PRODUCT DIFFERENTIATION

FROM AN INDUSTRY PERSPECTIVE

Instructional GoalsYou will understand:

• How product differentiation increases market power

• The social benefits and costs of product differentiation

Product differentiation is based on two fundamental premises:

1. A brand exerts greater constraint on a second brand's price when they are perceived to be close substitutes

2. Products/services are differentiated because consumers think they are different.

Assumptions Standard This class

Consumers have preferences for goods or services per se —characteristics of those goods are known and, implicitly, invariable.

Consumers have preferences regarding attributes that can bundled in an infinite variety of ways — the majority of which have not yet been discovered.

Products as points along a dimension (or attribute space),

• The closer two products are to each other in attribute space, the better substitutes they are.

• Individual satisfaction levels decrease with the distance from the optimal node

Consumer Satisfaction: Attribute space/Location model/S&D model

If consumers were spread out equallyalong a single dimension and if they could

support only 2 brands, A&B, the social optimum would look like:

The market equilibrium would look like:

Is Product Differentiation Socially Inefficient?

• It is a MESSY process

• Not an inefficient one

• Some PRODUCT DIFFERENTIATION is wasteful, but, on balance, the process appears to produce more BENEFITS than COSTS

The Costs & Benefits of PD

• Product differentiation raises costs– R&D costs

– Increases transaction costs

– May increase production/delivery costs

• Product differentiation increases consumer satisfaction (measured in terms of willingness and ability to pay)

Market Equilibrium w/o PD

Maximum PD

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Product differentiation is consistent with "dynamic equilibrium" -- for the rate of investment in all things, even product development, to rise towards the level at which this investment yields only a normal return.

Rivals imitate or produce close substitutes to innovator's product.Demand becomes more elastic. Organizations reduce markups of price over marginal cost (p - mc)/p = 1/|e|. If markups are not big enough to recover fixed costs, producers must exit the market or create new products that have less elastic demands.