ECON 20005 / 316–210
Competition and Strategy
Topic 7: Industrial Organisation II,
Product Differentiation, R&D and Rent-Seeking

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David Byrne
Department of Economics
University of Melbourne

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Recommended reading: Class Notes
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Product Differentiation
Introduction

So far we have assumed that firms compete only in prices or quantities. In reality, firms often compete by choosing different qualities or different characteristics of a product, or by selling the same good at different locations.
By differentiating their products or their sales locations, firms can reduce competition, which may allow them to increase their prices and their profits.

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Product Differentiation
Introduction

We can model product differentiation by assuming that firms can locate at different points in a geographic or product space
(as first proposed by Hotelling).
There are two ways to think about such location models:
1. Costumers and stores are at different geographic locations and traveling is costly.
2. Consuming products with characteristics further away from the consumers ideal choice leads to less pleasure.

There are two main types of location models:
1. Firms choose their location while prices are fixed.
→ Icecream salesman
2. Firms choose prices while their (different) locations are fixed.
→ Linear city

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Coco Pops

Sweet
Frosties

Froot Loops

Crunchy-Nut

Special K
All-Bran

Cheerios
Corn Flakes

Crunchy
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Children
Coco Pops

Sweet
Frosties

Sweet-tooth
Students

Froot Loops

Crunchy-Nut
Sweet-tooth
Students

Special K

Personal Trainers

Triathletes
Cheerios

All-Bran
Corn Flakes

Crunchy
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Product Differentiation
Icecream Salesman

Consumers are spread evenly (uniformly distributed) along a
1km beach, and each consumer wants to buy one icecream.
The consumers prefer to go to the closest salesman since the sand is hot.
Two icecream salesmen are competing for consumers, but the icecream prices are fixed and the same for both salesmen.
Hence, each salesman chooses his location to maximize his market share.

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Product Differentiation
Icecream Salesman

Assume the salesmen locate at opposite ends of the beach:
How many consumers does each salesman serve?
Can some salesman capture more of the market by moving?

Assume one salesman moves to the middle of the beach:
How many consumers does each salesman serve?
Can some salesman capture more of the market by moving?

Assume both salesmen locate in the middle of the beach:
How many consumers does each salesman serve?
Can some salesman capture more of the market by moving?

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Product Differentiation
Icecream Salesman

Hence, the unique Nash Equilibrium is for both sellers to locate in the middle of the beach.
The socially optimal outcome is the one that minimises the distance that an average consumer has to walk:
What are the socially optimal salesmen locations?
What distance does an average consumer have to walk given these locations?
What distance does an average consumer have to walk in the
Nash Equilibrium?

QUESTION: What does this model suggest will happen in other markets, for example the music industry?

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Product Differentiation
Linear City

There is a linear city with 100 inhabitants, which are spread evenly along the 1km long main street.
There are two stores in linear city located at each end of main street: store 0 and stores 1
The stores sell identical products, and compete with each other in Bertrand (price) competition.
Each stores marginal costs are c = 10.
Each inhabitant wishes to consume one unit of the product, and experiences linear travel/transportation costs of t = 20 per km traveled.
The timing is as follows:
1. The stores simultaneously set their prices p0 and p1 .
2. The consumers decide from which store to buy.
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Product Differentiation
Linear City

We start at the end by looking at the consumers decisions.
Consider a consumer living at location x (km) on main street:
The consumer is at a distance of x from store 0 and at a distance of 1