In many markets consumers prefer to concentrate their purchases with a single supplier, usually on grounds of convenience, but sometimes for quite irrational reasons of `brand loyalty'. Such `shopping costs' may explain firms' preference to produce product lines rather than single products, mergers that broaden such product lines, or even certain features of firms' internal organization.

Conventional analyses of product differentiation usually neglect shopping costs by considering two identical firms, each of which first chooses the characteristics of a single product and then sets its prices. Selling identical products would result in zero profits under competitive pricing, so the firms will choose different characteristics, and ceteris paribus, this `principle of differentiation' will apply equally to firms that produce ranges of products as to those producing single products.

In Discussion Paper No. 446, Research Fellow Paul Klemperer argues that introducing shopping costs may lead firms to prefer to compete head to head, since consumer shopping costs affect the similarity between the firms' product lines. If firms offer different product ranges, some consumers will nevertheless use multiple suppliers to increase product variety. These purchases will be sensitive to differences in prices, so the market may be quite competitive. If firms offer identical product ranges, however, no consumer will purchase from more than one firm, so undercutting a rival firm's prices would attract very little additional custom. The market may therefore be less competitive and equilibrium prices higher. This contrasts with the standard economic intuition that firms selling single products can minimize competition by differentiating their products.

Klemperer finds that the relative attractiveness of head-to-head versus `interlaced-products' competition depends on the distribution of shopping costs across consumers and on the nature of consumers' preferences for product variety. If a large body of consumers has no shopping costs or equal shopping costs at the competing firms then head-to-head competition is extremely competitive and firms will prefer interlaced products. If, on the other hand, many consumers' shopping costs differ across firms but are small relative to the cost of the variety forgone by buying from only one supplier, then many consumers will buy from both firms. In this case, interlaced-products competition may be very competitive, and firms will prefer to compete head to head. Firms' preferred mode of competition will also depend on the shape of the `substitution cost' function, which measures the cost of forgoing product variety.

Product Line Competition and Shopping Costs: Why Firms May Choose to Compete Head-to-Head
Paul Klemperer