20 E-commerce 5

Aaron Schiff

ECON 204 2009

Introduction

• Product differentiation is another strategy used extensively by firms in addition to or instead of price discrimination.

• Objectives of this lecture: Understand the basic principles of product differentiation, the Hotelling model, and discuss the implications for e-commerce.

Product Differentiation

• Perfect competition = zero profits.

• Firms would prefer to make higher profits, if they can.

• One way firms can do this is to differentiate their product from others, so that all products are no longer homogeneous.

• In this case, consumers won’t just simply buy from the cheapest firm, but will also care about their preferences across the different products.

Product Differentiation

• With differentiated products, consumers who really like the product offered by a particular firm will be reluctant to change to another firm even if the price increases a little.– “Brand loyalty”.

• Product differentiation aims to make the demand that a firm faces less elastic.

• Ultimately, product differentiation allows firms to increase prices and profits compared to perfect competition.

Product Differentiation and E-commerce

• Recall that some aspects of e-commerce increase the intensity of competition among firms.

• Product differentiation can help to offset this.– Important for e-commerce firms.

• Implementing product differentiation requires knowledge about consumer tastes.– E-commerce firms have good opportunities to collect and use

this information.

• Product differentiation requires customising a standard good or service.– Maybe easier to do with online services or digital goods.

Product Characteristics

• We imagine every good or service as having a set of characteristics that consumers can observe.– Colour / size / quality / location / support etc.

• Characteristics are chosen by the firms.– Firms compete in product design as well as by setting

prices.

• Think of products as being points in a characteristics space.

Quality

Flavour

Vertical vs Horizontal Differentiation

• Vertical differentiation: Products differ according to a characteristic such that all consumers agree which product is better or worse.– Examples: Quality, energy efficiency.

• Horizontal differentiation: Different consumers have different preferences over characteristics.– Examples: Flavour, crunchiness.

• We will concentrate on horizontal differentiation.

Horizontal Differentiation

• We will examine the “Hotelling” model of horizontal product differentiation.

• Two firms are differentiated along a single dimension in a product characteristics space.

• Consumers tastes are uniformly distributed along this dimension.

• Firms compete by setting prices, given their product characteristics.

Hotelling Model

• Consumers are uniformly distributed along a line between 0 and 1.

• A consumer’s location x represents her ideal preference for the single product characteristic.

• Examples:0 1

Mild HotChili sauce:

0 1

West End East End

Icecream vendorson a beach:

Hotelling Model

• Ideally, a consumer would like a product to be exactly at her ‘location’.

• But each product exists only at a single point along the line.

• Consumers experience disutility from consuming a less-than ideal product.

• Disutility is proportional to the distance between the consumer’s location and the product’s location.

Hotelling Model

• Each consumer wants to buy one unit of one product, which gives some utility v.

• Disutility for a consumer located at x from consuming at product located at y is given by t × |x – y|, where |x – y| is the absolute distance between the consumer’s location and the product’s location.

• The parameter t measures the degree of horizontal differentiation between the products, from consumers’ point of view.– No differentiation: t = 0– Very differentiated: Large t.

Hotelling Model

• A consumer also pays a price pi to buy from firm i. – Assume that v is large enough so that all consumers

buy one of the two products.

• Thus the net utility of a consumer located at x from buying the product of firm i located at yi is:

ui = v – t × |x – yi| – pi

• Each consumer chooses the product that gives them the highest net utility out of the two.

Hotelling Model

• Assume that the products’ locations are fixed at y1 = 0 and y2 = 1.

• This gives net utilities:

u1 = v – tx – p1

u2 = v – t(1 – x) – p2

Hotelling Model

• Illustration:

0 1

v – p1

u1u2

v – p2

Buy product 1 Buy product 2

Hotelling Model

• Consumer who is indifferent between the two products is located at x* where:

v – tx* – p1 = v – t(1 – x*) – p2

Which gives:

x* = ½ + (p2 – p1)/(2t)

• Demands (market shares) for the two products are:

D1 = x* = ½ + (p2 – p1)/(2t)

D2 = 1 – x* = ½ + (p1 – p2)/(2t)

Note each firm’s market share is increasing in its rival’s price and decreasing in its own price.

Example 1

• Suppose in the Hotelling model that v = 10 and t = 2.

• Questions:– Find the demands for the two products when

p1 = p2 = 5 and illustrate graphically.

– Show what happens when p1 reduces to 4.

Hotelling Model

• Suppose marginal cost is c for both firms.

• Profit functions:

1 = (p1 – c)D1 = (p1 – c)[½ + (p2 – p1)/(2t)]

2 = (p2 – c)D2 = (p2 – c)[½ + (p1 – p2)/(2t)]

• Each firm’s profit depends on its own price and its rival’s price.

Hotelling Model

• Each firm chooses its price to maximise its profit taking its rival’s price as given.

• This gives (need to use calculus):

p1 = ½(c + t + p2)

p2 = ½(c + t + p1)

• We then solve simultaneously to get the equilibrium prices:

p1 = p2 = c + t

Hotelling Model

• Observations:– Price equals marginal cost plus a mark-up that depends on the

degree of product differentiation (t).– Stronger differentiation = higher mark-up = higher prices.– No differentiation (t = 0) gives perfect competition (p = c).

• Profits at equilibrium prices:

1 = 2 = t / 2.

• Stronger product differentiation equals higher profits.– Stronger differentiation makes consumers more ‘loyal’ to a

product in the face of a price increase.– Firms can increase prices with less fear of losing customers to

their rival (makes each firm’s demand less elastic).

Example 2

• Repeat the previous example for t = 4 and compare.

• Suppose c = 1. Calculate equilibrium prices and profits in the Hotelling model for t = 2 and t = 4 and compare.

Implications for E-commerce

• Product differentiation can increase profits and help to offset pro-competitive effects of e-commerce such as freer entry and exit.

• E-commerce stores are easier to customise, and can be customised to every individual consumer.

• Use information about customer’s past purchases and activity to customise the web store for them.

Implications for E-commerce

• Example: Amazon customisation

Implications for E-commerce

Recommendations explicitly based on purchase history.

Implications for E-commerce

• Amazon uses my purchase history to customise its website for me.

• Its ability to do this makes Amazon more valuable to me than a competitor that I have never used before.

• This differentiates Amazon from its rivals and makes it less likely that I will switch if Amazon raises its prices a little.

• Differentiation based on customer data.