Two-dimensional Vertical Differentiation with Attribute Dependence

Abstract

[Abstract] This paper studies how the type and magnitude of the interaction between quality characteristics determine the nature of the differentiation strategies of firms. The vertical differentiation models with multi-characteristic product preferences consider that the characteristics are independent. We incorporate a non-additive component into a two-dimensional model. Sufficiently high attribute dependence gives rise to maximal differentiation in both qualities: if the qualities are complements, one firm offers the highest quality in both attributes, while the other firm the lowest; on the other hand, if the qualities are substitutes, each firm specializes in one of the qualities. The usual outcome with maximal differentiation in one quality dimension and minimal in the other is achieved if there is low or no attribute dependence. In our model, the magnitude of attribute dependence determines whether differentiation relaxes or intensifies subsequent price competition. Some examples from the banking sector are presented to illustrate the model.