PRODUCT DIFFERENTIATION

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PRODUCT DIFFERENTIATION

• FROM AN INDUSTRY PERSPECTIVE

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Instructional GoalsYou will understand

• How product differentiation increases market
  power
• The social benefits and costs of product
  differentiation

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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.

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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.

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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

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Consumer Satisfaction Attribute space/Location
model/SD model
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If consumers were spread out equallyalong a
single dimension and if they could support only 2
brands, AB, the social optimum would look like
The market equilibrium would look like
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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

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The Costs Benefits of PD

• Product differentiation raises costs
• RD costs
• Increases transaction costs
• May increase production/delivery costs
• Product differentiation increases consumer
  satisfaction (measured in terms of willingness
  and ability to pay)

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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.
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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.