Product Differentiation
1. Introduction
A significant part of economic theory focuses on the assumption of a representative consumer buying a homogeneous good. For example, think of the standard Bertrand and Cournot models of oligopoly. Consumers only care about the prices in the market and decide how much of a good to buy and from which firm in order to maximize their utility (given a budget constraint). We know that price competition is fiercer than quantity competition and this result is described by the so called Bertrand Paradox (i.e. in an oligopolistic market for homogeneous goods price competition leads to the zero profits outcome).
In the real world however goods might differ not just in prices, but also in other characteristics such as variety and quality. As pointed out by Waterson (1989) and Cremer et al. (1991), “product differentiation is one of the pervasive features of modern economies” and “most of the real world markets are characterised by product differentiation”. Goods, even if they satisfy identical needs, are not always identical, homogenous. At the same time, consumers are not identical either: they can have different willingness to pay (or income) and different preferences regarding some product characteristics.
The literature distinguishes between horizontal and vertical product differentiation. Following Lancaster (1979) characteristics approach, a good can be thought as a bundle of characteristics. Two product varieties are horizontally differentiated when they contain different amounts of each characteristic and two consumers with different tastes for such characteristics would not unambiguously choose the same good. Two product varieties are vertically differentiated instead when a variety contains more of all characteristics than the other, so that if goods are sold at the same price all consumers would prefer the former. Examples of goods horizontally differentiated can be two cars: one faster but less safe than the other (consumers who value speed
A significant part of economic theory focuses on the assumption of a representative consumer buying a homogeneous good. For example, think of the standard Bertrand and Cournot models of oligopoly. Consumers only care about the prices in the market and decide how much of a good to buy and from which firm in order to maximize their utility (given a budget constraint). We know that price competition is fiercer than quantity competition and this result is described by the so called Bertrand Paradox (i.e. in an oligopolistic market for homogeneous goods price competition leads to the zero profits outcome).
In the real world however goods might differ not just in prices, but also in other characteristics such as variety and quality. As pointed out by Waterson (1989) and Cremer et al. (1991), “product differentiation is one of the pervasive features of modern economies” and “most of the real world markets are characterised by product differentiation”. Goods, even if they satisfy identical needs, are not always identical, homogenous. At the same time, consumers are not identical either: they can have different willingness to pay (or income) and different preferences regarding some product characteristics.
The literature distinguishes between horizontal and vertical product differentiation. Following Lancaster (1979) characteristics approach, a good can be thought as a bundle of characteristics. Two product varieties are horizontally differentiated when they contain different amounts of each characteristic and two consumers with different tastes for such characteristics would not unambiguously choose the same good. Two product varieties are vertically differentiated instead when a variety contains more of all characteristics than the other, so that if goods are sold at the same price all consumers would prefer the former. Examples of goods horizontally differentiated can be two cars: one faster but less safe than the other (consumers who value speed