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Teaching notes for chapter 12

As mentioned in Chapter 7, product differentiation is one of the possible answers to the Bertrand "paradox," the fact that, even with two players only, price competition implies zero margins. As in many other chapters, one may approach this problem from a "positive" point of view or from a "normative" point of view. From a positive point of view, the question is how to solve the "Bertrand paradox": how come in practice we observe firms pricing above marginal cost even though theory seems to imply pricing at the level of marginal cost? From a normative point of view, the relevant issue is how firms can escape the "Bertrand trap," the trap of engaging in aggressive price-cutting. In strategy-oriented courses, the emphasis should be on the latter aspect. This is especially true with respect to the topic of product positioning.

In most IO texts, one of the central aspects in the chapter on product differentiation is the distinction between vertical and horizontal product differentiation. While this is a useful distinction for pedagogical reasons, in practice most cases combine both horizontal and vertical product differentiation. The general model that encompasses both forms of differentiation is the hedonic, or characteristics, model of product differentiation. Although the characteristics model is difficult to implement, the basic idea is quite simple. It is therefore worth it to take students through a simplified example--as the one in the text--so that they get an idea of what's involved in applying the model.

The inclusion of imperfect information and switching costs in the same chapter as product differentiation is somewhat unusual. There are two reasons that justify this option. First, both product differentiation and imperfect information / switching costs share the feature that cross price elasticity is lower than it would be in the situation of product homogeneity / perfect information / no switching costs. Second, the actual models that describe the situations of imperfect information and switching costs are almost isomorphic (i.e., identical) to the model of product differentiation.

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