stay committed to their current locations.

Maximum product differentiation is beneficial to firms as it allows them to capture a greater share of the market, and increases in demand will boost seller’s profits to higher levels than if minimum product differentiation was in place, all other things equal. Consumers get their wants satisfied to a higher degree as there are wider varieties of products giving consumers a bigger choice.

The following two graphs, labelled figure 4 and figure 5, are from a spatial competition experiment by Kruse, Cronshaw and Schenk (1993). In the experiment, firms chose simultaneously where to locate along a line of a set distance. The consumers in the experiment are identical and have downward sloping demand curves, so as prices increase they demand less and likewise if prices fall demand increases, other things equal. The consumers are equally distributed along the line. Consumers will always buy from the firm that is closest to them as it minimises transport costs. Factors like the price are controlled and fixed so the competition is spatial. The firms have to consider two things when chosing where to locate on the line. First, market share and second, proximity to consumers.

The two figures above represent the equilibrium locations shown in figure 4 and figure 5 below. The top figure shows the principle of minimum differentiation because the two firms are located next to each other in a cluster. The result of the clustering is a low level of sales. On the other hand, the bottom diagram is more analogous to maximum differentiation and the sales are higher than in the above diagram as a direct effect of firms producing a wider variety of products which capture a greater market share and produce higher demand which boosts firm’s profits higher than in the top figure.

Telser (1988) comes to the conclusion that in the case of n amount of firms the equilibrium is for firms to be at equi-space distance from each other which is what is represented by the quartile positioning of firms above in the duopoly case. The equilibrium condition depends on transport costs.

Consider two communication cases:
1. No communication
2. Communications are allowed in the spirit of “cheap talk” (Farrell 1987) and sellers can suggest that each would be better off by locating symmetrically away from the centre of the market. Communicators remain anonymous in this experiment through the use of a VAX phone system which renders different voices to be all the same voice and incomparable. The marginal costs are constant and the price is fixed so the firms try to maximise quantity sold by getting the highest possible market share. The principle of minimum differentiation does not always hold when transport costs are sufficiently high.
Sellers locate in the centre as shown in figure 4 because of the failure to co-ordinate due to no communication between firms; however, when communication is allowed there is clearly a co-ordination effort and collusion results. Allowing co-ordination is socially optimal as consumers are located closer to firms so transport costs are smaller than when companies cluster in the centre.

Why do convenience stores tend to locate themselves apart from each other and near to large amounts of consumers? Why do restaurants usually locate close to each other? Why do car dealers chose to locate close to each other but go to great lengths to product differentiate through expensive advertising? Convenience stores maximise sales by locating by large amounts of consumers as these areas have the highest demand. As there is a large distance between rival convenience stores there is a high level of maximum product differentiation and firms sell a large variety or products differing in quality and shape etc. which increases demand and market share thus boosting revenues to the firms.

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