Instructional Goals: You will understand:
And the relevance of these concepts to operational decision making.
Product differentiation is based on two fundamental premises:
The Effect of Differentiation on an Organization's Residual Demand Curve
Where an industry serves its market with differentiated products, the residual demand facing an organization depends on the behavior of each of its individual rivals. In undifferentiated markets the market will be cleared by a single price. In which case, the inverse residual demand function facing a single firm can be written as:
pi = p = D(q1 + q2 + . . . + qn) = D(Q)
For example, if n = 2, p = a - bQ = a - b (q1 + q2) = a - bq1 - bq2. In contrast, if consumers are not indifferent between brand/products, organization 1's demand function will be subtlety different insofar as pi p: p1 = a - b1q1 - b2q2, where a > 0 and b1 > b2 > 0, which means that an increase in organization 1's output has a greater effect on its price than a similar increase in organization 2's. Hence, the more an organization differentiates its product, the more insulated demand for its product is from the behavior of other organizations, the steeper the slope of its demand curves, and the greater its market power.
Location Models
In this class we make the presumption that consumers have preferences regarding attributes or characteristics that can bundled into services or goods in a nearly infinite variety of ways &endash; the majority of which have not been discovered yet. This view contrasts with the standard view found in elementary economics texts, which holds that consumers have preferences for goods or services per se &endash; and that the characteristics of those goods are known and, implicitly, invariable. The standard view is quite satisfactory for a number of purposes (e.g., understanding the demand and supply of 'white bread' bonds), but is fundamentally incompatible with the goals of this course. Even where financial markets are concerned, it has the effect of directing attention away from product innovation and development (financial engineering).
If each product is a bundle of attributes, it follows that, if the relevant attributes can be identified, each product can be mapped on an n-dimensioned (one for each attribute) space. For example, soft drink brands can be mapped as points along the sweetness dimension (or attribute space), with club soda at one extreme, Coke in the middle, and Jolt at the other. The closer two products are to each other in attribute space, the better substitutes they are. This is because consumer preferences also exist in attribute space, with each individual's optimum located at a particular node, surrounded in all dimensions by indifference surfaces (necessarily non intersecting), so that individual satisfaction levels decrease with the distance from the node. See Figure 8.1
Figure 8.1: Consumer's Satisfaction (Utility) Function
Figure 8.1 also shows that a location model is merely an alternative way of showing a Marshallian D&S schedule.
Location models can produce some surprising results. For example, 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:
But the market equilibrium would look like:
Of course this equilibrium is inherently unstable. Add a firm, it breaks down. Because, incumbent brands are often hard to reposition and because incumbency often reflects unique organizational and/or brand specific attributes, actual outcomes are frequently path-dependent. To an economist this is very messy. It means that there may easily be more brands (or fewer) in reality than would be prescribed by the optimal static equilibrium.
Fortunately, mangers, unlike economists, aren't really interested in finding equilibria, but in creating and exploiting disequilibrium.
Is Product Differentiation Inefficient?
To say that product differentiation is messy does not mean that it is inefficient. If the logic of locational models is valid, product differentiation is inherently wealth creating (or net benefit maximizing) when it supplies goods that some people prefer to a homogenous good. This makes residual demand schedules steeper and shifts total demand for goods in this market up and out.
To show that this is the case, we have to talk first about how individual demand schedules are aggregated and combined with costs to measure changes in net welfare. This process is illustrated by Figure 8.2
In Figure 8.2, demand is added horizontally. Consequently, given an equilibrium price of $4, our consumer surplus would be $517.5, our producer surplus, $100 &endash; for a net gain to society (equal to the sum of consumers' and producers' surpluses) of $617.5.
Figure 8.3a&b, uses this analysis to show the welfare consequences of product differentiation.
Contrast, figure a to figure b. Both of these figures assume that identical technology is available to all, costless exit and entry, fixed costs of $2000 per brand, and increasing marginal costs. In figure a, we have a static equilibrium in which only two firms operate, but both are price takers, make an identical product &endash; milk-flavored ice cream, let's say &endash; and operate at optimal scale and price, given D. In figure b, product innovation has taken place, let's say 4 organizations invent new flavors: vanilla, chocolate, strawberry, and peppermint, and, for convenience let's say, the demand for each of these flavors is identical, but with an intercept (2a) twice that of milk-flavored ice cream (a). So long as the knowledge of how to make flavors is proprietary, there will be only four firms. Each will have considerable market power, and operate where mr = mc. In which case, the price in the ice cream market would increase from $5 to $12.50 per unit. The consumer surplus for each flavor would be $2,343.75; the producer surplus, $6,906.25 , less fixed cost of $2,000; producing net benefits of $7,250 per flavor, or $29,000 altogether &endash; five times the net benefit produced by the homogenous product!
Product differentiation is consistent with "dynamic equilibrium" &endash; 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. In the ice cream example above, once others learn the secret of flavors, firms will enter the market and compete all supranormal profits away. This story is consistent with empirical research on industrial dynamics which shows product life cycles marked by waves of entry and exit, innovation and production, and profits. Moreover, these waves can be derived from the interaction of selection effects and search effects (innovation) in multi-attribute product-space models (nk-landscapes). That is: organizations imitate the innovator's product, or produce close substitutes, and this causes demand to become more elastic. As demand becomes more elastic, organizations reduce their markup of price over marginal cost (i.e., they cut prices): (p - mc)/i = 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.
Schumpeter called this the process of "creative destruction." Note that this process is similar to but not the same as the mechanism that drives long run competition in price competitive markets.
Examples: Gummy Bears; IBM PC's; Macintosh operating system.
Discuss Carlton & Perloff, Examples 8.1 and 8.2.
Do they strongly prefer their favorite brand? That is, would they be willing to pay a specified amount more for that brand?
Then have then have them answer the following questions about each of the drinks in the blind taste test.
Discuss the example of bleach: Chlorox brand receives a premium for a chemically identical product. Chlorox may obtain its premium due to advertising that convinces consumers the product is better in some unspecified way. Consumers may believe that it is more likely to be full strength (not adulterated). Or, consumers may prefer its container (hence the product really does differ physically).