Quality preference, congestion, and differentiation strategy

The high quality preference of consumers expands the market share of high quality firm; however, it yields negative network externalities of consumers that come from congestion and affects firms' differentiation strategies and quality behavior conversely. In this case, we extend the Hotelling model in which firms maximize their profits by means of their location and quality in the presence of the congestion cost. We show that the only differentiation set is two firms separate at the endpoint of the interval if the quality preference is sufficiently high or low. When the consumers' quality preference is not sufficiently high or low, the two firms conduct the Principle of Limited Differentiation. In addition, we also find that the quality and price strategies of firms are related to their differentiation strategy and have different effects on firms’ optimal quality and prices.