Consumer Informedness: A Simple Way to Explain Maximal or Minimal Differentiation
The principle of Minimum Differentiation arises as the equilibrium outcome in spatial models when price is fixed (Hotelling 1929). Conversely, when firms set prices independently, models suggests that firms will differentiate in order to reduce the intensity of price competition (d.Aspremont et al. 1979). Yet in many competitive industries where firms compete on price, firms are observed to collocate. This puzzle has been referred to as the Hotelling paradox. We propose an explanation for this puzzle based on two simple observations. The first is that markets are imperfectly informed of the alternatives that are available within a category. That is, despite the marketing investments of competing firms, there is a significant fraction of the market that is uninformed about a firm’s offer. The second observation is that the awareness of local products tends to be marginally higher than the awareness of non-local products. The magnitude of this effect is a function of the category but this effect permeates all markets where consumer heterogeneity is location (or geographically) based. With these two simple observations, we propose a model that recovers both minimal and maximal differentiation as a function of the degree to which consumers are aware of products.
Specifically, maximum differentiation will occur when consumers are well informed about the products in the market, but minimum differentiation will occur when consumers have low awareness of the products. Moreover, the model explains why competing products possess similar characteristics in the introductory stage of the Product Life Cycle but firms naturally move to differentiated offerings as a category matures. In an extension, we make the level of informedness a choice variable for the .rms. The extension confirms the intuition of the base model but also demonstrates how media intensity can be used to create endogenous differentiation between firms. The need to differentiate through the choice of location is attenuated when firms differentiate through the choice of media intensity.