Differentiation softens price competition. Given this, does it make sense for firms to always look for the maximum product/service differentiation that is achievable? The answer is that, while more differentiation is usually preferable to less, there are forces which oppose differentiation that need to be considered when determining how much differentiation is optimal.
First, in many cases demand is driven by physical location. Many service providers and some product providers), choose to locate close to their customers, where the demand is. This concentration intensifies price competition and may blunt differentiation. In this case, increasing differentiation, or undertaking horizontal differentiation, may be required.
Secondly, there may be positive externalities between firms. related to the above, there may be externalities that induce firms to locate close to one another. Firms may choose to be closer to their source of supply for input materials to reduce transportation costs, or they may choose to locate close to one another to reduce the search costs of customers. An example of the latter is auto malls, where the dealers of various manufacturers cluster. In these cases, while price competition is intensified, it may be offset with greater differentiation of the product or service being provided.
Thirdly, price competition may be limited by legal or technical reasons. For example, resale-price maintenance agreements imposed by manufacturers may serve to limit the degree of price competition for some products. in these cases, where price competition is softened as a result, firms have less incentive to differentiate fully.
There is no easy to answer to how much differentiation is enough. However, a consideration of the above three forces may give clues as to the relative amount of differentiation that may be needed in any given setting.