Influence of market-level and inter-firm differences in costs on product positioning and pricing

The objective of this article is to study the impact of differentiation and firm positioning on firm’s pricing decisions in a horizontally differentiated competitive market. We build a parsimonious game-theoretic model and analyse simultaneous entry of firms. The effect of differentiation is modelled as an additional cost incurred by both firms based on the degree of differentiation between the firms. The cost of positioning is modelled as a market level cost affecting both firms whereby firms incur a cost if they want to position themselves away from the centre of distribution of consumers. Our analysis provides some surprising results, explains some conflicting empirical observations documented in previous research and may also be useful for further empirical research in this area by providing sharper predictions about the impact of various types of costs on market outcomes. For example, we find that if the cost of positioning is sufficiently high, then a firm with lower cost of differentiation charges a higher price in equilibrium, even when no differences in exogenous costs exist. We also find that under some circumstances the cost disadvantaged firm can enjoy higher price-cost margins compared to the cost leader thereby suggesting that higher costs could be a blessing in disguise.