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PRODUCT DIFFERENTIATION

 

 

by Valentino Piana (2003)

 
     
 
 

Contents


 
 
1. Significance
 
 
2. Vertical differentiation
 
 
3. Horizontal differentiation
 
 
4. Mixed differentiation
 
 
5. Determinants
 
 
6. Impact on other variables
 
 

7. Product differentiation and price differentiation

8. Substitute goods and product differentiation

9. Long-term trends

 
 
10. Behaviour during the industry life-cycle
 
 
11. Policies
 
 
12. Formal models
 
 
13. Data
 
 
14. Links
 
 
 
 

Significance

Offered under different brands by competing firms, products fulfilling the same need typically do not have identical features. The differentiation of goods along key features and minor details is an important strategy for firms to defend their price from levelling down to the bottom part of the price spectrum and prevent other firms from supplying the same good to the same consumers.

Within firms, product differentiation is the way multi-product firms build their own supplied products' range.

At market level, differentiation is the way through which the quality of goods is improved over time thanks to innovation. Launching new goods with entirely new performances is a radical change, often leading to changes in market shares and industry structures.

In an evolutionary sense, differentiation is a strategy to adapt to a moving environment and its social groups.

Vertical differentiation

Vertical differentiation occurs in a market where the several goods that are present can be ordered according to their objective quality from the highest to the lowest. It's possible to say in this case that one good is "better" than another.

Vertical differentiation can be obtained:

1. along one decisive feature;
2. along a few features, each of which has a wide possible range of (continuous or discrete) values;
3. across a large number of features, each of which has only a presence/absence "flag".

In the second and third cases, it is possible to find out a product that is better than another one according to one criteria but worse than it in respect to another feature. This generates tensions and trade-offs, with competing firms trying to highlight the importance of the feature their goods are stronger in. For instance, green products have a lower (or zero) negative impact on the environment, whereas they may be turn out to be inferior to conventional products under other axes of differentiation.

Vertical differentiation is a property of the supplied goods but, as it is maybe needless to say, the perceived difference in quality by different consumer will play a crucial role in the purchase decisions.

In particular, potential consumers can have a biased perception of the features of the good (say because of advertising or social pressure and cultural conditioning).

Consumer decision rules when the product is differentiated are presented in this paper.

Vertical product differentiation examples include products with ranked ingredients (e.g. in descending order: olive oil, mais oil, palm oil, mixed oils) or dychotomous materials (e.g. fake vs. original assembled parts).

When evaluating a real market, a good starting point is a top-down grid of interpretation, we shall present first in 3 segments.

Class Price Crucial feature
Low

Low

The price is low, the product simply works

Middle

Middle

Use of the good is comfortable. Most people use it. Mass market brand

High

High

Quality, exclusivity, durability
(= low life-long price)

To this basic classification, one should add two intermediate classes:

Class Price Crucial feature
Middle-low

Low

The cheapest nation-wide brand

Middle-high

Middle

The cheapest product of high quality

Two extreme classes should finally be added:

Class Price Crucial feature
Extremely low

Very Low

It usually does not work, it does not last, and it has important defects

Extremely High

Very high

Exclusivity, non practical, status symbol

In this way, you can vertically position different brands and product versions, also using clues from advertising campaigns.

If you compare widely different goods fulfilling the same (highly-relevant) need, you may distinguish at the extreme of your spectrum necessity goods and at the other luxury goods. In other cases, what makes this difference is, instead, the nature of the need fulfilled and the number of needs fulfilled.

As a general rule, better products have a higher price, both because of higher production costs (more noble materials, longer production, more selective tests for throughput,...) and bigger expected advantages for clients, partly reflected in higher margins.

Thus, the quality-price relationship is typically upwards sloped. This means that consumers without their own opinion nor the capability of directly judging quality may rely on the price to infer quality. They will prefer to pay a higher price because they expect quality to be better.

This important flaw in knowledge and information processing capability - an instance of bounded rationality - can be purposefully exploited by the seller, with the result that not all highly priced products are of good quality [1].

Through this mechanism, the demand curve - that in the neoclassical model - is always downward sloped, can instead turn out to be in the opposite direction, with higher sales for versions having higher prices.

Horizontal differentiation

When products are different according to features that can't be ordered in an objective way, a horizontal differentiation emerges in the market.

Horizontal differentiation can be linked to differentiation in colours (different colour versions for the same good), in styles (e.g. modern / antique), in shapes, in flavours, in tastes, in well-known category-idiosyncratic axes as well as elaborated proprietary marketing categories.

A typical example is the ice-cream offered in different tastes. Chocolate is not "better" than lemon.

This does not prevent specific consumers to have a stable preference for one or the other version, since you should always distinguish what belongs to the supply structure and what is due to consumers' subjectivity. Some consumers would prefer lemon to chocolate, others the opposite, but this relates not to the product line structure but to them (both as a whimsical choice or as a category of people they feel, choose or know to belong).

It is quite common that, in horizontal differentiation, the supplier of many versions decide a unique price for all of them. Chocolate ice-creams cost as much as lemon ones. Similarly, several variants of tastes or flavour are often offered at the same price. In restaurants, all desserts might be all priced at the same level. Some would say that in such cases the consumer is really free to express its preferences, as all alternatives cost the same.

Another example of horizontal differentiation is represented by films: each film is different from the others, while the price of entry to cinema is always the same. This example shows that the internal organization of the differentiation space can be structured around "genres" and several similarity measures can be taken (e.g. two films having in common the film-maker, an actor, etc.), without being linear and continouos (nor too precise!).

When consumers don't have strong stable preferences, a rule of behaviour can be to change often the chosen good, looking for variety itself. An example is when you go to a fast food and ask for what you haven't eaten the previous time.

Fashion waves often emerge in horizontally-differentiated markets with imitation behaviours among consumers and specific styles going "in" and "out".

Other examples of horizontal differentiations are politically-oriented newspapers and political parties.

In certain conditions, several versions of horizontally differentiated products can be "located" along one or more axes of differentiation and some "distance" measure can be computed. Consumers can then interpreted to have an "ideal" location and to rank all versions according to that distance (with preferred version being nearer). This distance can be symmetric or asymmetric, i.e. with one direction being preferred to the other. For instance, chocolate bars can contain different percentages of cocoa (11%, 45%, 60%, 70%, 85%, 99%, ...), with each consumer expressing a "perfect" percentage and rules about deviations from it (e.g. "reject versions with percentage higher than...."). This is similar but not identical to what happens to vertical differentiation. In the latter, the higher the better, irrespective of consumer ideal position.

However, more in general, horizontal differentiated versions may not be ordered along axes, but merely juxtaposed.

Mixed differentiation

Certain complex markets are characterised both by horizontal and vertical differentiation. For instance, apparel, garments and shoes have an amazingly rich combination of shapes, colours, materials, complementarities to each other and to the cumulative bundle already in the consumer's house, seasonal and territorial specificities, appropriateness to social events, relative distance to ideals promoted by media, stylists and the showbusiness. The quality of the materials can often be seen as a vertical differentiation but some other elements are clearly horizontal, like shapes.

Internal to each version of clothing, there are different sizes (e.g. S, M, L, XL for Small, Medium, Large and Extralarge respectively, translated - with many difficulties - into numbers, according to national and international standards, often deviated by companies). This is a case when the consumer should know his "type" and look for products matching it. He has no (or very mediated) control over its size. Consumer evolution of preferences for sizes is led by objective bodymass increases and other changes in the shape of the body.

Conversely, the production should reflect the distribution of sizes in the target population (but some sizes may remain unsold and some people disappointed).

Another great example of mixed differentiation is the car market, with a huge number of parametres, partially horizontal and partially vertical.

In such a environments of mixed differentiation, consumers can develop fairly different styles of comparision, with some spending large amount of time getting exposed and evaluating versions, talking with others and sharing judgments, while others drastically reducing the difficulty of the comparision through repurchase of very classical items.

Some consumer explore many alternatives, others try to reduce the number of the options to the the lowest possible. Some would analyse many features of every option, others would concentrate on the highest ranked features. Some would highlight many different levels for each axis of comparison, others would dychotomize in presence / absence of a certain characteristics. Some would keep into account several variables and "compensate" across weaknesses and strenghts, others would set minimal requirements independently for each variable, without comparison across axes. Those who follows the first of each abovementioned statements might be called as "highly sophisticated" consumers, those who follows all the second ones as "simplifiers", but many mixed cases can be constructed (in agent-based models) and observed (in the real world). Empirical surveys could try to see whether men and women are mainly "sophisticated" or "simplifiers" or - better - whether "sophisticated" and "simplifiers" are disproportionately present in gender-sensitive categories, possibly including age. For a wider discussion on consumer rules of this kind see here.

In services, e.g. hair-cutting, the personal skills, attitudes and behaviours of the people personally performing the service to the customer can lead to a widely mixed differentiation, resulting from the interaction with the customer and his latent and outspoken tastes and requests. Earlier, the same personal selling activity leading to the purchase can differentiate the service in one place from what is supplied somewhere else.

Determinants

Contrary to the neoclassical approach of technique choice along isoquants, every change in proportion of productive inputs (entering in the final product) leads to product differentiation.

How a product rates according to different measures of quality or taste depends on both its physical and immaterial characteristics.

The raw material from which it has been built, the share of high/low quality ingredients / components, its engineered design, its production process are typical determinants of product specificity, whose complexity might be reduced by consumers looking at its brand.

On labels, the producer can emphasise the presence or the absence of a certain ingredient (e.g. GMO, saturated fat, gluten-free, etc.); a time dimension can lead to labels like "New" / "New formula" or, by constrast, "Original recipe" / "Old style".

More broadly, product differentiation can be:

1. the indirect effect of different endowments in raw materials, know-how, style preference of different firms ignoring each others;

2. the conscious choice, out of firm strategies, to position each product against competitors;

3. the costly, uncertain, and difficult outcome of innovation efforts.

In perspective 2, how to achieve product differentiation? The steps are the following:

a. to map all competitors' products and compare them couplewise or in groups;

b. to identify explicit and implicit axes of differentiation, qualitative or quantitative;

c. to identify the accumulation points where most competitors are focused;

d. to highlight "empty spaces" where combination of features are abstent;

e. to brainstorm around which consumer segment could be interested in such (unusual / counterintuitive) combination of features;

f. to preliminarily estimate the size of the segment;

g. to explore if the firm has the capability of offering such product and at which cost (fixed and variable);

h. to transform the segment into a viable niche by choosing a price, an advertising strategy and a distribution channel (as other selling costs) in a way that assures that the supply of the product is profitable over a reasonable time;

i. to defend the niche against "invaders".

In short, product differentiation can be a driver for new product development and product innovation. In this vein, patents on differentiated products can defend the innovator from imitation.

In another perspective, product differentiation in industrial goods can be achieved by these key ways e.g.:

1. by processing the same raw material (e.g. wood) or key intermediate good (e.g. paper) towards several alternative products, matching totally different needs (e.g. newspapers, toilet paper and paper towels);

2. by adding different chemical or non-chemical additives so as to change its properties (e.g. flavours into a cosmetics);

3. by substituting key components and introducing necessitated further coherent changes;

4. by putting in competition new services with goods (e.g. cars vs. car renting);

5. other manipulation, modification and substitution of sub-components and ingredients.

In certain cases, the conscious effort of seller is to increase the buyers' difficulty to compare prices across products that are largely similar in their basic features, so differentiation reverts to non-standard sizes and packages, non-standard price expressions, and totally extrinsical added features (e.g. merchandising of a new animation film copied on the package of a product for kids).

The distribution of tastes and evaluation routines across final consumers is extremely relevant for the success of differentiating the product. Indeed, if all consumers would have the same preferences, they would largely converge on one or few versions. It's because consumers have unstable, heterogeneous and context-dependent preferences that product differentiation can systematically characterise a market.

Producers can play it safe when offering features that are commonly evaluated as positive (and shared by many other goods) while risk more by offering strange and extreme features that some love and others hate. In the first case, the product will be somehow "normal" and mainstream, possibly requiring large advertising to be seen as the "barycentre" of the market, whereas in the second case, the product will address a niche of connaisseurs.

The presence of a wide product differentiation, however, is not a guarantee that every possible combination of features will be offered, thus some consumers might find disappointed as for their ideal version. This lack of versions is the results of three overlapping phenomena:

1. to offer a version can entail fixed costs (e.g. in research or in capital equipment), so no firms will offer a combination that is expected to attract an unsufficient number of consumers, whose purchase generate total margins higher then the fixed costs;

2. much of the product differentiation is provided in terms of "deviation" from a standard model (a "market barycentre" or "market benchmark" or a "dominant design") along one axis per product and not more than one. For instance, from a central "drink" you could generate versions that are, respectively, sweeter, less-calories, more acid, etc. But there is no version that is at the same time more acid and low-calory.

In a geometrical representation, the market is like a star (the central product) and its rays (versions). But two rays do not cross each other.

Another example is from the car industry: in certain countries, "automatic driving" is a frequent variant from the dominating manual driving; also LPG-fueled cars are existing variants from the dominating gazoline-fueled cars. But it's hardly possible to find LPG-fueled automatic cars, especially in small-sized cars.

3. firms might be wary of cannibalising their existing product sales, if they introduce versions that substitute them while providing lower margins.

However, if a consumer does not find a perfect version maybe it's simply because no producer is aligned with his preferences or has imagined such a thing; it may be just the result of ignorance or lack of imagination. From the "critical response" to a lack of market supply, a product innovation can come.

In a different perspective, producers can deliberately choose to share certain "standards" (i.e. not to differentiate along those features) in order to offer a critical mass of users for complementary devices as well as to pool consumer experience, reducing the difficulty of use the product. The lawmakers can encourage or mandate such behaviours, also in the interest of competition along other axes (e.g. price).

An important selective role of the width of the product differentiation available to final consumers is played by retailers (and distribution channels in general). If inventory and storage costs are high, retailers might try to limit this range, that instead grows exponentially in the case of particularly low inventory and storage costs (as it happens with many e-commerce sites). More in general, the width of offer (number of varieties on sales) depend on the strategies of category management at retailers (embedded in "formats" but with some degree of freedom inside). For instance, by sharing selling costs to different products and variants of products, retailers can provide superior services to customers or cheaper final prices.

Impact on other variables

Differentiated versions of a good can have widely different costs of production. Product platforms have been introduced to balance a large varieties with cost containement.

Upstream, diffentiated products may be produced using different raw materials and semi-manufactured parts, thus referring to diverse suppliers and their relative market power. Import of exotic substances can be the effect of the attempt to introduce new goods on the market (think for instance to cosmetics).

Downstream, the supply of different and better goods allows for deeper fulfilment of consumption needs, for production processes at higher productivity as well as for the opening of export opportunities to other countries, as international trade is largely an exchange of differentiated products.

For the firms introducing the new version of the product, the expected results are mainly improvements of profits (thanks to lower elasticity of consumption to price and higher mark-up on costs), sales, and market shares.

Retailers usually love premium products. The advantage of credibly sustain a higher price over competitors can in fact translate into larger margins to retailers per each unit sold. If the retailer think that the consumer will buy one unit for that class of products, it will select for its shelves products that maximise the absolute margin it gets. Conversely, a cheap product can have an enemy in the distribution channel, as they feel to suffer reduced margins from sales because of "cannibalisation" of existing brands.

However, a retailer may have the interest in providing "enough" product differentiation on its shelves, so as to extract the maximum amound of willingness to pay from consumers of different incomes, reserve prices and tastes, as well as to avoid that a customer loyal to a certain variant of a good will look for it in other commercial premises, which might be an irreversible shift in sourcing if the competitor demostrate further advantages to its new customer. For a restaurant, to offer a fairly wide menu allows to attract and retain customers. The width of product line on offer is a key competitive weapon and is expression of competitive positioning (e.g. restaurants offering food previously frozen can offer an amazingly wide menu while top quality restaurants might bet on few exceptional dishes).

For the consumer, product differentiation can increase the satisfaction from her/his consumption, as the product better fit her/his needs, conditions of use and special purposes. At the same time, (s)he will be confronted with a wider spectrum of prices. Test whether how much quality is expensive by playing this business game.

When faced with the burgeoning choice spectrum at supermarket premises among product varieties of the same category, the consumer can react with several rules of selection; retailers take them into account to assure profits and profitability, as you can experiment with this spreadsheet.

At the same time, product differentiation can lead to the exploration of the product space by un-loyal customers, who use the repurchase occasions to try new versions.

Product differentiation can be constructed to be opaque and difficult to appreciate, generating confusion and uncomparability of prices, as with the case of private label by retailers that are present only in their premises and not in their competitors' ones.

Consumers skills in evaluating goods across versions and prices are nurtured by a sufficiently rich environment of social interaction and information (e.g. labelling laws and industry practices, independent consumer magazines, etc.).

In particular, in contrast to neoclassical claims that "preferences are given", tastes evolve over time due to experiences (both personal and indirect, e.g. by looking at others).

Personal experience can be a process leading to getting to like certain previously unacceptable versions, as the following instruction by the producer of a high cocoa percentage chocolate.

Another important dimension of consumer behaviour that is influenced by the width of product differentiation is the time length of search for the purchase, that can be increased if differentiation is wider and opaque (e.g. requires visits to many points-of-sale, hidden features, etc.).

Product differentiation and price differentiation

At first sight, product differentiation seems to be a pre-condition and a justification for differentiation of prices: different products can easily have different prices. However, price differentiation occurs even without it:

a. products can be physically identical and be priced widely differently just because of "brand" (which means they differ just because of the producer or the group of producers under the same label, maybe a private label of a retailer);

b. exactly the same branded product can be priced differently depending on the distribution channel (e.g. supermarkets vs. small family-run shops) or within the same channel (e.g. in different supermarkets);

c. even in the same Point of Sale the price can be different over time (e.g. with reversible temporary promotions);

d. a perfectly identical product in the same shop can have two (or more) prices at the same time (e.g. to fidelity card owners vs. non-owners).

Conversely, horizontally differentiated goods can well share the same price, as it happens with vertically differentiated one, e.g. during promotion periods in which the superior good is temporarily priced down or aross different points of sales.

These dynamics influence consumer behaviours, purchase postponements and switches over time and points of sales.

Please note that price differentiation is not price discrimination: it's a broader concept where prices across both the same and other producers (and brands) are different from each other, whereas price discrimination refers to products of the same producer.

For a model of price differentiation, implicitly assuming product differentiation and heterogeneous cost structures, see this model of ours.

Substitute goods and product differentiation

You would expect that the varieties of the same good are substitute for each other: a consumer would actually compare them and choose only one, possibly being sensitive to price differentials. However, it is fully possible that:

1. an undecided (and possibly affluent) consumer can purchase more than one version, even in the same shopping trip (co-purchase);

2. the quantity to be purchased of a product, according to this rule, is more than one pack and the consumer buys different versions of it (instead of identical items) not because he is undecided (as in case 1) but in order to enrich his cumulative bundle and have the opportunity of a second selection (at home) among different versions (he chooses to have a choice later on);

3. a collectionist purchases many or even all version of a good he likes, piling up an extensive cumulative bundle;

4. far-away versions of the differentiated good (be they at the opposite extremes of a vertical dimension or separated in the horizontal dimension or category) can well not belong to the set of goods actually compared for making a purchase, because they satisfy different needs - in addition to a common one (e.g. luxurious versions of a good respond to status symbol and prestige requirements that cheap versions can't satisfy);

5. substitution ranges across different products, not only different versions of the same product; you can even substitute (or compare to select) products with services, e.g. the need for fun of a kid can be satisfied with a toy, by going and seeing a cartoon film or simply by joking with him.

It's unlikely that two versions of a good are complements, in the sense that they would be used together in the same occasion; they are usually substitutes but not only! By the way, goods are not just substitutes or complements, as the neoclassical theory would say - there are many other categories of goods.

Long-term trends

The ever growing product differentiation process due to new emergent firms/countries and the innovation efforts of incumbents has encountered in the last decades some form of brake due to the pressure of globalized, standardized homogeneous goods with a dominant design.

Behaviour during the industry life-cycle

High product differentiation with radically different proposals is typical of the early stage of an infant industry, until a dominant design will replace technically imperfect or simply unlucky models.

Afterwards, when the industry reaches the maturity stage with few main competitors, differentiation re-emerge (often due to minor external changes) as an attempt to soften price competition and to reach new niches of consumers.

Policies

Most experimentation with product differentiation is spontaneous in the market economy. However, there may be specific features of products that touch the public interest. For instance the safety of product can be forced to be high by the policymaker, to avoid cheap and dangerous versions be offered to customers.

For the transition to a low-carbon economy, standards of energy efficiency might also be imposed by the policymaker. More in general, to get technologically and socially close substitutes to brown products is the goal of an innovative economic policy for climate change mitigation, underlining that green products risk often to be considered inferior to polluting ones under certain axes of differentiation, so their sales be still confined to a niche of green consumers. In this case a mere tax on CO2 emissions, raising the price of brown products, would not be enough for large majorities of consumers to shift towards the green substitutes.

This CLOS policy is the theme of a chapter in this book.

Formal models

Dynamic competition with bi-directional product differentiation, bounded rational consumers, innovation, advertising, and finance

Consumer decision rules

An empirical measurement index of product differentiation

An index of product variety and its empirical application to an important industrial process

Technological diversification and product differentiation

Data

Consumers data (income, preferences for performance and comfort, decision rules)

World trade data on aggregates of differentiated goods (prices, quantities, values in bilateral flows from every country of the world to every other country of the world)

Links

An empirical analysis of prices of vertically differentiated personal computer

Data about price of a differentiated good: on-line comparison of car attributes and prices

Price comparisons across shops, brands and product categories

NOTES

[1] Check the quality-price relationship over time in these microdata and by playing this business model.

 

 
 
 
 
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