The Principle of Moderate Differentiation

Abstract

What would happen if firms could collusively choose cost of transport (inconvenience) in Hotelling's spatial model? This paper endogenises inconvenience in a three stage game, where firms choose locations, the inconvenience, and finally compete in price, on the assumption of a common reservation price. The equilibrium of the game reveals a novel mechanism which induces firms to differentiate their products in moderation by locating halfway to the center and choosing inconvenience such that the market remains covered in equilibrium. Furthermore, using Launhardt's model with differential freight rate, it is shown that the collusive inconvenience is a Nash equilibrium.