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.

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.

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).

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

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

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

Two extreme classes should finally be added:

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.

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.

Horizontal differentiation

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

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

Horizontal differentiation can be linked to differentiation in colours (different colour version for the same good), in styles (e.g. modern / antique), in tastes.

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.

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.

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 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".

Determinants

How a product rates according to different measures of quality or taste depends on its physical and immaterial characteristics. The raw material from which it has been built, its engineered design, its production process are typical determinants of product specificity.

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

More broadly, product differentiation can be:

• the indirect effect of different endowments in raw materials, know-how, style preference of different firms ignoring each others;
  
• the conscious choice, out of firm strategies, to position each product against competitors;
  
• the costly, uncertain, and difficult outcome of innovation efforts.
  

Impact on other variables

Differentiated versions of a good can have widely different costs of production. Upstream, they 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.

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.

For the consumer, product differentiation can increase the satisfaction from its consumption. At the same time, 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 unloyal customers, who use the repurchase occasions to try new versions.

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.

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)

Links

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.