•Why is this not true in the real world? •Consumers are heterogeneous (not just firms) –Coke creates more value for some consumers; Pepsi creates more value for others –Some car customers place a high value on quality and get a bigger surplus from a high-priced car; others place a lower value on quality and prefer a low-priced car •This means many firms can have positive added value and earn profits •Understanding the structure of consumer heterogeneity is key to carving out a successful strategy
28 Vertical Differentiation • Vertical differentiation refers to dimensions where all consumers agree “more is better” – freshness of food in a restaurant – miles-per gallon of a car – memory & speed in a computer – first / business / economy class on a plane • If consumers differ in their valuation of quality (or their sensitivity to price), some firms will offer high-price & high-quality goods while others will offer low-price & low-quality goods
29 Vertical Differentiation: Example •Suppose Apple and Dell both make one laptop model: –Dell Inspiron: has 1.5GHzprocessor, and costs $900 –Apple MacBook Pro: has 2.5GHzproc., costs $1700•Suppose there are two kinds of consumers –Powerusers have U = 1000 + 1000*SPEED - P–Normalusers have U = 500 + 500*SPEED – •Who will buy which computer? •What would a more sophisticated model of vertical differentiation include? P
Apple’s Product Matrix 30
31 Horizontal Differentiation • Horizontal differentiation refers to dimensions where consumers disagree about which is better – Food: meat vs. fish vs. tofu – Car: SUV vs. sedan vs. sportscar – OS: Windows vs. Mac vs. Linux – Hotel: Loop vs. Mag Mile vs. Lincoln Park • Markets with horizontal differentiation lead firms to carve out different niches targeting specific customers • Locating “far away” from competitors softens price competition and boosts profits • Useful question: are there any customers who like my product better than anyone else’s
32 Horizontal Differentiation: Example • An obvious example of horizontal differentiation is geography • The classic model of this is due to Hotelling – Suppose two shops locate at opposite ends of a street – Consumers are evenly distributed along the street and pay some transportation cost t per unit travelled – Firms set prices simultaneously (as in Bertrand) Store 1 Store 2 consumer
33 Horizontal Differentiation: Example • Note: Hotelling line is just a metaphor for any characteristic that can be ordered – Hotels: very classic to very modern – Drinks: very bitter to very sweet – Laptops: light / small screen to heavy / large screen – Politicians: far left to far right Store 1 Store 2 consumer
34 Product Differentiation and Positioning • In making positioning decisions, firms must trade off two potentially conflicting incentives – Consider what happens if store 1 moves closer to store 2 on the Hotelling line – Store 1 captures more consumers (this is the direct effect) – Store 1 faces stiffer price competition (this is the strategic effect). Demand becomes more elastic. • Key to a good strategy: locate where there are lots of consumers and few competitors Store 1 Store 2
35 From Added Value to Strategy • Best way to increase profits is to increase added value —that is, drive a bigger wedge between benefits and costs • How do we identify what strategic moves will do this?
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