Horizontal Product Differentiation and Entry Barr

HORIZONTAL PRODUCT DIFFERENTIATION AND ENTRY
BARRIERS ACCORDING TO EUROPEAN COMPETITION LAW

di Maurizio Di Cola
Libera Università Internazionale degli Studi Sociali Guido Carli di Roma

Classificazione JEL: L 110
ABSTRACT
Nella letteratura economica la differenziazione del prodotto è stata a lungo considerata come una
barriera all’ingresso. In un’ottica di tutela della concorrenza, tale conclusione ha conseguenze sul grado
di dominanza delle imprese. Il presente lavoro intende mostrare come sia necessario un approccio case-by-
case al fine di individuare il vero ruolo svolto dalla differenziazione del prodotto. Scopo primario di questo
lavoro è quello di esaminare esclusivamente gli effetti della differenziazione del prodotto sulle possibilità
di ingresso dei nuovi entranti e dimostrare come tale strategia non rappresenta una barriera all’entrata
per i nuovi concorrenti. Attraverso l’applicazione del principio del max-min e attraverso l’ipotesi di
multidimensionalità dello spazio delle caratteristiche è possibile spiegare come sia possibile per nuove
imprese entrare nei mercati differenziati. A conferma dell’assunto iniziale sono stati analizzati alcuni casi
esaminati dalla Commissione europea, dove tale organismo non è stato in grado di dimostrare la relazione
tra differenziazione orizzontale del prodotto e barriere all’entrata.
Economic literature has considered product differentiation as an entry barrier. From the point
of view of competition law this conclusion has effects on firms’ dominance degree. This work is intended
to demonstrate the need of a case-by-case approach in order to assess the role played by product
differentiation. The main objective of this work is to examine exclusively product differentiation effects on
newcomers’ possibilities to enter and to demonstrate how this strategy does not represent properly a
barrier. It is possible to explain how newcomers can enter in differentiated markets through the use of
max-min principle and characteristics space multidimensionality hypothesis. In order to support the main
thesis of the work, some EC Commission cases dealing with the relationship between horizontal
differentiation and entry barriers will be analysed and commented.
INTRODUCTION
In competition law analysis a crucial role is played by the conditions of entry in
the markets. The assessment of the existence of impediments to entry is fundamental in
establishing the competitive level into the markets. In economic and legal literature
these impediments are called barriers to entry. Often, it is argued that one of these
impediments could be represented by the production of several varieties of the same
good. In other words, product differentiation is considered a barrier to entry.
The principal aim of this work is to prove how product differentiation could not be
an entry barrier, in contrast with the European Commission’ s point of view. This
position is observable from the analysis of some case law, like the Nestlé- Perrier case
or the Kimberly-Clark’s acquisition of Scott case, where the Commission considered
product differentiation as entry barrier.
From a theoretical point of view, the concept of horizontal product differentiation
as a barrier to entry derived from some economic models that have shown how
incumbent firms can pre-empt the market through brand proliferation.
I QUADERNI DEL GRIF, ANNO I , 2005 3

Horizontal Product Differentiation and Entry Barriers According to European Competition Law
To better understand how the brand proliferation strategy works and why it
cannot represent a credible threat is considered only the effect of horizontal product
differentiation. For this reason this work considers advertising, brand loyalty and
goodwill effects that can be linked with product differentiation, but not necessarily are
they presented together. Hence, the analysis is conducted without considering
advertising and other effects that can influence the judgment on product
differentiation.
The first useful model to study the relationship between product differentiation
and entry barriers is the Hotelling address model. After this model, several scholars
have developed models to try to explain how firms already established in the market
manage to avoid the entrance of new competitors by crowding the characteristics space
with the production of many varieties of the same good. One of the most famous is the
Schmalensee’s model on the ready to eat breakfast cereals model.
Moreover, the limit of this model is in the dimension of the characteristics space.
Besides, consumers’ tastes are considered in one dimensional characteristics space like
a main street in a city. This is one of the elements that confused the analysis in
differentiated market. Particularly these models assimilate the distance between the
goods in the characteristics space and the favorite brand of the consumer with a
geographical distance. The pre-emption of the market is possible only where the space
is finite therefore in physical places like streets or cities. Otherwise, when the
consumers’ preferences are considered, the characteristics space is not one dimensional
but multidimensional on the basis of the multidimensionality nature of the consumers’
tastes. Hence, the better way to describe consumers’ preferences is through a
multidimensional characteristics space. With this representation it is possible to derive
the powerful principle of max-min differentiation. In one dimensional models, firms have
two opposite incentives, on one hand the incentive to locate far from the other firms
(strategic effect) and on the other hand the incentive to locate near other firms, in the
middle of the main street using the Hotelling’s terminology (agglomeration effect).
Under these two principles, in the classical Hotelling’s model it was impossible to find
the Nash equilibrium in price and location. Whilst, in multidimensional characteristics
space it is possible for the firms to break on through this trade off, besides, it is possible
to choose maximum differentiation along one characteristic and minimum
differentiation along the other n-1 characteristics.
Hence, the ultimate aim of this work is principally to show how brand
proliferation strategy is not a credible threat. For this reason horizontal differentiation
cannot be a barrier to entry.
Furthermore, the first chapter describes entry barriers to understand what they
are, how they work and why they are important in Competition law analysis. The
second chapter presents a detailed analysis on horizontal product differentiation. This
part analyzes the well-known model developed by Hotelling. The second section of
this chapter describes the analysis developed by Schamalensee to see why product
differentiation is considered a barrier to entry. Finally, the last chapter shows how it is
always possible for newcomers to enter differentiated markets. In the same chapter is
inserted the model developed by Irmen and Thisse to demonstrate how it is possible to
describe the characteristics space in a multidimensional way. Furthermore, the last
sections describes through games theory tools as the pre-emption strategy is not a
credible threat.

1. ENTRY BARRIERS
“The entrant is free, however, to form his product as he wishes, and the incumbent’s
differentiation can make his path more difficult only if consumer prefer the incumbent’s
version of the product. There is nothing remotely objectionable in that”.
(R.H. Bork, Antitrust Paradox, New York, Basic Books, 1978).
This chapter analyzes the nature and the meaning of entry barriers. Impediments
to entry in the market are a very important source of inefficiency. Through entry
barriers the incumbent firms can gain positive profits and at the same time avoid the
entrance of newcomers. In other words, entry barriers permit established firms to
exploit market power. This is a very important market failure that represents one of the
biggest negative externalities. One of the aims of competition law is to remove market
failures, hence, the assessment of entry barriers represent a very crucial aspect.
The first section, on the basis of the economic literature, presents the various
definitions of entry barrier. After a discussion on the various different definitions of
entry barriers the second section presents a classification of different kinds of entry
barriers in economics and in the European jurisdiction tradition.
1.1 What is an entry barrier: the definition challenge

The definition of what is an entry barrier is a very disputed topic. In literature
there is not a single accepted definition. The definition of entry barrier changes
between the school of thought considered. However, it is possible to present a
historical overview of the various definitions used in literature.
1.1.1 The Structuralist or Harvard approach to entry barriers

The first school of thought that analyzed the concept of entry barriers is the
structuralist or Harvard approach. According to this school the intensity of competition
is strictly dependent on the structure of the market. Furthermore, the incumbent firms
are capable of manipulating the market structure, for example through product
differentiation.
A good starting point is Bain’s analysis. In this prospective the well-known paradigm
of Structure-Conduct-Performance is noticeable. According to Bain, the structure of the
market plays a crucial role for the performance of the firms established in the market.
He distinguished between entry condition and barriers to entry. Bain argued that
……“the condition of entry is determined … by the advantages of established sellers in an
industry over potential entrant sellers…..” (Bain 1956, p. 3), and that ‘the condition of
entry is…primarily a structural situation… which describes… the circumstances in
which the potentiality of competition will or will not become actual’. He recognizes
also the possibility for incumbent firms to strategically affect entry conditions, in fact
he distinguished between the fundamental structural conditions which create
symmetries between firms and the strategic behavior of incumbents which exploit
them.

The condition of entry depends directly on the presence of entry barriers. He measures
the height of entry barriers by ……“the extent to which, in the long run, established
firms can elevate their selling prices above the minimal average cost of production and
distribution without inducing potential entrants to enter the industry…...” (Bain 1968,
p. 252).
Bain identified three categories or types of entry barriers, namely economies of
scale, product differentiation and absolute cost advantages1.
Both definitions are based on the Structure-Conduct-Performance paradigm, but it
is easily observable how, with the refusal of this approach, the definition of barrier to
entry changes radically. That change is observable in the Chicago School approach.
1.1.2 The entry barriers concept in the Chicago School approach

Another interesting view is represented by Stigler, an important representative of the
Chicago School. He proposed that “…..a barrier to entry may be defined as cost
producing which must be born by firms which seek to enter an industry but is not
borne by firms already in the industry…..” (Stigler 1968, p. 67).
As such, Stigler focused on the existence of relative cost advantages of established
firms over potential entrants, i.e. the cost differences between the incumbent and the
new entrant is equal to the height of the entry barrier. In this definition it is easily
observable that the height of the barrier is equal to the difference of the costs of the
firms in the market2. Therefore, Stigler seems to draw a comparison between the two
after entry has occurred. By the way, Stigler considers an entry barrier to exist only if
the conditions of entry were less difficult for established firms than for new entrants.
Bork, another leading exponent of Chicago School, defines entry barriers as artificial
barriers instead of natural barriers. According to him, the competition law only should
consider the first type of entry barriers. Bork argues that artificial barrier to entry is an
exclusionary practice; in this field the competition law may therefore have a role to
play (Bork, 1978).
According to Bork, competition law should not deal with natural barriers because
the role of antitrust Authorities should maintain the competitive functioning of the
market and not facilitate the entrance of all firms (even the inefficient firms) in the
markets.
These definitions are more useful to better understand what an entry barrier is, but
they do not consider the effect on social surplus of the entry impediments in the
market. Hence, it is also useful to consider the normative aspect of the analysis of entry
barriers.
1 The relationship between entry barriers and product differentiation will be analyzed in the next sections
where I will show how the horizontal product differentiation is could not be considered a barrier to entry.
2 In Stigler’s definition the height of the entry barrier is equal to Ce(x)- Ci(x) where Ce(x) represents the cost
of producing x for the entrant and Ci(x) the cost of producing c for the incumbent.

1.1.3 Welfare analysis of entry barriers

The first normative definition could be found in the Von Weizsaker analysis of entry
barriers (Geroski et al., 1990).
This definition is normative because it is not focused on the factors that impede the
mobility of capital, but rather with socially undesirable limitation to entry to resources
which are due to protection of resource owners already in the market (von Weizsacker,
1980).
Von Weizsaker defines a barrier to entry “……as a cost of producing which must be borne by firms
which seek to enter an industry but is not borne by firms already in the industry, and which implies a
distortion in the use of economic resources from the social point of view……” (von Weizsacker, 1980, p.
398).
1.2 Entry barriers and European competition law

Entry is a source of competitive discipline on the industrial performance of firms,
through the entry process or even a potential entry, incumbents can behave in a
competitive way without a perfect competitive structure of the market (Geroski et al.,
1990). The concepts of actual and potential competition are very important for the
analysis of entry process. The difference is that in the first case the concept of effective
competition is strictly linked to the concept of interchangeability, while the concept of
potential competition refers to the situation where the behavior of an undertaking in a
market is constrained by potential competitors when they are easily able to enter the
market. From the competition law’s point of view this mismatching between these two
concepts lead to a different analysis in the market definition. By the way, potential
competition is actually taken into account not at the stage of market definition but later
in the competitive assessment when considering an undertaking’s position in the
market (Jones et al., 2001).
Hence, entry process is a crucial element to establishing the level of competition
into the relevant market.
The analysis of entry barriers is crucial to the assessment of market power. A firm
may exploit its market power for a significant period of time only if it manages to
avoid the entrance of newcomers through the erection of barriers to entry. The concept
of market power has not meaning without the definition of the place where that power
can be exercised. Hence, it is necessary to define the relevant product market and
geographic relevant market, such as the economic and geographical place where firms
can exercise market power. A useful definition of relevant product market comes from
the Commission (Commission Notice on the definition of the relevant market for the
purpose of Community Competition law [1997] OJ C372/5, [1998] 4 CMLR 177):
“The relevant product market comprises all those products and/or services which are
regarded as interchangeable or substitutable by the consumers, by reason of the products’
characteristics, their prices and intended use”.

The European Court of Justice (ECJ) set out an interesting definition of the relevant
geographic market (ECJ, Case 22/76, Commission v. United Brands Co and United Brands
Continental BV [1978] ECR 207, para. 65):
“The opportunities for competition under article 82 of the Treaty must be considered
having regard to the particular features of the product in question and with reference to a
clearly defined geographic area in which it is marketed and where the conditions of
competition are sufficiently homogeneous for the effect of the economic power of the
undertaking concerned to be able to be evaluated”.
After the definition of the relevant market and then the place where firms
can erect an entry barrier it is useful to see how the concept of barriers to entry is
considered in European competition law.
The assessment of the existence of barriers to entry is very important in several
situations in competition policy’s analysis. One of these situations could be the
assessment of an abuse of dominant position on the basis of article 82 of the Treaty. In
that case an initial problem is therefore, to identify the point at which an undertaking
becomes dominant and so subject to the prohibition of article 82 (Commission Notice
on the definition of the relevant market for the purpose of Community Competition
law [1997] OJ C372/5, [1998] 4 CMLR 177, p. 232). One useful definition of dominant
position came from the ECJ in the United Brands case (ECJ, Case 22/76, Commission v.
United Brands Co and United Brands Continental BV [1978] ECR 207, para. 65).
“The dominant position referred in article 82 relates to a position of economic

strength enjoyed by an undertaking which enables it to prevent effective competition
being maintained on the relevant market by giving it the power to behave to an
appreciable extent independently of its competitors, customers and ultimately of its
consumers”.
From this definition it is possible to see how the dominant position is a whole of
elements that lead to recognize the possibility for a firm to exploit its market power.
One of the most important elements is the analysis of entry conditions, the concept of
economic strength…which enables a firm to impede effective competition, however
may, indicate the idea of the ability to foreclose and keep other firms out of the market
(Korah, 2000).
In that view, the assessment of the existence of entry barriers that impede the
entrance of other firms in the market is then relevant.
Furthermore, the existence of hindrance to entry in the market is crucial in the
assessment of the relevant market therefore a dominant position in merger cases,
where it is necessary to ascertain if a concentration could ‘significantly impede
effective competition in the common market or in substantial part of it, as a result of
the creation or strengthening of a dominant position’3.
3 See new ‘Merger Regulation’, Regulation n. 139 /2004.

An important aspect in the analysis of entry barriers is the classification, because

after defining what an entry barrier is, it is crucial to characterize which elements
represent a hindrance in real life. Then, the most important thing for the competition
law’s point of view is to recognize which factors are actual barriers to entry. For this
aim it could be useful try to draw a classification of several types of barriers to entry
relevant for the competition investigations.
It is possible to distinguished barriers to entry in the following:
1) entry barriers arising from absolute advantages;

2) entry barriers arising from strategic-first mover advantages;
3) entry barriers arising from vertical integration and refusal to supply;
4) entry barriers arising from predatory conduct.
1.2.1 Entry barriers arising from absolute advantages

Absolute advantages are easy to identify by looking at government regulation.
Monopoly rights granted to a single trader or a group of professionals constitute entry
barriers for potential competitors who are not allowed to sell similar goods or perform
similar services (Van den Bergh et al., 2001). A clearer example is observable in the
sector of liberal professions and entry regulation in retailing.
Bain was the first to consider the absolute cost advantage of the incumbent firms
as entry barriers. He defines ‘an absolute cost advantage as a situation where the incumbent
firm had lower average cost than an entrant at any potential scale of operation’. From Bain’s
point of view, absolute cost advantages can arise in several situations, for instance
“…..when the entrance of a new competitor may elevate the price of one or more factors paid by
all firms, when established firms may be able to secure the use of factors of production, or when
established firms have access to economical techniques of production than potential entrant…..”
(Bain, 1968, p. 12).
It is possible to see how an important element of absolute cost advantages as entry
barrier is the access to a superior factor of production by incumbents. This superiority
could be represented by lower price or better characteristics. The ultimate result is that
the incumbent can produce at a lower cost than newcomers or with higher quality that
permits to the established firm to exploit market power.
Others forms of this kind of barriers to entry was found in technological superiority as
high expenditure in research and development. These represent sunk cost therefore
could be entry barriers for newcomers. One leading case was the Hoffmann-La Roche
case (ECJ, Case C-85/76 Commission v. Hoffmann-La Roche [1979] ECR 461..
The primary challenge for competition law analysis is to distinguish between
factors that create a rent for firms deriving from superior efficiency and those that
confer advantage due to first-move advantage. It is fundamental to separate these two
effects, because if efficiency advantages were confused with incumbent advantages,
they would be a promotion of inefficient firms with a social welfare decrease as a
result.

1.2.2 Entry barriers arising from strategic-first mover advantages

Strategic first mover advantages are incumbent advantages that derive from the
asymmetry of timing between incumbent and entrant (Harbord et al. 1994). The
advantages derive because the incumbent is already in the market, hence, it can exploit
its position to avoid the entrance of new competitors.
Strategic advantages can be several, some of these can be capital requirements,
economies of scale and sunk costs, product differentiation, advertising, switching cost,
goodwill and reputation.
Capital requirements are a very long-disputed topic. Bork argued on this matter
that “……capital requirements exist and certainly inhibit entry just as talent requirements for
playing professional football exist and inhibit entry. Neither barrier is in any sense artificial or
the proper subject of special concern for antitrust policy….” (Bork, 1978, p. 320). In that
view capital requirements are considered a normal factor to enter the market therefore
it is not a strategic move by the incumbent. Nevertheless, if the incumbent can raise
capital requirements necessary to enter the market this represents a barrier to entry
therefore competition law analysis has to focus only on the artificial raising of capital
requirements.
The existence of economies of scale is considered another important kind of first
mover advantage. On economies of scale, there exists a very disputed debate; on one
hand there is the clear advantage of the incumbent firm to increase the output to
produce with decreasing average cost, but on the other hand if economies of scale are
not exploited, there is inefficiency. The production could be done at lower cost and if
there are many firms in the industry it is very difficult to exploit that market
characteristic.
Strictly linked to economies of scale are the sunk costs. Incumbent firms can create
economies of scale through expenditure in sunk cost to avoid the entrance of new
competitors. Furthermore, when fixed costs are sunk can, this creates a barrier to entry
because the incumbent can be protected from entry without the need to engage in
strategic behavior. Sunk costs can be defined as an expenditure that has been made and
cannot be recovered.
Dixit (Dixit, 1980) showed how incumbent firm through expenditure in sunk costs can
credibly threaten to exploit economies of scale and then hinder the entrance of
newcomers. Through investments in production capacity, the incumbent firm can
credibly impede the entrance of new competitors. In that way, the incumbent can
commit to exploit economies of scale and then produce a quantity that make the
entrance not profitable. Furthermore, if incumbent firm does not exploit all its plants
therefore its production capacity it will incur in losses, hence, for the established firm it
is profitable to use all production capacity and then exploit economies of scale in a way
to produce at a level where the entrance for newcomers is not profitable.
The same result could be achieved through strategic investments in R&D or even
in advertising. All expenditures that are sunk could represent a strategic mover
advantage therefore could be a barrier to entry.
Another important first mover advantage could be represented by product
differentiation.

Usually, but not necessarily associated to product differentiation is advertising.

Expenditure in advertising could be considered a first mover advantage. Spence,
argued there are economies of scale in advertising, hence they can represent an entry
barrier for newcomers (Spence, 1979). Furthermore Sutton considered expenditure in
advertising as endogenous sunk costs, hence advertising can deter entry of new
competitors by its very nature as sunk cost (Sutton, 1991). Another element linked to
product differentiation could be represented by switching costs. Klemperer showed
how the existence of switching costs can represent an entry barrier for newcomers
(Klemperer, 1987). Many products are differentiated for a consumer who has already
bought the good, because of ex post switching costs, even though the goods of rival
firms were perfect substitutes before the first purchase. The height of the barriers
depends on the market share of the incumbent firms before the entry of newcomers.
The larger the market share, the smaller the residual share left for the entrants, is.
These theoretical insights represent a source of a very disputed debate in
competition law analysis. Besides, the primary challenge for competition law’s
Authorities is to distinguish between factors that create a rent for firms deriving from
superior efficiency and those that confer advantage due to first-move advantage. It is
fundamental to separate these two effects, because if efficiency advantages were
confused with incumbent advantages, they would be a promotion of inefficient firms
with a social welfare decrease as a result.
By the way also first-mover advantages were considered as entry barriers in
European jurisdictional tradition. The first types are economies of scale and sunk cost.
As shown above on economies of scale there is a very huge debate. It is not clear if
these are entry barriers or not. Nevertheless ECJ and Commission have taken the view
that economies of scale can deter new entrants (Modigliani, 1958).
In the case of sunk costs the judgment is less discussed. This kind of cost
represents a very hard impediment for the entrance of new competitors. The difficulty
is to establish with certainty which costs are sunk and then not recoverable. This view
was clearly pointed out by ECJ in the United Brands case (ECJ, Case 22/76, Commission
v. United Brands Co and United Brands Continental BV [1978] ECR 207, para 122).
Another example is in the Havilland case, where the Commission argued that the
high sunk cost are entry barriers and can deter the entrance of other competitors.
The other category of entry barrier as first-mover advantages is the capital
requirements.
The problem of capital requirements is that it is difficult to separate these from
sunk costs. Besides, financial resources could be sunk costs that deter entry. Both
Commission and ECJ ‘take capital requirements Per se to be a barrier to entry, whether
or not they are associated with sunk entry cost’.
1.2.3 Entry barriers arising from vertical integration and refusal to supply
Vertical integration, vertical restraint or refusal to supply are very controversial
aspects in competition law’s theory. These kinds of behaviors can avoid the entrance of
newcomers in the market. In competition law’s investigations, it is very usual to find
restrictive practice like exclusive dealing and tying or unilateral anticompetitive
practice like refusal to supply.

In the opposite direction, the Chicago School strongly argued that vertical
restraints and integration should not be a concern of antitrust policy because they are
motivated by consideration of efficiency. It was demonstrated, for instance, how
vertical integration manage to avoid the double marginalization problem with huge
advantages for firms and consumers. At the same time it is possible how a vertical
integration could raise rival costs. Moreover vertical restraints can improve the whole
welfare through the elimination of the free riding problem. The actual conclusion is
that these practices could represent a barrier to new competitors but in several cases
are led to efficiency improvements. competition law’s investigations must have a case-
by-case approach to try to consider the welfare improvements.
Hence, vertical integration and restriction are the most disputed kind of entry
barriers, these practice could lead to vertical foreclosure and exclusion.
Hugin and Hilti represented the two most important cases regarding refusal to
supply and tying.
Hugin is a Swedish company with a 13 percent of United Kingdom market of cash
registers. The crux of the case was on the definition of the relevant market, because it
was said that the relevant market was to be cash register as a whole. The court rejected
this view and considered the relevant market as spare part for Hugin cash registers. For
this reason Hugin was found monopolist in the supply of its own spare parts (ECJ, Case
22/78 Commission v. Hugin Kassaregister AB [1979] ECR 1869).
The Commission found that the refusal to supply had the result to remove other
competitors in the market for service, maintenance, repair and supply of reconditioned
machines. Then Hugin was found guilty of abuse of dominant position. This decision
was very controversial because many economists would have likely accepted Hugin’s
arguments about the possibility to exploit market power in aftermarket without a more
than compensatory loss in sales in the primary market.
On the other hand, Hilti, a leading nail gun manufacturer for the construction industry,
was found to be abusing of its dominant position by tying the purchase of nails and
cartridges to the purchase of guns. In this case as the others there is not only one
element to take in analysis. Besides, in Hilti’s case, the patent that covers both nail gun
and its cartridges was relevant. Also in this case Hilti was found to abuse its dominant
position. Through tying, Hilti hindered the entrance into the market for Hilti-
compatible nails of independent nail producers. The result was the price
discrimination strategy among Member States that permitted Hilti to earn high extra-
profits (CFI, Case T-30/89 Commission v. Hilti AG [1991] ECR II 1439).
Another important issue is represented by exclusive contracts. The leading case on
this matter is the Tetra Pak II case (CFI, Case T-83/91 Commission v. Tetra Pak II [1994]
ECR II-755). This case law could be considered one of the most complicated in the
whole European competition law’s history. Tetra Pak is the world leader in packaging
liquid foods in cartons. Tetra Pak produced both packaging machinery and relative
cartons. The Commission found four relevant markets, aseptic and non aseptic
packaging machinery and aseptic and non aseptic cartons. The entrance in the aseptic
packaging was very difficult for the existence of several patents. Elopak Italia, a
manufacturer in non aseptic packaging, complained to the Commission that Tetra Pak
was selling cartons and machinery at predatory prices thereby imposing unfair
contractual conditions on the sale and lease of its machines. The ultimate aim for these

strategies was to drive out of the market Elopak Italia. The Commission found that the
prices below average cost represented an abuse of dominant position and the second
practice was found illegal4. Also the ECJ recognize that these practices had the effect of
foreclosing the market, because these practices made the customers entirely dependent
upon Tetra Pak for the entire life of the machine.
An interesting underlining of the tying practice and European competition law is
developed by Van den Bergh and Camesasca (Van den Bergh et al., 2001): “It is not easy
to determine which explanation for tying is the most convincing in the cases decided under
article 82 EC Treaty…when tying is seen only as a way to expand monopoly power into another
market, many relevant issues will remain unanswered”.
In the field of exclusive contracts, the Commission does not automatically consider
the refusal to supply or tie-in product’s themselves are abuses of dominant position
but applies the concept of objective justification to such behavior.
1.2.4 Entry barriers arising from predatory conduct

Predatory conduct is the implementation of a strategy designed specifically to
deter rival firms from competing in a market (Pepall, 2002). The key of this practice is
to influence the behavior of the competitors, to do that it is necessary that the
incumbent make a credible threat. From a policy making perspective, to be considered
anticompetitive, a firm’s conduct it must be the case that the firm’s action is profitable
only if it causes a rival firm to exit, or deters a potential rival from entering the market.
Only from this viewpoint a determined practice can be considered a barrier to entry.
The principal predatory conducts are predatory pricing and limit pricing. There is
predatory pricing when a firm charges such a low price that drives rival firms out of
the market. Mc Gee, an exponent of Chicago School argued that predatory pricing is
not always a profitable strategy for incumbent firms (Mc Gee, 1958). This kind of
practice is profitable only if two conditions are met: increase in post-predatory is
sufficient to compensate the predator for the loss incurred during the predatory price
war; and there is no more profitable strategy to achieve the same outcome. In McGee’s
analysis the merger strategy is a dominant strategy for the incumbent firm than is
preferred to the predatory pricing strategy.
Otherwise the limit price strategy was developed by Bain (Bain 1968) and Sylos-
Labini (Sylos Labini, 1957) and Modigliani (Modigliani, 1958). In that case, the
incumbent limit or prevent the emergence of new rivals through the higher price that
makes the entrance for the competitors not profitable. The incumbent choose the price
that becomes the profits of new entrant equal to zero.
(1.1) π e (qe + qi ) = P(qe + qi )qe − C (qe ) = 0

Where πe are the profits of the new entrant, qe and qi are the outputs of new
entrant and incumbent, P is the price. In the graph, it is possible to see how with a price
equal to PL the new entrant gains zero profits. If the incumbent decides to produce qLi
4 Tetra Pak was condemned to pay a fine of no less than 75 million ECU for the violation of article 82 of the
Treaty.

with a price PL, there is no space for the entrance, because even if the newcomer wishes
to produce a little quantity, he ought to charge a price above PL. The entrance is
actually blocked if the incumbent can credibly threat to produce qLi. It is possible to
make a credible threat through expenditures in sunk cost in the period before the
entrance of new competitors.
Through these practices the entrance of new competitors could be avoided.
Also in this case there is not certainty on the nature of the entry barrier; it depends
on the situations and the considered theoretical background.
Important elements to consider are the presence of sunk cost, capital market
imperfections, reputation developed by the predator (Van den Bergh et al, 2001).
Predatory behavior could be considered as entry barrier. The problem in these
cases is to establish when a practice or behavior is predatory. Harbord and Hoehn
propose a two stage test for predatory pricing (London Economics, 1994). The first part
consists of the analysis of market structure to determine whether predatory behavior is
a rational strategy. To do that, it is crucial to establish if, after the predation time, the
incumbent can recover the losses incurred. The second part is an examination of
conduct or market behaviour using a price-cost test.
The classical reference in European competition law analysis is the AKZO case (1 ECJ,
Case 62/82, Commission v. AKZO Chemie B.V. [1991] ECR 3359..
AKZO Chemie was the biggest European producer of organic peroxides, one of which,
benzoyl peroxide. This compost was used in flour additives in the United Kingdom
and Ireland. The biggest parts of sales of organic peroxide were in European plastic
market, where AKZO was a dominant supplier. In 1979, ECS, another producer of
peroxide started to expand into European plastics market. AKZO answered to that
action with direct threats of overall price reductions in the UK flour additives market
and price cuts targeted at ECS main customers if ECS did not withdraw from the
plastic sector.
The Commission found AKZO guilty of predatory behaviour on the basis of
internal documents that indicated that the elimination of ECS was its strategy and
internal management documents apparently demonstrated that AKZO prices for
selected customers were below average variable and marginal cost. Finally
Commission concluded that AKZO’s predatory behaviour was creating a barrier to
entry and pointed to evidence of other predatory episodes as well as evidence of
financial difficulties at ECS that limited its ability to sustain a prolonged price war.
This case is useful to understand the relation between entry barriers and predatory
behavior. Furthermore, market with easy entry makes predation less likely to be
profitable, because it is more difficult to recoup the loss incurred in the price war
period. Another empirical argument is that predation appears to be likely in markets
with low barriers to entry, because predation with large entry barriers as sunk costs or
exit costs is more difficult to drive out of the market other competitors.
2. PRODUCT DIFFERENTIATION
Several scholars developed models to explain the functioning of markets with
homogeneous goods, but in real markets homogeneity is the exception whilst

differentiation is the rule. In each market it is possible to see firms that sell
differentiated products. Hence, the necessity for competition law to focus on these
markets and understand what horizontal differentiation for firms really means is clear.
The principal aim to differentiate is to create market power; through product
variety, firms can charge prices above marginal cost. But this is not the whole story,
because through differentiation, social welfare could be enhanced. Consumers can
have more varieties of the same good, this can increase their surplus because they can
find a good that is closer to their preferences with an increase of their utility. The gains
from product diversity can be large and may easily outweigh the inefficiency cost
resulting from downward sloping demand curves (Indic , 1998). Another task that lead
firms to differentiate their products is the growth. Through the production of several
varieties, firms can sell their product to consumers who before did not buy the good,
because they can meet consumers’ tastes in a better way.
The first useful distinction of the several types of product differentiation is
between horizontal and vertical differentiation. The former case is when goods are
differentiated only in their characteristics and not in quality. Goods have different
tastes, colors and shapes, consumers can choose the closer good to their preferences.
Vertical product differentiation concerns also the quality of goods. Firms decide to
produce several goods with different qualities. It is possible to say that horizontal
differentiation is subjective whilst vertical differentiation is objective.
The aim of this chapter is to analyze some economic models to better understand
what horizontal product differentiation is and why this practice is considered a barrier
to entry. This analysis will be useful for the next chapter where I will show how
horizontal differentiation is not an entry barrier.
2.1 Spatial models of imperfect competition

This section describes the well-known model of Hotelling. This address model is
very important because it describes the market with differentiated products in a very
real way. Moreover, this model is relevant because it is useful to analyze the entry
process in horizontal differentiated market. The most important basic assumption is
the concept of asymmetric preferences, this means that if consumer’s preferred brand is
a then the consumer prefers brands that are close to a in terms of their characteristics.
One of the implications of the asymmetric preferences choice is that competition
among firms is localized, so each movement of one firm has an effect on the behavior
of other firms in the market.
As Hotelling argued, in a differentiated market, firms compete on price so they
engage in Bertrand competition. Naturally, the differentiation avoids that the outcome
is the same in the original Bertrand model, because firms can exploit market power.
This means that firms can charge price above marginal cost, but not at monopoly level
because products are slightly substitutes.
In Hotelling’s model there are two firms, which are free to choose a location in the
Main street, a unit line of l length. The products are homogeneous but for consumers
they are differentiated in two characteristics, on the geographical location and on

transport cost necessary to reach the seller5. Consumers are uniformly distributed
along the line and each buy just one unit of the good. Consumers will buy from the
firm that will charge the low delivered price. The price for consumers is composed of
the price of the good plus the transport cost to reach the seller. An interesting way to
analyze this model is the interpretation of Gabszewicz and Thisse (Gabszewicz et al.,
1986). They showed how, with the assumption of quadratic transportation costs, it is
possible to find a Nash equilibrium on price and location. The representation of the
uniformity distribution in the main street is drawn in figure 2.1.
Figure 2.1 – Hotelling’s Main Street
0 S1 1/2 S2 1
Each firm is symmetrically located at a distance α from the mid-point. There is s1=
½ - a and s2= ½ + a. The whole price is equal to the price of the good (pi), and the
transportation cost t(s,s’). Then t(s,s’)=c│s-s’│+ d(s-s’)2 ; c,d ≥ 0.
The first thing is to locate the indifferent consumer, that is, the consumer for whom
buying from firm 1 or firm 2 is indifferent.
(2.1) p1 + t(s1, χ) = p2 + t(s2-χ)
Gabszewicz and Thisse considered in their model the price of firm 2 as given at
p2*. They built the demand curve for firm as:
χ1(p1, p2*) = 0 if p1> p1++
p 2 ∗ − p1 + 2ac + 2ad
= , p1++ > p1 > p1+ ,
4ad
5 The geographical distance could be used also to measure the distance in consumer’s tastes.

p 2 ∗ − p1 + c + 2ad
= , p1+ > p1 > p1- ,
4ad + 2c
p 2 ∗ − p1 + 2ad − 2ac
= , p1- > p1 > p1-- ,
4ad
= 1 if p1- - > p1 ≥ 0
Figure 2.2 – Demand curve of firm 1
p1++
p1+
p2*
p1-
p1- -
½-a ½ ½+a 1
χ1(p1, p2*)
This derivation of the demand curve opens the door to several special cases, for
instance, if a = 0, we have p1++= p1+= p2* = p1- = p1- -. In this case if p1 > p2* ⇒ χ1= 0 and
if p1 < p2* ⇒ χ1= 1, the ultimate result in this case is that when firms chose to locate at
centre of the main street, the only equilibrium is the Bertrand result p1e = p2e = 0
(Beath et al., 1991).
In economic terms, central location for both firms means that the products are
homogeneous therefore perfect substitutes. In this case, firms have no market power so
the outcome is like in the Bertrand model.
The relevant elements for the shape of the demand curve are the transportation
costs. These have influence on the continuity and concavity of demand and profits
functions.
Gabszewicz and Thisse found that if a is large enough, a Nash equilibrium in
prices will exist. This is the case when a boundary χ, is between the two firms, then the
profits function is

p i[ p j − p i + 2 ad + c ]
(2.2) ∏ i ( pi, pj) =
4 ad + 2 c
The two firms need to be a critical distance apart to find a Nash equilibrium with
positive prices. Gabszewicz and Thisse found that condition is :
1 c 
(2.3) 2a ≥ min  , 
3 2 d + c 
The result found by Hotelling was different because he developed the principle of
minimum differentiation. He found that firms choose to locate close to each other, in a
way to conquer the biggest part of the market. Then, both firms choose to locate in the
middle of the main street, they choose minimum differentiation. The incentive for the
firms to locate close to each other is known as agglomeration effect. Nevertheless, in real
markets, it is possible to see how firms do not choose to locate close to each other but
they have the incentive to locate far from the others. Furthermore, if firms choose a far
location from the others, they have market power to exploit. In other words, firms can
charge a price above marginal cost thereby making positive profits. This principle is
known as strategic effect. It is possible to see how this effect is completely absent in
Hotelling’s address model. The relevant question to find the Nash equilibrium in
differentiated market is to see which of these two forces is dominant. For this reason,
several scholars tried to remove some of the basic assumptions made by Hotelling.
Differently, from the classical model developed by Hotelling where the Nash
equilibrium with linear transportation costs do not exist, in Gabszewicz and Thisse’s
model there is the Nash equilibrium in price and location. They considered
transportation costs as a quadratic cost function cx2. The interesting aspect of this
model is then the possibility to find an equilibrium point by removing some basic
assumptions.
This description is very useful to understand the next chapter where I will remove
another assumption made by Hotelling: the one- dimensionality of characteristics
space.
The next chapter considers a multi-dimensional characteristics space in a way to
better approximate consumer preferences. Through this assumption it is possible to
develop the max-min principle.
2.2 Entry process in markets with differentiated products: Ready to eat Breakfast
cereal and entry deterrence
After the analysis of the well-known model developed by Hotelling, it is useful to
bear the problem of the entry process in markets with differentiated products. This
section analyzes the issue of entry in differentiated markets and the reasons for why
product differentiation is considered an entry barrier.

The model developed by Schmalensee is the most important theoretical approach

on this argument. This model is very useful to understand why product differentiation
is considered an entry barrier.
He, considered product proliferation as a sunk cost, therefore incumbents can fill
up the characteristics space with the aim to erect an entry barrier. The economic
consequence of this assumption is the condition of immobility for the established firms.
With sunk cost necessary to enter in the market and localized competition an entry
barrier is created. Then, firms can choose to pre-empt the market in a way to leave not
enough space for the entrance of other firms.
One of the assumptions is about the shape of the characteristic space, instead to a
linear segment; Schmalensee considers a unit circular market.
There are n firms in the market, each produce a single brand and are located at a
distance of 1/n around the circular market (Figure 2.3).
Figure 2.3- Schmalensee’s Characteristics space with two incumbent firms.
Firm 1 Firm 2
The demand function is decreasing in price and in the number of firms into the
market, and then could take the following form:
∂a ∂b
(2.4) Q( p, n) = a( p)b(n) ; with <0 and <0
∂p ∂n
Fixed costs and marginal costs are respectively F and m, therefore, the profit function
is:
(2.5) π ( p, n) = ( p − m)Q − F = A( p)b(n) − F
(2.6) with A (p) = (a (p) (p-m)

Consider a given price p, n~ is the solution to the equation π ( p, n) = 0, in this case

~
profits are positive only when n ≤ n
The newcomer wish to localize in the middle between two existing firms, hence
when the other firms charge a price p, the profits are π ( p,2n) . This because the
distance between the newcomer and one of each incumbents is half of that between
existing firms.
For as long as n~ /2 < n < n~ all existing firms can earn positive profits6, but for
newcomers entrance is not a dominant strategy because they will earn a profit equal to
π ( p,2n) and since 2n > n~ entry is not profitable. Hence, also with this model the result
found by Eaton and Lipsey is confirmed, established firms are able to earn positive
profits even with free entry condition. This also means that product proliferation could
be a strategy to avoid the entrance in the market. Existing firms can choose to produce
different varieties of the same product in a way to conquer the necessary space to avoid
the entrance of newcomers. That is like if there are different firms, so the profits for
each variety decrease with the number of varieties produced, but the whole profits for
the incumbent firms do not decrease because it is the producer of all varieties into the
market. For instance, suppose that n ~ is equal to ten and there are two incumbent
firms. They can choose to produce only two products, but in this way there is space for
the entrance of eight newcomers. Now, suppose that each incumbent starts to
introduce two varieties of his product. The profits for each varieties are low than the
previous case because the profit function is decreasing in the number of firms or
varieties in the market, but the whole profits for each incumbent is the same because he
is the only producer of two varieties7. Hence, existing firms can find profitable to full
fill the market through the production of five varieties each. In this case, the profits for
each incumbent firm are the same but the entrance is blocked.
To see this effect, it is possible to assume that incumbent firms can collude and
maximize their joint profits with respect to both price and the number of brands.
(2.7) max[nπ ( p, n)] = max[nA( p)b(n) − nF ]
Subject to
(2.8) π ( p,2n) = A( p)b(2n) − F ≤ 0
It is possible to deduce two cases in post-entry condition, the first is the

maximization of (2.7) without constraint and the second case is the maximization of
(2.7) under the constraint of (2.8).
6 ~ ~ ~
All firm earn positive profits because since n < n and π is decreasing in n if n /2 < n < n ⇒ π (p, n)
> 0. Whilst for newcomers we have that the expected profits is too low because the number of firms that
~
maximize the profit function is to high 2n > n .
7 This is the case when marginal cost to producing another variety is zero.

In the first case the results are nm and pm. Where the profits for the new entrant are
equal to: π ( p,2n m ) ≤ 0
Hence, the optimal number of firms is n* = nm ; in this case, the entrance of new
competitors is blocked.
But, when the number of brands that will deter entry will be grater than nm, the
profits for newcomers are positive π ( p,2nm) > 0 . Therefore, in this case, there is the
possibility for the newcomer to enter in the market and earn positive profits, this
means that exist somewhere a point k that satisfies the following relation:
(2.9) π ( p,2 k n m ) > 0 > π ( p,2 k +1 n m )
Then, it is possible to consider 2 k n m as the maximum number of brands consistent

with positive profit in equilibrium. Otherwise, if we consider that existing firms
produce a number of brands nd such that
(2.10) 2 k n m ≤ 2n d < 2 k +1 n m
Then
(2.11) π ( p, 2n d ) = 0
The value of nd is found through the maximization of (2.7) under the constraint of
(2.8). Hence, with nd entry is deterred.
Now, we can compare the two results, one in the case of entry not blocked and the
second case with entry deterred. To see which strategy is more profitable for the
incumbent firms is necessary to compare the profits in both situations:
(2.12) π ( p d , n d ) > π ( p,2 k n m )
Under (2.10) nd < 2 k n m . Therefore, product proliferation is the production of the

minimum number of brands that deters entry. This is a dominant strategy for
incumbent firms, because that reach to avoid the entrance of new competitors and at
the same time earn positive profits under free entry condition.
Nevertheless this model is correct if all assumptions are satisfied, in the next
chapter the analysis of this issues will have the aim to remove some of these basic
assumptions, and first of all the one-dimension of the characteristics space. Will be
possible to show how the two forces that characterize the differentiated markets,
agglomerate effect and strategic effect, can live together.

3. THE ESSENCE OF COMPETITION IN DIFFERENTIATED MARKETS

As shown in the previous chapter, horizontal product differentiation could be
considered an entry barrier. This conclusion has an important result in competition law
investigation. Besides, a firm can be declared in dominant position also because
produces several varieties of the same good. This implies a very different regime for
the firm. Furthermore, many conducts can be considered as an abuse, therefore, the
firm can be accused of infringement of article 82 of the Treaty. Even though the
dominant position of the firm deriving from product differentiation could represent an
important element not to allow a concentration on the basis of the new merger
Regulation (Regulation 139/2004).
Hence, primary aim of this chapter is to show how product differentiation could
not be an entry barrier. In every market it is possible to find firms that sell
differentiated products or produce several varieties of the same good. Considering
horizontal differentiation as entry barrier, the true role played by differentiation is not
understood. In several differentiated markets, it is possible to see the entrance of
newcomers. If competition Authorities consider product differentiation as an entry
barrier it is as if they say that new cigarette brands like West or Pall Mall, could not
enter the market because there are already established firms that produce several
varieties of cigarettes; therefore, it is as if they consider that the BMW could not enter
the B-car segment and produce series 1, because Autogerma pre-empted the market
with the production of several varieties in this segment (Audi A3 and Volkswagen
Golf, Skoda Fabia, Seat Ibiza).
Therefore, a deeper view in real markets tells us that incumbent firms cannot
avoid the entrance of new competitors through a brand proliferation strategy.
A crucial role, in horizontal differentiated markets is played by consumers’
preferences. Products are differentiated in characteristics that become goods
subjectively differentiated. Hence, the preferences for each variety depend on
consumers’ tastes. As shown in the previous chapter, consumers buy differentiated
products on the basis of the characteristics of the goods. Then, they consider products
as a bundle of characteristics. In this view, the multidimensional analysis is the best
approximation of the characteristics space. With this system, it is possible to consider
all different preferences and tastes of different consumers. Therefore, the first chapter
analyzes the multidimensionality of the characteristics space. The second section
considers the max-min principle. Through this principle, it is possible for the firms to
enter the market and choose maximum differentiation along one characteristic and
minimum differentiation along the n-1 characteristics.
Furthermore, the third section describes a simple two stage game to show how
brand proliferation is no credible threat, whilst the fourth section considers the
relevance of exit costs in the outcome of the entry process under brand proliferation.
Finally, the last section analyzes two of the most important cases in competition law on
product differentiation as entry barrier, the Nestlé- Perrier case and the Kimberly Clark-
Scott case.

3.1 The multidimensionality of the characteristics space

This section removes some basic assumptions of Hotelling’s model. First of all, the
dimension of characteristics space. Therefore, it considers a multi-dimensional
characteristics space in a way that consumers’ preferences can be approximated in the
best way.
The intuition of multidimensionality manages to meet consumers’ tastes with
more precision, with powerful mathematical tools, it is possible to consider this
hypothesis. Besides, most analysis of product differentiated markets are based on the
one-dimensional characteristics space assumption. Clearly, it was made for
mathematical convenience.
However the aim for each research must be the best approximation of reality to
understand real markets and their mechanisms. Only in that way is it possible to
assure the certainty of the law and the economic efficiency in competition law
investigations.
As shown in the previous chapter, under all basic assumptions of classical version
of Hotelling’s model there is not a uniqueness of price equilibrium. Through removal
some of these assumptions it is possible to find the Nash equilibrium in price and
location (Gabszewicz, 1986). This result is reached with the assumption of quadratic
transportation cost. Furthermore, another principle that does not seem to be always
present in differentiated market is the minimum differentiation principle. On the basis
of this statement elaborated directly by Hotelling, firms will choose to locate close to
each other with a consequent Bertrand competition. D’Aspremont et al. showed how
firms want to maximize product differentiation to relax price competition and exploit
market power (d’Aspremont et al., 1979).
Several scholars focused their analysis on the multi-dimensionality of the
characteristics space, with two (Economides, 1986) or three dimensions (Ansari et al,
1996); this section develops a first general expression of n-dimensions and the last part
analyzes the three dimensions case.
Assume the presence of two firms and the product variants are given by the
location of the firms in the space ℜ n . Then the location of firm A is given by a vector
a = (a1 ,...., an ) and the location of firm B is described by a vector b = (b1 ,...., bn ) .
The assumption of uniformity distribution of consumers in the characteristics
space is maintained, specifically consumers are distributed over the unit
hypercube C = [0,1]n . If we consider the continuous and non-negative density function
g (z) with the location of a consumer described by the vector z = ( z1 ,...., z n ) , it is
possible to find the total population as ∫ g ( z )dz = N .

ℜn
Through some mathematical tools, it is possible to describe analytically the utility

function in a multidimensional characteristics space; to do that, it is possible to use the
Euclidean distance as a measure of the distance between two points in the space.
Consider Vi (z ) as utility function with i = A,B; a consumer buying good A enjoys a
utility equal to the surplus that derives from consuming the good, minus the cost to

buy the good (the price) and minus the distance from his ideal good (Caplin et al.,
1991).
(3.1) VA (z) = S − pA − ∑tk (zk − ak )2

k =1
S is equal to the surplus that the consumer enjoys by consuming the good minus
the price paid to buy the good and minus the square of the weighed Euclidean distance
between the consumer’s ideal point and the location of variant A; whilst t k represents
the coefficient of characteristic k8.
After the expression of the utility function, it is possible to derive the demand
curve for firm A. Assuming that consumers have unit demand and that S is large
enough for all consumers to buy at any location with the corresponding price; the
demand for variant A is then defined by the group of consumers for whom this variant
is preferred to variant B:
(3.2) DA = ∫ g ( z ) dz
{z ;V A ( z ) ≥ V B ( z ) }
Furthermore, it is assumed that each variety is produced at constant marginal cost

equal to zero.
To find the Nash equilibrium in price and location, it is possible to refer to the
model developed by Caplin and Nalebuff. They found the conditions for the existence
and uniqueness of price equilibrium. This result depends on the functional form and
the distribution of consumer preference and the uniform distribution complies
with ρ − concavity (Caplin et al., 1991). This condition, for Caplin and Nalebuff, with a
twice differentiable demand curve and the log-concave uniform distribution, implies
the uniqueness of price equilibrium for each location pair.
3.2 Max-min principle and multi-characteristics space

This section describes the work developed by Irmen and Thisse to show how it is
possible to find the product positioning in multidimensional characteristics space
(Irmen et al., 1996).
The power of the multidimensionality shape of the space permits us to draw some
interesting conclusions. With n-dimensions, it is possible that the agglomeration and
the strategic effects can live together. Furthermore, firms can choose minimum
differentiation along nth characteristic and maximum differentiation along the other n-1
characteristics.
8 For simplicity consider the characteristics weighed equally across consumers.

Besides, Irmen and Thisse have shown how, in a product differentiated duopoly, it
is possible to find the Nash equilibrium in price and location where firms choose
maximum differentiation along n-1 characteristics and minimum along the nth
characteristic9.
3.2.1 Demand in n-dimensions space

First of all it is necessary to build the demand function for the firms in the market.
Hence, it is necessary to locate the indifferent consumer, who can buy variety A or B
indifferently.
n n
(3.3) p A + ∑ t k ( z k − ak ) 2 = pB + ∑ t k ( z k − bk ) 2
k =1 k =1
Then the relative consumer address is equal to:
n
pB − p A + ∑ t k (bk2 − ak2 ) n
t k (bk − ak )
(3.4) zˆ ( z1 , z 2 ,...z n −1 ) = k =1
−∑ zk
2t n (bn − an ) k =1 t n (bn − an )
With the assumption of b ≥ a , the slope of the hyper plane is negative along each
dimension. Figure 3.1 provides an illustration when n =310.
Figure 3.1- Marginal consumer’s address with n=3
Z3
Z2
1
*B
1
DA *A
0 1 Z1
9 The same results are found by Ansari et al and by Economides, 1986.

10 A very clear analysis with two characteristics was made by Ansari et al, 1996.

The size of the market place of each firm is equal to the sum of the volume of
pyramids. The dimensions of the flanks of these pyramids depend on the price
differentials. Therefore, the marginal consumer will choose a determined variety on the
base of the price differential and the distance of each variety from his ideal point.
Irmen and Thisse assume that t n (bn − an ) ≥ t n −1 (b n −1 − an −1 ) ≥,..., ≥ t1 (b1 − a1 ) , to
demonstrate how firms will choose minimum differentiation along the nth characteristic
and maximum along the other n-1 characteristics. For this reason, they define the nth
characteristic as dominant, whilst the others are dominated (Irmen et al., 1996).
Through several passages, Irmen and Thisse found how, under condition of strong
dominance of nth characteristic, demand middle piece for firm A is equal to11:
n n −1
~
pB − ~
p A + ∑ t k (bk2 − ak2 ) − ∑ t k (bk − ak )
~
(3.5) DA2 n −1 = k =1 k =1
2t n (bn − an )
This means that firm A can choose a pair of location and price in this demand area.
3.2.2 Nash equilibrium in price under max-min principle

Through demand function in (3.5), it is possible to solve the first order condition of
maximization to find a unique solution:
n n −1
2t n (bn − a n ) − ∑ t k (bk2 − a k2 ) + ∑ t k (bk − a k )
(3.6) ~
p *A = k =1 k =1
3
n n −1
4t n (bn − an ) − ∑ t k (bk2 − ak2 ) + ∑ t k (bk − ak )
(3.7) ~
pB* = k =1 k =1
3
In their work, Irmen and Thisse demonstrated how these two prices represent a
unique Nash equilibrium in price.
This result is interpretable through the principles of minimum differentiation
found by Hotelling and the principle of maximum differentiation found by
d’Aspremont et al (d’Aspremont et al., 1979). Furthermore, firms, on one hand, have
the tendency to locate close to each other in such a way as to exploit bigger market
shares, but with high price competition. On the other hand, firms have the incentive to
locate far from the other firms to relax price competition but with a reduced market
place. In one dimensional characteristics space, these two effects were a trade off. In a
11 The middle piece of firm B is determined since DB=1-DA.

multidimensional space these two principles can live together. Firms will choose
minimum differentiation in n-1 dimensions and maximum differentiation along the nth
characteristic. The price result is not the Bertrand one, because firms can still
differentiate their products. Hence, in this way the price is not at monopoly level but
neither at a competitive level, but in a point between these two values.
The result of the existence and the uniqueness of Nash equilibrium in price and
location imply a first result of the possibility for two firms to live together in a
differentiated market. This also means that, if in the market an incumbent that pre-
empts the market through product proliferation is present, newcomers can enter the
market and choose a location in the characteristics space in such a way as to choose
minimum differentiation along n-1 characteristics and maximum differentiation along
nth characteristic. Then, there is always space enough for entrance and to produce n
different varieties. In that way, newcomers can enter the market and choose a position
very close to the incumbent. Therefore, they can earn sufficient profits to entrance.
3.2.3 Equilibrium in location

After finding the Nash equilibrium in price, it is also possible to derive the
equilibrium in location for both firms.
Initially the profit function for firm A is given by:
π *A = p*A (a, b) DA (a, b, p *A (a, b), pB* (a, b))
Now substituting the (3.6), (3.7) in the demand function of firm A (3.5), the profit
function assumes the following form:
n −1 n
[2t n (bn − an ) − ∑ t k (bk − ak ) + ∑ t k (bk2 − ak2 )]2
(3.8) π~A2 n −1 = K =1 K =1
18t n (bn − an )
After finding the profits function and location equilibrium for firm A, Irmen and
Thisse showed their results in a special case when n=3.
The first statement is that maximum differentiation along all three characteristics is
never equilibrium. They showed how also maximum differentiation in two of three
characteristics is never location equilibrium12.
Hence, firms will choose maximum differentiation along one characteristic and
minimum along the others. Firms always want to differentiate their products to relax
12 Also in two dimensional characteristics space is confirmed the principle of max-min principle. See T.
Tabucchi (1994), pp. 207-227.

price competition. Because through relaxing price competition, firms are always better
off. Then in a multidimensional environment, it is possible for the firm to break
through the trade off that exists in a one dimensional characteristics space. In the
multidimensional space, firms can choose strategic effect in one characteristic and
agglomeration effect in the other n-1 characteristics.
3.3 Credible entry

The aim of this section is the description of a two stage game to show how brand
proliferation is a dominated strategy and then the pre-emption of the market is a no
credible threat. To understand why product differentiation is not an entry barrier, it is
possible to look to real markets, where the entrance of newcomers in differentiated
market, is observable everyday.
Hence, the entrance of new firms in market with differentiated products is a fact,
therefore, it is the duty of law and economics to explain the reasons of these behaviors.
Suppose that there is only one firm that produces several varieties of the same good.
That firm will gain extra profits in a way to attract other firms to enter. At this point, it
is possible for newcomers to enter the market and to decide whether to choose a
different intensity of differentiation along n characteristics. The newcomer can choose
this combination and can start a Bertrand competition. By the way, he can choose to
collocate near the incumbent in n-1 dimensions and at the same time decrease the
price. The task of the newcomer must be to maintain the value of the utility function
constant. As I described in relation (3.1), the utility function depends on the price of the
good and the distance from the preferred variety. Hence, if the newcomer decides to
collocate near the incumbent and charges a price below the incumbent’s price, he can
compete for the same consumers. In this case, the result is not the same found by
Bertrand with homogeneous goods, but the equilibrium prices are positive, at half way
between the competitive and monopoly outcome.
This dynamic is observable in several markets with horizontal differentiated
products. An example could be the Dutch cigarettes market. In this market, as in many
in the world, the dominant position is covered by Philip Morris and particularly by
Marlboro cigarettes. Then, I could consider Philip Morris, through the Marlboro brand,
an incumbent in this market. Some years ago, West, a new European brand tried to
enter in the market. To do that, West introduced the same varieties produced by Philip
Morris with Marlboro’s brand. West produced varieties near, in some characteristics, to
the Marlboro’s varieties.
In the West’s entry process, it is possible to find all elements of the max-min
principle. To enter the market, West, produced varieties of cigarettes with maximum
differentiation along one characteristic and minimum differentiation along the other n-
1 characteristics.
Therefore, it is possible to see how maximum differentiation between Marlboro and
West is in the taste of tobacco. Marlboro always advertised the American provenance of
its tobacco, whilst West heavily advertised the European taste of its tobacco. The
minimum differentiation between these two products is clearly observable in several
situations. For instance, the values of the cigarettes sold are similar (tar 10 mg; nicotine
0,8 mg; CO 10 mg for Marlboro and tar 10 mg; nicotine 0,9 mg, CO 10 mg for West).
Another similar characteristic in which West chose minimum differentiation is in the

colors of the package, strong taste cigarettes with red look as in Marlboro, super light
type in blue as the principal super light cigarettes produced by Philip Morris (Philip
Morris super lights). Another relevant effect is the price reduction by new entrant, in fact
West sold its cigarettes at 3.30 euro against 3.90 charged by Philip Morris for its
Marlboro.
The same situation is observable in the Italian cigarettes market, where the
incumbent is still represented by Philip Morris through Marlboro, and the newcomer is
represented by British American Tobacco (BAT) through Pall Mall brand. This
newcomer entered the Italian markets some years ago through the production of
similar varieties produced by Philip Morris. In this market, the same result of the
Dutch market can be observed. BAT differentiated its cigarettes by English nature of
the tobacco and chose minimum differentiation along other characteristics like the
colors of the package (red for the strong taste, blue for the super light taste). Also, in
this case, the entrance of the newcomer is followed by a reduction of the price in
relation to the price charged by the incumbent. Besides Marlboro sells its cigarettes in
Italy at 3.50 euro, whilst Pall Mall are sold at 2.80 euro.
In these simple examples, it is possible to see how a newcomer can enter the
market and sell products with maximum differentiation in one characteristic and
minimum differentiation along others. This strategy permits the newcomers to solve
the trade-off present in one dimensional characteristics space between agglomeration
and strategic effect. Furthermore, a newcomer can conquer new consumers through
decreasing his price; this result was found also by Ansari et al (Ansari et al, 1996). The
interesting conclusion is that newcomers can profitably enter the market. They,
through the production of varieties near the incumbent’s variety and a price reduction,
can conquer a sufficient market share. This market share is composed by three groups
of consumers. The first group is composed by the consumers in the most elastic part of
the incumbent’s demand curve. In other words, all consumers for whom the price is
more important than the variety.
The second group could be composed by all consumers for whom the new
varieties produced by newcomers are preferred to the incumbent’s variety. Finally, the
last group could be composed by new consumers who before did not buy the good.
After finding some example in real markets, I will try to describe this mechanism
in a games theory way.
There are two firms A and B. The former is the incumbent and the latter the
newcomer. This is a two stage sequential game. For simplicity let’s assume that firms
can produce only two varieties. We assimilate the production of both varieties to the
pre-emption strategy. Furthermore I assume that the marginal cost to produce another
variety is positive and constant equal to c.
In the first stage, there is only firm A in the market. It can choose to pre-empt the
market through product proliferation or produce just one variety. In the second stage,
firm B can choose to enter or stay out. If it enters, it gains positive profits whilst if it
decides to stay out, it gains zero profits.
At the base of the game there are some basic assumptions:
Assumption 1: the production cost of each variety is constant and positive equal to
c; This means that the production of other varieties is not costless for the firm, even if

this cost is low, the pre-emption strategy in case of two varieties will lead to double
costs. Furthermore there are no entry and exit cost. This is a strong assumption but in
relation to entry cost, it is not so strong because it is possible to consider the entrance of
manufacturers of product similar to the products in the new market, for instance if a
producer of tea decides to produce mineral water, entry costs are not so high because
for example he can use the same machinery and can exploit the same experience
economies. The case of positive exit costs is analyzed in the next section.
Assumption 2: for simplicity, let’s consider that firm B will enter only in the most
profitable variety produced by firm A.
Assumption 3: product differentiation is used only to avoid the entrance of
newcomers;
This assumption is less strong than it appears to be at first sight, because the aim of
this work is only to see the effect on the entry process. The brand proliferation strategy
leads firms in the market to produce several varieties only to avoid the entrance of new
competitors. The negativity of this strategy is that firms want to produce even varieties
that are not profitable, just with the aim to erect an entry barrier. Hence, it is possible to
consider the following relation:
(3.9) RiM, j = RiM
RiM, j indicates the revenue for the incumbent when he produces both varieties; whilst
RiM indicates the revenue for the incumbent when he produces only one variety.
It is possible to consider x a number of varieties that are profitable, and exceeding
this number by producing other varieties it is not profitable therefore the aim to do that
is only to avoid the entrance of new competitors. It is possible to consider the (3.9) the
situation in which firms exceed the number of varieties profitable to produce only pre-
emptive varieties. For this reason from the point of view of profits, firms do not gain
more profits from producing other varieties, therefore the aim is only to lock the door
to other firms.
This assumption derives directly from the previous models developed to
demonstrate that product differentiation is an entry barrier. It was said that the
production of several varieties has the sole aim to avoid the entrance of new
competitors. For this reason, I shared the foreclosing effect from the other effects
related with product differentiation (i.e. the gain of positive profits that derive from the
conquest of new consumers), to see if the brand proliferation strategy is profitable for
incumbent firms. To share the foreclosing effect from the others, I considered the
revenues of the incumbent under a brand proliferation strategy as the revenues in the
case of the production of just one variety. Revenues are the same in both situations,
because the incumbent produces many varieties only with the aim to avoid the
entrance of newcomers and not to earn more profits.
Assumption 4: newcomers can enter in the market producing a variety similar to
the one produced by the incumbent. They can choose to produce a variety with
maximum differentiation along the main characteristic and minimum differentiation

along the other n-1 characteristics. In that way, there is enough space for entrance,
because the newcomers can conquer a sufficient market share. As shown above, this
market share could be composed by three groups of consumers. This base of
consumers make the entrance for newcomers profitable.
Through the game’s tree, it is possible to see how for firm B entrance is always
profitable, therefore it is its dominant strategy. Furthermore, for firm A the pre-empt
threat is not credible, therefore it is not rational because it represents a dominated
strategy. I tried to show how, it is possible for newcomers to enter the market, because
they can choose maximum and minimum differentiation along n-characteristics. For
this reason the brand proliferation strategy is useless. New entrants can find a space
where they can sell their differentiated products in n-1 characteristics.
Having described the general game, I will analyze each stage of the game, more in
depth.
In the first stage there is only firm A in the market. It can choose to produce one or
two varieties. In both cases it earns monopoly profits because it is the only firm in the
market.
Then the profits for firm A, in case of product proliferation, is equal to revenues
from both varieties minus the relative production costs.
(3.10) π A = R − nc in this case is π AM (i, j ) = R AM (i, j ) − 2c(i, j )
π AM (i, j ) are the profits for firm A in monopoly regime and product proliferation;
R AM (i, j ) are the revenues from producing both varieties in monopoly regime, and c is
the marginal cost for producing each variety and in this case, it is double because firm
A produces both varieties.
If firm A decides to produce only one variety without product proliferation, the
profit function is the following:
π AM ( j ) = R AM ( j ) − c( j ) or π AM (i ) = R AM (i ) − c(i )
After the description of the situation before the entrance, it is interesting to look at
the payoffs after the entrance and then see the Nash equilibria.
In figure 3.2, it is possible to distinguish two sub games, the case when firm A
chose to pre-empt the market through brand proliferation and the case when firm A
chose to produce only one variety.
From the game tree the sub game equilibrium in the pre-emption case is Enter and
firm B would earn profits equal to( π BD (i, j ) >0 ), whilst if firm B stayed out, it would
earns zero profits.

In case firm A chose to produce only one variety, the sub game equilibrium would
be Enter again, because firm B would earn positive profits equal to π BD (i ) >0 instead
zero profits.
After finding the sub-game equilibria, to see the equilibrium of the game, we have
to look at the choices of firm A(figure 3.2).
In this case, it is evident how firm A will choose to produce just one variety
because, in case of brand proliferation, the profits are the same but the costs to produce
another variety is positive and leads to double production cost equal to 2c. Hence,
brand proliferation strategy, considered a strategy with the only aim to avoid the
entrance of newcomer is a dominated strategy therefore it is never profitable. For this
reason it is possible to say that brand proliferation is not a credible threat. Hence, the
aim for firms to produce many varieties is only to earn more profits and conquer
newcomers and not to avoid the entrance of newcomers.
Brand proliferation could be a profitable strategy only in geographical locations,
like the location of shops along a street, but not in the case of product location into the
characteristics space. The difference between these two cases is crucial. The confusion
in previous address models was started by considering consumers’ preferences such as
a location in a physical geographic space as the Hotelling main street. In a city or in a
street, the space is really finite and, therefore it is possible to pre-empt the market
through the occupation of the space. Consumers’ preferences are not identifiable to a
finite space as one-dimensional characteristics space. The best representation is the
multidimensional characteristics space that explains how firms always can sell
products to different consumers. New entrants, through the production of similar
varieties to the one produced by the incumbent at a lower price, can conquer three
types of consumers.

Figure 3.2 – Game’s equilibrium

Enter
R1D − nc; R2D − c
Pre-empt
Stay out
R1M − nc; R2O
A
Enter
R1D − c; R2D − c
No pre-empt B
Stay out
R1M − c; R2O
3.4 Exit cost and entry process

This section considers the case of low exit cost. In this situation, there are very
important implications for the entry process. If there is an incumbent that produces
several varieties, it was demonstrated how, in case of entry, it is more convenient for
the incumbent to withdraw in the other varieties where there are not new entrants. For
this aim I will use the model developed by Judd (Judd, 1985).
In this model, Judd considers the existence of two goods, orange and apple that are
substitutes. Through a four stage game he shows how product proliferation is not
credible with low exit cost. Entry and exit are not costless. A crucial role is played by
exit costs and the distinction from sunk cost of entry. High entry costs, such as
irreversible investment in product-specific capital, do not affect rational choice after
both firms have entered.
“…..The advantages of exit to a multi-product incumbent faced with entry are unaffected
by such sunk costs. The level of exit cost, that is, the cost arising only because of the act of exit,
are important and may lead the incumbent to remain in a market even after entry….” (Judd,
1985, p. 154).
In stage 1, firm one enters the apple (A) market, or in the orange one (O), or both
(AO) or neither. In stage 2, firm two enters in A, O, AO or neither. Stage 3 is
characterized by the exit choices of the firms. When the newcomer enters the market,
he starts a Bertrand competition. Decreasing price in one market has the effect of
decreasing the demand in the other market, because the two goods are complements.
The ultimate result is that the incumbent bears a price war in one market and a
decreasing demand in the other market. Hence, the profits for the incumbent are
consistently low. The best response for the incumbent is to withdraw from one market
and sell only in the other one.

As argued by Judd, in differentiated market, exit costs in each variety are usually
low; his analysis suggests that ‘pre-emption by crowding may not be an important
barrier to entry’ (Judd, 1985).
3.5 Product differentiation and European competition law: the Nestlé-Perrier case
and the Kimberly Clark- Scott case
The Nestlé-Perrier case (ECJ, Case IV/M 190 Nestlé/Perrier [1992] OJ L 356/1) and the
Kimberly Clark- Scott case (ECJ, Case IV/M 623 Kimberly-Clark/Scott Paper [1996] OJ L
183/1) are the most important cases in which the role of product differentiation and
brand proliferation strategy in Europe was considered.
3.5.1 The Nestlé-Perrier case

That case is very important also for other two reasons. Firstly in this case, the
Commission tried to extend the concept of dominant position to the concept of
collective dominance. Secondly in this case, ‘the SSNIP’s European presence was
upstaged’ (Van den Bergh et al, 2001).
Nestlé is a Swiss company which, at the time of the decision, was active in many
sectors of nutrition. The Nestlé group had a consolidated worldwide turnover of more
than ECU 28000 million. Perrier was a French company which is mainly active in the
manufacture and distribution of bottled waters. Perrier had some activities in the
cheese market. The consolidated worldwide turnover was of over ECU 2000 million.
In 25 February 1992 Nestlé notified the Commission a bid for 100% of the shares of
Perrier.
The principal difficulties in this case was the definition of the relevant market.
Nestlé proposed that there was no separate market for bottle source of water, and that
the relevant market to assess the proposed concentration should be that of non-
alcoholic refreshment beverages, including both bottle source water and soft drinks.
On the other hand, the Commission showed how through demand and supply
substitution there are separate markets for non-alcoholic beverages and bottled source
water. The relevant geographic market was individuated as being France.
After the market definition challenge, the second problem was the high degree of
brand recognition and brand proliferation in the market.
This concept was underlined several times in the decision. From the point of view
of the Commission, after the merger, only two big incumbents in the market that sell
many brands exist. The new entity Nestlé-Perrier had eight still mineral water sources
of which three major sources (Contrex, Volvic and Vittel) and seven sparkling mineral
water sources of which two major sources (Perrier and Saint-Yorre). At a national level
there is the other competitor, BSN with only one major water source (Evian), and one
major sparkling mineral water source (Badoit). These several brands for the
Commission could deter entrance of new competitors. This decision could be read as if
the Commission considered advertising and brand proliferation as entry barriers.
At the end, for several reasons, the acquisition by Nestlé of Perrier was declared
compatible with the common market.

In this case, the relevant element, is that the Commission did not achieve to
demonstrate that product differentiation is an entry barrier. However, the aim of this
work is to show how the Commission’s view is not correct. The consideration of
horizontal as barrier to entry is not supported by theoretical models. As shown in
previous models, it is possible to see how entrance of newcomers in differentiated
market is possible. Furthermore, firms choose to differentiate with the aim to earn
more profits and not to avoid the entrance of new competitors.
3.5.2 The Kimberly Clark-Scott case

This case regards the intention of Kimberly Clark (KC) to merge with Scott. In fact,
KC on 8 August 1995, notified its intention to merge with Scott Paper company to the
Commission. On 12 September of the same year, the Commission Concluded that the
notified operation fell within the scope of Regulation 4064/89 (Merger Regulation).
On one hand, KC was mainly engaged in the production and sale of a wide range
of paper and related products for personal, business and industrial use on a worldwide
dimension. Its total turnover was about ECU 6200 million . On the other hand, Scott
was active worldwide primarily in the manufacture and sale of tissue products for
personal care, environmental cleaning and wiping, health care and food services. Its
total turnover was about ECU 3000 million.
The important aspect in this operation was that the merged entity formed the
world’s largest manufacturer of tissue products and it was the number one producer of
tissue in Europe. Therefore, KC and Scott, through the merger, can strength their
market position by combining strong consumer brands and bringing together their
considerable production and marketing resources. This case is also important because
it shows how it is ‘crucial to assessing a merger’s real-world competitive effects are
estimates of price and cross-elasticity of demand placed in the wider context of the
hypothetical monopolist setting’ (Van den Bergh et al, 2001, p. 117).
The merger was considered a concentration on the basis of the article 3 of the
Regulation 4064/89. Furthermore, the notified operation met all the thresholds of
article 12 of the Merger Regulation, therefore, was considered as a concentration with
Community dimension.
The Commission found the relevant consumer tissue paper product markets were
toilet paper, kitchen paper and handkerchiefs-facials tissues as a single market. This
market was defined as Away-from-home tissues products (AFH).
Furthermore, the Commission recognized two separated market segments, the
branded and the private-label.
In this case, the Commission made extensive use of toilet tissues market studies.
Particularly, it presents more data to show how the high degree of advertising and
brand loyalty can represent a very important barrier to entry for newcomers. By the
way, the correlation between advertising expenditure and market shares was
interesting.
The Commission indicated how market share was a dependent variable of the
level of advertising. This conclusion was found by the analysis of the figures in tables 1
and 2.

Tab. 1- Advertising expenditure 1990 to 1994
Combined KC-Scott advertising As percentage of total

expenditure advertising expenditure
Toilet tissue UKL 51 million 88%
Facials UKL 11 million 93%
Kitchen towels UKL 6 million 82%
Source: European Commission, decision C(96) 44 final, 16 January 1996
Tab. 2- Comparison of market share with advertising expenditure
Combined branded products market Percentage of total

share of KC-Scott advertising expenditure
Toilet tissue 70-80% 88%
Facials 70-80% 93%
Kitchen towels 50-60% 82%
Source: European Commission, decision C(96) 44 final, 16 January 1996.
Through these figures the Commission tried to prove how brand proliferation and
advertising could be a barrier to entry for newcomers. In other words the
establishment of a new brand would require heavy investment in advertising and
promotion in order to persuade brand loyalty consumers to switch away from their
usual brand. Such expenditure is a sunk cost and adds to their risk of entry.
As I described, in the previous chapters, it is improbable that incumbent firms can
avoid the entrance only through brand proliferation. Furthermore, it is easily
observable how a newcomer could enter the market through the production of similar
varieties and with a lower price, in order to attract all consumers who are more
sensible to price. In that way, the newcomer can find its way to penetrate the market. It
is not right to think of the possibility for newcomers to compete at the same level or at
same scale with established firms. Incumbents can take their position through several
years in the market and through the production of high quality products. Therefore, it
is important to look at the real possibility for a newcomer to enter in the market and
gain a sufficient market share.
Besides, the correlation between market shares and expenditures in advertising is
not clear and scientifically proved. In other words, the incumbents could gain their
market shares because they sold a high quality product for an extended period of time.
Advertising could permit consumers to discover the high quality of products sold by
incumbent firms.

Nevertheless, this work analyzes only the effect of product differentiation.

Therefore, on the basis of the previous models, presented in this chapter, it is possible
to say that only product differentiation could not avoid the entrance of newcomers. A
new brand can enter the most profitable varieties and it can enter by producing a
similar variety to the one produced by the incumbent.
As shown by the Commission’s decisions, advertising could be a barrier to entry,
but not product differentiation Per Se. Even if advertising is considered a sunk cost, it is
necessary to separate the effect of advertising from the effect of product differentiation.
Another actual barrier could be represented by a patent. It cannot permit a newcomer
to produce similar varieties of the one produced by an established firm. Only in this
case, it is impossible for new competitors enter the market, although, the effect of the
patent is not necessary linked to product differentiation.
From the analysis of these two cases, it is observable how a case-by-case analysis
and a greater rule of reason approach are really necessary. With a case by case analysis,
it is possible to separate the several aspects that characterize differentiated markets
(Brand loyalty, brand proliferation and advertising). Furthermore, through a rule of
reason approach, it is possible to better understand if in the market only the effect of
product differentiation is present. Through product differentiation more consumers
can found their preferred products, and at the same time firms can conquer new
segments and new consumers.
Therefore, the Commission’s view is too restrictive in the analysis of differentiated
markets. It is not possible to consider the production of several varieties only a way to
pre-empt the market. Firms want to differentiate their products only with the aim to
earn more profits. Therefore, in competition law analysis it is necessary to carefully
look at the effect of product differentiation and the effect of elements that could it
presents together. 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. Then it is necessary to consider only the real barrier to entry.
CONCLUSIONS
Product differentiation represents an important characteristic for many markets. In
several markets differentiated products are sold. Therefore, it is important to establish
the real role played by horizontal differentiation in the market. It is necessary to
establish which the reasons for firms to differentiate their products are. Usually,
competition law’s Authorities consider product differentiation as an entry barrier.
However, a case in which product differentiation represented an element to
declare a concentration incompatible with the common market; or an abuse of
dominant position does not exist. This is an evidence of the difficulty to demonstrate
how product differentiation is an entry barrier.
As shown in this work, the best way to represent consumers’ preferences is
through a multidimensional characteristics space. In this kind of space, firms can enter
the market and produce a variety that permits to make the entrance profitable.
I showed how the results found by Hotelling are correct only in a one-dimension
characteristics space. Therefore, to approximate this space to consumers’ tastes is not

correct. Through a multidimensional characteristics space it is possible to develop the

max-min principle. This principle is very important, because it permits us to understand
the real functioning of differentiated market. With a multidimensional space, firms can
choose maximum differentiation along one characteristic and minimum differentiation
along the other n-1 characteristics. Thereby the max-min principle, firms can overcome
the trade-off that characterize the space with one-dimension. This trade-off was
represented by the strategic and agglomeration effect.
The big error in the assessment of entry barriers in differentiated markets is to
consider many effects as only one. In case law, as Nestlé-Perrier case or in Kimberly
Clark-Scott case, the Commission considered the presence of several varieties,
advertising and brand loyalty as one thing. This is not the best way to analyze
differentiated market. As such, an efficient behavior like product differentiation is
considered the culprit that hinders the entrance of newcomers. In other words it is
necessary to distinguish the role played by each element (product differentiation,
advertising, sunk costs etc.). The aim of this work was to show how just product
differentiation is not an entry barrier, but only a way for firms to conquer new
consumers.
The useful conclusion is the necessity for competition law’s authorities to use a
greater rule of reasons approach and a case-by-case analysis. Through these actions, it
is possible to distinguish the good effect of product differentiation from other effects
that could be presented together. Through a case-by-case analysis, it is really possible
to see if the benefit of product differentiation is covered by the negative actions of
other elements as high sunk cost or, even worse, patents. Therefore, this work calls for
a greater use of a rule of reason approach. Besides, where these effects are not
separable, it is necessary to establish if the efficiency gains that derive by product
differentiation are outweighed by other negative effects.
In conclusion, this work showed how only a brand proliferation strategy is not a
credible threat, therefore, it is not a profitable strategy for incumbent firms. The future
hope is that the next researches will clear, in a better way, which elements represent an
entry impediment and which are efficient behaviors.

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HORIZONTAL PRODUCT DIFFERENTIATION AND ENTRY

BARRIERS ACCORDING TO EUROPEAN COMPETITION LAW

Libera Università Internazionale degli Studi Sociali Guido Carli di Roma

I QUADERNI DEL GRIF, ANNO I , 2005 3

I QUADERNI DEL GRIF, ANNO I , 2005 4

1.1 What is an entry barrier: the definition challenge

1.1.1 The Structuralist or Harvard approach to entry barriers

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1.1.2 The entry barriers concept in the Chicago School approach

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1.1.3 Welfare analysis of entry barriers

1.2 Entry barriers and European competition law

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“The dominant position referred in article 82 relates to a position of economic

3 See new ‘Merger Regulation’, Regulation n. 139 /2004.

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An important aspect in the analysis of entry barriers is the classification, because

1) entry barriers arising from absolute advantages;

1.2.1 Entry barriers arising from absolute advantages

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1.2.2 Entry barriers arising from strategic-first mover advantages

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Usually, but not necessarily associated to product differentiation is advertising.

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1.2.4 Entry barriers arising from predatory conduct

(1.1) π e (qe + qi ) = P(qe + qi )qe − C (qe ) = 0

I QUADERNI DEL GRIF, ANNO I , 2005 13

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2.1 Spatial models of imperfect competition

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Figure 2.1 – Hotelling’s Main Street

(2.1) p1 + t(s1, χ) = p2 + t(s2-χ)

χ1(p1, p2*) = 0 if p1> p1++

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Figure 2.2 – Demand curve of firm 1

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The model developed by Schmalensee is the most important theoretical approach

Figure 2.3- Schmalensee’s Characteristics space with two incumbent firms.

(2.5) π ( p, n) = ( p − m)Q − F = A( p)b(n) − F

(2.6) with A (p) = (a (p) (p-m)

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Consider a given price p, n~ is the solution to the equation π ( p, n) = 0, in this case

(2.7) max[nπ ( p, n)] = max[nA( p)b(n) − nF ]

(2.8) π ( p,2n) = A( p)b(2n) − F ≤ 0

It is possible to deduce two cases in post-entry condition, the first is the

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(2.9) π ( p,2 k n m ) > 0 > π ( p,2 k +1 n m )

Then, it is possible to consider 2 k n m as the maximum number of brands consistent

(2.12) π ( p d , n d ) > π ( p,2 k n m )

Under (2.10) nd < 2 k n m . Therefore, product proliferation is the production of the

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3. THE ESSENCE OF COMPETITION IN DIFFERENTIATED MARKETS

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3.1 The multidimensionality of the characteristics space

possible to find the total population as ∫ g ( z )dz = N .

Through some mathematical tools, it is possible to describe analytically the utility

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(3.1) VA (z) = S − pA − ∑tk (zk − ak )2

Furthermore, it is assumed that each variety is produced at constant marginal cost

3.2 Max-min principle and multi-characteristics space

π A = pA (a, b) DA (a, b, p A (a, b), pB (a, b))