How may horizontal product differentiation act as a barrier to entry?

Extraordinary amounts of time and money are spent by competition, antitrust, and merger
authorities on the definition of barriers to entry as they act as a key signal as to the level of
competitive activity within markets. The absence of barriers to entry and hence the
attraction of new entrants to markets is essential, within some models, for the efficient
provision of welfare through the threat of entrants forcing incumbent firms to act
competitively. Product differentiation is a contested type of these barriers to entry: the
European Commission stands in agreement that differentiation can be uncompetitive, while
some academics consider product differentiation a proponent for the entrance of new firms
to markets. This essay shall discuss the importance of product differentiation for the levels of
competition within markets.

(Bain, 1956, p. 3) A barrier to entry is an advantage of established sellers in an industry over

potential entrant sellers, which is reflected in the extent to which established sellers can
persistently raise their prices above competitive levels without attracting new firms to enter
the industry. This definition has later been evaluated by authors such as Stigler, who
considered a barrier to entry the difference in cost of production for a new entrant in
Ce barriers
comparison to the incumbent i.e. the height of entry -Ci is equal to (x) (x) where Ce
represents the cost of producing X for the entrant and Ci the cost for the incumbent
(Stigler, 1968).

Barriers to NewInCompetition
his book, , Bain outlined three types of these barriers to
entry: economies of scale, product differentiation and absolute cost advantage. Product
differentiation in this case can take two forms: vertical or horizontal. Vertical differentiation
represents the difference in the objectifiable quality of goods while horizontal differentiation
can be seen as the ordering of goods by unobjective qualities like colour, style and tastes,
where consumers can choose goods closer to their preferences. It is this horizontal form that
this essay will consider in its anti-competitive nature.

1
Models

There are two important models that are useful in the analysis of the impact of horizontal
differentiation on the entrance of new firms to markets: Harold Hotellings Linear City
model and Salops Circular City model. In Hotellings model, there are two firms who are
free to choose a location on a street; products are homogenous but horizontally
differentiated by the spatial location of the consumer and the transport costs. Hotelling
found that there existed two contradicting effects on the differentiation between firms: the
principle provides an incentive for the two firms choose to locate
in the middle of the street (agglomeration) to capture the largest market share, while there
existed a strategic incentive to locate as far from the other firm as possible as to maximise
exploitable market power.

Salops Circular City (and review by Schmalensee, 1978) model builds on the Linear City
model in a manner that allows for theoretical analysis of the impact of differentiation on the
entrance of new firms.

Fig 1.

Figure 1, taken from Salop (1979), page 144. There are firms in the market that operate on
a circular market, equidistant from each other, where the demand function is decreasing in
price and the number of firms in the market. The zero profit entry condition provides an

2
equilibrium number of firms within the market given an existing market price, such that
(p,n*)=0, and there exists only profit when < . Maurizio Di Cola provides proof that a
new entrant will wish to localize in between two existing firms and make profits of
(p,2n) as the distance between the newcomer and one of each incumbents is half of that
between existing firms (Di Cola, 2005). Meaning that for a new firm, entry would generate
(p,2 ) but since 2 > entry cannot be profitable.

It stands then, that opposed to leaving these gaps in the market where newcomers could
enter and produce different varieties of the same product, existing firms could produce these
varieties themselves. This product proliferation would act in the same manner as the entry of
new firms in that it would lower market price (and profit) per variety but, as the incumbent
firms are the ones to produce all the varieties, they suffer no loss in profits. Existing firms
can therefore find it profitable to engage in horizontal product differentiation to fill the gaps
in the market that potential entrants would seek to enter, thereby producing a barrier to
entry.

Empirical Evidence

The empirical evidence stands in contrast to the conclusions of the models previously
explained: there exist several examples of firms entering markets where the incumbent firms
already produce a number of varieties of goods which show that, in actuality, incumbent
firms cannot avoid the entrance of new firms through brand/product proliferation.

Di Cola again provides proof for this through the evaluation of the entrance of several
cigarette brands into markets with incumbent firms that already product several variety of
cigarettes. In the case of the Dutch cigarettes market, where it was considered that Philip
Morris, through the brand, was an incumbent in the market there was a
successful entrance by a new brand (Di Cola, 2005). This newcomer entered the
market through the production of the same varieties as the incumbent firm (minimum
differentiation), while also producing varieties distant in their characteristics with the

3
incumbent varieties (maximum differentiation). in this case study also chose to
undercut the market price charged by Philip Morris. The cigarette market in Italy provides
the second case: again the brand acted as the incumbent while the new brand
tried to enter. In this market, the same result of the Dutch Market can be observed ..
differentiated its cigarettes by nature of the tobacco and chose minimum differentiation
along other characteristics (Di Cola, 2005) while simultaneously undercut the
price of the incumbent. A third case study considers the introduction of BMWs 1 Series car
into the B-car segment, which should have been impossible as the incumbent Autogerma
already produces numerous varieties in this segment yet this wasnt seen.

It would appear then, that in disagreement with the Circular City model, that it is possible
for a new entrant to enter a market with horizontally differentiated goods. Through the
strategy of maximising and minimising the differentiation of varied goods there can be
found an equilibrium of agglomeration and strategic effect.

EU Commission

Article 70 of the Council Regulation (EC) 139/2004 on the guidelines for horizontal mergers
states Potential entrants may encounter barriers to entry which determine entry risks and
costs and thus have an impact on the profitability of entry. Barriers to entry are specific
features of the market, which give incumbent firms advantages over potential competitors..
It is in the view of the EU Commission then, that horizontal differentiation may limit entry
(and increasing competition concerns) by i) eliminating a potential entrant ii) increasing the
incentive of an incumbent merged firm to enact strategy to deter entry.

The Commission has sought in various law cases to question the role of product/brand
differentiation as potential barriers to entry through an attempt to prove that establishment
of a new brand would require heavy investment in advertising, and promotion in order to
persuade brand loyalty customers to switch as such expenditure is a sunk cost and thereby a
barrier to entry. The Commissions decisions have, in the past, proven advertising to be a

4
barrier to entry, but not horizontal product differentiation itself as they have failed to
separate their respective effects, for If a large expenditure in advertising is necessary for a
newcomer to enter the market, it is not possible to consider the production of several
varieties a barrier to entry just because advertising in some cases is linked to product
differentiation (Di Cola, 2005).

Conclusion

Horizontal differentiation, in theory, has the capability to produce barriers to entry for firms
and provides a threat sufficient that bodies as large as the European Commission deem it
significant enough to apply its impact to numerous famed law cases. In reality, however,
there does not appear to be any significant barrier to the entry of firms to differentiated
markets, as shown through case studies. There is still a call for case-by-case analysis by
regulatory bodies with regards to the effect of horizontal differentiation on the conquering
of new customers and exploitation of market power, but no call for the stamping of
horizontal differentiation as a barrier to entry.

References

Ansari, A. Economides, N. and Steckel, J. (1996) The Max-Min Principle of Product Differentiation. Regional
Science and Urban Economics, November, pp. 1-26.

Council Regulation (EC) No. 139/2004 of 20 January 2004 Guidelines on the assessment of horizontal mergers
[2004] OJ C 31.

Bain, J. (1956) Barriers to New Competition. Cambridge, Mass.: Harvard University Press.

Hotelling, H. (1929) Stability in Competition. Economics Journal, 39(153), pp. 41-57.

Di Cola, M. (2005) Horizontal Product Differentiation and Entry Barriers According to European Competition
Law. Quaderni Del Grif, Anno 1.

Salop, S. C. (1979) Monopolistic Competition With Outside Goods. The Bell Journal of Economics, 10(1), pp.
141-156.

Schmalensee, R. (1978) Entry Deterrence in the Ready-to-Eat Breakfast Cereal Industry. The Bell Journal of
Economics, 9(2), pp. 305-327.