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.

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 Low It usually does not
work, it does not last,
and it has important
defects
Extremely High 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.

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