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PRODUCT
DIFFERENTIATION
FROM AN INDUSTRY
PERSPECTIVE
Instructional Goals
You 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
Consumers have
preferences for goods or
preferences regarding
services per se —
attributes that can
characteristics of those
bundled in an infinite
goods are known and,
variety of ways — the
implicitly, invariable.
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 equally
along 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.