Ineconomics,strategic management andmarketing,product differentiation (or simply "differentiation") is the process of distinguishing aproduct orservice from others to make it moreattractive to a particulartarget market. This involves differentiating it fromcompetitors' products as well as from afirm's other products. The concept was proposed byEdward Chamberlin in his 1933 book,The Theory of Monopolistic Competition.[1]
There are three types of product differentiation:
Firms have differentresource endowments that enable them to construct specificcompetitive advantages over competitors.[2] Resource endowments allow firms to be different, which reduces competition and makes it possible to reach newsegments of the market. Thus, differentiation is the process of distinguishing the differences of a product or offering from others, to make it more attractive to a particulartarget market.[3]
Although research in aniche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences. This is done in order to demonstrate the unique aspects of a firm's product and create a sense ofvalue. Marketing textbooks are firm on the point that any differentiation must be valued by buyers[3] (a differentiation attempt that is not perceived does not count). The termunique selling proposition refers toadvertising to communicate a product's differentiation.[4]
Ineconomics, successful product differentiation leads tocompetitive advantage and is inconsistent with the conditions forperfect competition, which include the requirement that the products of competing firms should beperfect substitutes.
The brand differences are mostly minor; they can be merely a difference inpackaging or an advertising theme. The physical product need not change, but it may. Differentiation is due to buyers perceiving a difference; hence, causes of differentiation may be functional aspects of the product or service, how it isdistributed and marketed, or who buys it. The major sources of product differentiation are as follows.
Theobjective of differentiation is to develop aposition that potential customers see as unique. The term is used frequently when dealing withfreemium business models, in which businesses market a free and paid version of a given product. Given they target thesame group of customers, it is imperative that free and paid versions be effectively differentiated.
Differentiation primarily affects performance through reducing directness of competition: as the product becomes more different, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move a product from competing based primarily onprice to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).
Most people would say that the implication of differentiation is the possibility of charging aprice premium; however, this is an over-simplification. If customers value the firm's offer, they will be less sensitive to aspects of competing offers; price may not be one of these aspects. Differentiation leads customers in a given segment to have a lower sensitivity to other features (non-price) of the product.[5]
Edward Chamberlin’s (1933) seminal work onmonopolistic competition mentioned the theory of differentiation, which maintained that for available products within the same industry, customers may have different preferences. However, a generic strategy of differentiation popularized byMichael Porter (1980) proposed that differentiation is any product (tangible or intangible) perceived as "being unique" by at least one set of customers. Hence, it depends on customers' perception of the extent of product differentiation. Even until 1999, the consequences of these concepts were not well understood. In fact, Miller (1986) proposed marketing andinnovation as two differentiation strategies, which was supported by some scholars like Lee and Miller (1999). Mintzberg (1988) proposed more specific but broad categories: quality, design, support, image, price, and undifferentiated products, which received support from Kotha and Vadlamani (1995). However, IO literature (Ethiraj & Zhu, 2008; Makadok, 2010, 2011) did deeper analysis into the theory and explored a clear distinction between the wide use of vertical and horizontal differentiation.[6]
Vertical product differentiation can be measured objectively by a consumer. For example, when comparing two similar products, the quality and price can clearly be identified and ranked by the customer. If both A and B products have the same price to the consumer, then themarket share for each one will be positive, according to theHotelling model. The major theory in this is that all consumers prefer the higher quality product if two distinct products are offered at the same price. A product can differ in many vertical attributes such as itsoperating speed. What really matters is the relationship between consumers' willingness to pay for improvements in quality and the increase in cost per unit that comes with such improvements. Therefore, the perceived difference in quality is different among different consumers, so it is objective.[7] For example, a green product might have a lower or zero negative effect on the environment; however, it may turn out to be inferior to other products in other aspects. Hence, the product's appeal also depends on the way it is advertised and the social pressure felt by a potential consumer. Even one vertical differentiation can be a decisive factor in purchasing.[8]
Horizontal differentiation seeks to affect an individual's subjective decision-making, that is the difference cannot be measured in an objective way. For example, different color versions of the same iPhone or MacBook. A lemon ice cream is not superior to a chocolate ice cream, is completely based on the user's preference. A restaurant may price all of its desserts at the same price and lets the consumer freely choose its preferences since all the alternatives cost the same.[9] A clear example of Horizontal Product Differentiation can be seen when comparing Coca Cola and Pepsi: if priced the same then individuals will differentiate between the two based purely on their own taste preference.
Whilst product differentiation is typically broken into these two types, it is important to note that all products exhibit a combination of both and they are not the only way to define differentiation. Another way to differentiate a product is through spatial differentiation. Spatial product differentiation uses geographical location as a way to differentiate.[10] An example of spatial differentiation is a firmlocally sourcing inputs and producing their product.
According to research conducted by combining mathematics and economics, decisions of pricing depend on the substitutability between products, the level of substitutability varies as the degree of differentiation between firms’ products change. A firm cannot charge a higher price if products are good substitutes, conversely as a product deviates from others in the segment producers can begin to charge a higher price. The lower non-cooperativeequilibrium price the lower the differentiation. For this reason, firms might jointly raise prices above the equilibrium or competitive level by coordination between themselves. They have a verbal or writtencollusion agreement between them. Firms operating in a market of low product differentiation might not coordinate with others, which increases the incentive to cheat the collusion agreement. If a firm slightly lowers there prices, they can capture a large fraction of the market and obtain short term profits if the products are highly substitutable.[11]
Product differentiation within a given market segment can have both positive and negative affects on the consumer. From the producers perspective building a different product compared to competitors can create a competitive advantage which can result in higher profits. Through differentiation consumers gain greater value from a product, however this leads to increased demand and market segmentation which can cause anti-competitive effects on price.[12] From this perspective greater diversity leads to more choices which means each individual can purchase a product better suited to themselves, the negative to this is prices within the market segment tend to rise. The level of differentiation between goods can also affect demand. For example within grocery stores, if a category of goods is relatively no-differentiated then a high amount of assortment depth leads to less sales.[13]
During the 1990s, steps taken by government onderegulation andEuropean integration persuaded banks to compete for deposits on many factors like deposit rates, accessibility and the quality of financial services.[14]
In this example using the Hotelling model, one feature is of variety (location) and one feature of quality (remote access). Remote access using bank services via postal and telephonic services like arranging payment facilities and obtaining account information). In this model, banks cannot become vertically differentiated without negatively affecting horizontal differentiation between them.[14]
Horizontal differentiation occurs with the location of bank's branch. Vertical differentiation, in this example, occurs whenever one bank offers remote access and the other does not. With remote access, it can spur a negative interaction between transportation rate and taste for quality: customers who have higher taste for remote access face a lower transportation rate.[14]
A depositor with a high (low) taste for remote access has low (high) linear transportation costs. Different equilibria emerge as the result of two effects. On the one hand, introducing remote access steals depositors from your competitor because the product specification becomes more appealing (direct effect). On the other hand, banks become closer substitutes (indirect effect). First, banks become closer substitutes as the impact of linear transportation costs decreases. Second, deposit rate competition is affected by the size of the quality difference. These two effects, "stealing" depositors versus "substitutability" between banks, determines the equilibrium. For low and high values of the ratio quality difference to transportation rate, only one bank offers remote access (specialization). Intermediate (very low) values of the ratio quality difference to transportation costs yield universal (no) remote access.[14]
This competition is a two factor game: one is of offering of remote access and the other is of deposit rates. Hypothetically, there will be two consequential scenarios if only one bank offers remote access. First, the bank gains a positive market share for all types of remote access, giving rise to horizontal dominance. This occurs when the transportation cost prevail over the quality of service, deposit rate and time. Second, vertical dominance comes into picture when the bank that is not offering remote access gets the entire market for depositors who have lowest preference for remote access. That is when the quality service, deposit rate and time prevails over the cost of transportation.[14]
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