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PRODUCT DIFFERENTIATION |
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by Valentino Piana (2003) |
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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 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; 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, with higher sales for versions having higher prices. 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 version for the same good), in styles (e.g. modern / antique), in tastes. 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 to them, not to the product line structure. 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 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". 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. 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, 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. In such an environment, 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. 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. 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: 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 offering a price, an advertising strategy and a distribution channel such that the supply of the product is profitable over a reasonable time i. to defend the niche against "invaders". The distribution of tastes and evaluation routines across final consumers is also 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") along one axis per product (e.g. from a central drink you could generate versiona that are, respectively, sweeter, a less-calories, more acid, etc.). Geometrically, the market is like a star (the central product) and its rays (versions). But two rays do not cross each other (e.g. there is no version that is at the same time more acid and low-calory); 3. firms might be wary of cannibalising their existing product sales, if they introduce versions that substitute them while providing lower margins. 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). 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 un-loyal customers, who use the repurchase occasions to try new versions. Consumers skills in evaluating goods across versions and prices are nurtured by a sufficiently rich environment of social interaction and product differentiation. 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.). 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. 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 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 Consumers data (income, preferences for performance and comfort, decision rules) 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 [1] Check the quality-price relationship over time in these microdata and by playing this business model.
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