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Product Differentiation in Industrial Organization

In marketing, product differentiation is generally defined as a tendency to develop a number of important characteristics for a product or a service, in order for those products to be easily distinguished from competitors’ offers. Product owners identify different features that are attractive and beneficial to the consumer, and try to implement those characteristics. In essence, differentiation is making a manufacturer’s offer easily distinguished from the total mass of competing offers from other manufacturers. It is differentiation that allows gaining a foothold in the mind of the consumer, take a favourable market position and gain a real competitive advantage. Using an efficient product differentiation strategy, any company can achieve the desirable level of sales and profits, because product differentiation enables price discrimination.

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A highly competitive market is usually characterized by the presence of a large number of players, including leading players, and the constant emergence of new companies. If all companies on the market sold products, only few of them would be able to survive competition and achieve success. For example, those who have access to cheaper resources or the opportunity to have a high level of investment in support of the product would succeed. In practice, in highly competitive markets, small companies can also exist and gain profits if they produce differentiated goods for a certain group or groups of consumers (Holt 431). Thus, product differentiation strategies allow even small companies to become successful in competitive industries by reducing the impact of high resource endowments on a company’s market share. Such strategies include determining the competitive advantages of its product based on the knowledge of the company’s strengths and existing opportunities in resources. Another step is to find a group of consumers for whom the selected competitive advantage of the product will be significant and set a price that will provide the desired level of profit.

Product differentiation, as a marketing strategy, has two important characteristics. These are the difference in consumer attributes of goods that satisfy various needs and the difference in the condition or quality of the goods that meet the same requirements. The first type of is commonly referred to as horizontal differentiation; the second type is called vertical differentiation (Holt 439). In conditions of real market structures, these two types of product differentiation tend to coexist. However, one of them may dominate, and this factor can also have certain effects on the way competition is developing, as well as the position each firm holds. In such markets, consumer’s choice depends on a number of different factors. With horizontal differentiation, consumers may prefer special products because they are loyal to certain brands or companies. With vertical differentiation, however, their choice is affected by the amount of money they are willing to spend, as well as the effective demand for the product. In the same way, the competitiveness of goods in horizontal differentiation structures is affected by the accordance to the preferences of prospective buyers. In conditions of vertical differentiation, the competitiveness depends on the prices of the goods.

Consumers can be considered in terms of space and products. If the consumer’s location is far away from the point of sale, they will have to have additional transport expenses to purchase a product. If the consumer buys goods with less desired properties, they get less utility from these products. Hotelling’s and Salop’s models of spatial product differentiation were built on the foundation of these principles. Thus, Hotelling’s model suggests that the prices will rise at a constant pace. Suppose the brands are different from each other according to only one indicator – remoteness from the consumer (Hotelling 42). Suppose that: 1) consumers are evenly spaced along a single street in the town; 2) each consumer makes a demand for one unit of goods; 3) two firms (stores) located at two ends of the city sell a similar product. The model suggests that the consumer will choose the company the trip to which will cost them less.

Salop’s model, in turn, suggests that firms decide to enter and leave the market depending on how much they are affected by the changes in profit. Salop also argues that if the customers are distributed through the market evenly, they mostly have similar preferences (Salop 144). Within this model, price competition can be made possible through the several factors. These include the maximum amount of money customers will be willing to pay, along with transport tariff rates and the number of companies who sell similar products. If there are not many offers in the market, companies are unlikely to engage into competing with each other. Each of them has a chance to become a monopolist, because all companies will have the customers who live in the areas that are closest to those companies.

In turn, D’Aspremont et al. argued that there is a flaw in Hotelling’s model and suggested his own one. They claimed that “when transportation costs are quadratic, the price effect dominates the demand effect and the firms engage in maximum price discrimination” (D’Aspremont, et at. 1146). Thus, this model proves the tendency of sellers to maximize product differentiation. Another model of differentiation, namely vertical differentiation, derived from the papers of Avner Shaked and John Sutton. The Shaked-Sutton model discusses dividing market demand into two segments: monopoly and competitive market. In the Shaked and Sutton model, the finiteness property was revealed, which set upper restrictions on the number of firms present in the market, depending on the degree of differentiation of consumer income (Shaked and Sutton 6). Thus, it is established that with the diffusion of disruptive technology, the markets in question are natural oligopoly.

The indisputable advantage of differentiation is that, having done appropriate research, companies can understand what is happening in the market and what positive outcomes can result from the fact that their product is unique. Differentiation also helps to reduce pressure from substitute products (Church and Ware 602). It ensures the survival of even small projects, allowing them to increase audience loyalty, as well as the profitability of the product due to the possibility of setting a higher price. The disadvantages, in turn, can include the lack of interest in the product, increased costs of producing a heterogeneous product, and the need for investment in communication of the distinctive properties of the product.

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Product differentiation is a strategy that marketing managers often use to increase the competitiveness of the company’s product. It mostly involves giving the product specific properties and characteristics that are likely to interest and attract consumers. There are various product differentiation strategies and models that explain the connection between product differentiation, price discrimination, and market competition. These include the models of Hotelling, Shaked and Sutton, D’Aspremont, and Salop. Product differentiation can have advantages and disadvantages, but its most significant advantage is arguably the fact that it allows smaller companies gain success and desired level of profits.

Works Cited

Church, Jeffrey, and Roger Ware. Industrial Organization: A Strategic Approach. Richard d Irwin, 1999.

D’Aspremont, C., et al. “On Hotelling’s “Stability in Competition“.” Econometrica, vol. 47, no. 5, 1979, pp. 1145-1150. Web.

Holt, Charles A. “Industrial Organization: A Survey of Laboratory Research.” The Handbook of Experimental Economics, 2020, pp. 349-444.

Hotelling, Harold. “Stability in Competition.” The Economic Journal, vol. 39, no. 153, 1929, pp. 41-57. Web.

Salop, Steven C. “Monopolistic Competition with Outside Goods.” The Bell Journal of Economics, vol. 10, no. 1, 1979, pp. 141-156. Web.

Shaked, Avner, and John Sutton. “Relaxing Price Competition Through Product Differentiation.” The Review of Economic Studies, vol. 49, no. 1, 1982, pp. 3-13.

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