So, from horizontal product differentiation let's now look at vertical product differentiation and see what that does to profits of firms and to, of course, price cost margins of firms. So, let's take the set up again, we're looking at ice cream, it's a big ice cream day today. But, let's have a look at a slightly different set up. We have the London city centre, we have consumers that again, are differentiated there are heterogeneous, but they're now heterogeneous in a different dimension. They are distributed according to their willingness to pay for high quality. So, some would pay a lot for good ice-cream, okay so this person is basically an ice-cream enthusiast, he loves good ice-cream and he's willing to pay any amount almost. For having a good quality of ice cream. Some are constrained either by money or they just don't want to spend as much money on ice cream so they would prefer an average ice cream at a more reasonable price. So, these would be down here. In other words, this line here indicates the willingness to pay for high quality. And again we've got two sellers of ice cream that are selling the same ice cream and that are located next to each other. Okay, so in essence, it's the same story as before, but we have slightly different strategic variables. So, let's start here, first, we have these two firms, A and B, and these two firms sell identical products at the same location. So we know what's going to happen, right? We know what's going to happen, namely, prices are going to be equal to cost. We know that profits are going to be equal to zero. For firm A and for firm B. Not a good outcome. Not an attractive outcome. So, firm A and firm B are thinking about what to do. Now what could they do? Well, as we know from the previous video, they might just move locations. Right? So, if they're currently located at the same place. On the same place in London city center, for example. Then, hey, moving away might be one option. But these are stubborn people. Right? These are stubborn ice cream sellers, they don't want to move. Or they don't have any opportunity to move. So, one thing they might do is they might just change the quality of their products. In particular, maybe seller A is going to see, he's going to look at his profit sheet and he's going to see I'm not making any profits. So, why spend so much on good quality or reasonable quality ice cream? He might just decrease the quality of his ice cream and charge a slightly lower price. For example, he's just going to use less expensive milk, less expensive ingredients and so on, which is going to make it cheaper. And he's going to be able to offer the ice cream at a cheaper rate. Of course it's less quality as well. But as we know, these consumers are distributed along the line of willingness to pay for quality. Now firm B might counter this by saying well actually I'm going to increase my quality. So I'm going to offer higher quality products rather than lower quality, a lower quality product as firm A did. So, what's going to happen here? Interestingly, seller A now can charge prices above marginal cost, and makes positive profits. Just as seller B is going to charge a positive price-cost margin, and is going to be able to make positive profits. Now, looking at this, they saw that clearly this was a good move. This was a good move for A, and it was a good move for B. Remember, they started out from the Bertrand Paradox, where no one was making any profits. So, a reaction might be that firm A actually decreases quality even more. And firm B is going to respond by increasing quality even more. So, now we have two very different products. One gourmet ice cream. And we have one very basic ice cream. And how is that going to play out in the in the market. Well. Now we have consumers whose willingness to pay for quality's fairly low, they're going to go for the low quality version. And we have consumers with a high willingness to pay, and these are going to go for the gourmet ice cream. And as it turns out, both firm A and firm B, make positive profits. And they make even higher profits than if they were more closely located to each other. So, let's take this model and spend a few minutes on an in-video quiz to see if you get the intuition of this model. So see you in a few minutes. So great. All of you did the in-video quiz, I hope that was useful. Let's now have a closer look at what are these supporting factors that positively influence prices and profits of these two firms. There's a difference in the quality of the products. So, the more different two products are, the easier it's going to get for both firms to make positive profits. In other words, if the low-quality version has another product in the market that's very high quality, then effectively, these are not competing very much. The second factor that affects the profits of firms is the degree of heterogeneity in terms of the willingnesses to pay of consumers. In other words, if there are two segments that are very, very different from each other. One segment of the market is very price conscious and has very small willingness to pay for higher quality. And another segment of the market is very much willing to pay high amounts of money, is willing to pay a lot of money for high quality. If that's the case then we're basically talking about two different markets, and these two firms will serve different markets. And will make fairly high profits. Now, one very important implication is that firms that offer low quality products can realize positive profits just as firms offering high quality products. And let's take this down one step, and think about it, what this means for business strategy. It means that in a market, you don't have to be the highest quality provider. In fact, if there is a high quality provider of a service, or of a product that it might be optimal for you to reduce the quality to make your products more different. And that can actually be increasing your profits, or that can be positive for your profits. Rather than trying to match the quality of the other one. In which case we would get more similar. And in that case, we would, again be back in the Bertrand paradox. So, in these last couple of videos, we looked at product differentiation. And we started out by distinguishing horizontal and vertical product differentiation. And then had a closer look at each of these. In the case of horizontal product differentiation we had consumers with heterogeneous preferences. And we had products that are different in taste, or image, or location. So, in our case, we looked at consumers distributed along a beach. And ice cream sellers also locating, finding a location on this beach. In the case of vertical product differentiation we had consumers with different financial constraints or willingnesses to pay for higher quality and correspondingly we also had products that were different in terms of quality. So, even though all consumers would prefer the product with higher quality, the consumers that have a fairly low willingness to pay would stick to the low quality product. Let's now move on, and in the next couple of videos we'll talk about some generic strategies that firms can implement to ensure stable and high profits. So do stay on and see you all in a second.
