Input specificity and product differentiation

Using a simple product differentiation model with elastic demands, we investigate the relationship between differentiation strategies and vertical relations. Depending on the competitive structure in the upstream market, three differentiation patterns (maximum, minimum and partial differentiation) can appear in equilibrium even though each downstream firm freely determines the degree of product differentiation. When downstream firms must incur positive investment costs to differentiate their products, they tend to do so if the upstream market is competitive.