differentiation (economics)

In economics and marketing, product differentiation (or simply differentiation) is the process of distinguishing a product or service from others to make it more attractive to a particular target market. This involves differentiating it from competitors' products as well as from a firm's other products. The concept was proposed by Edward Chamberlin in his 1933 book, ''The Theory of Monopolistic Competition''.

Rationale

Firms have different resource endowments that enable them to construct specific competitive advantages over competitors. Resource endowments allow firms to be different, which reduces competition and makes it possible to reach new segments 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 particular target market.

Although research in a niche 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 of value. Marketing textbooks are firm on the point that any differentiation must be valued by buyers (a differentiation attempt that is not perceived does not count). The term unique selling proposition refers to advertising to communicate a product's differentiation.

In economics, successful product differentiation leads to competitive advantage and is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes. There are three types of product differentiation:

# Simple: based on a variety of characteristics
# Horizontal: based on a single characteristic but consumers are not clear on quality
# Vertical: based on a single characteristic and consumers are clear on its quality

The brand differences are mostly minor; they can be merely a difference in packaging 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 is distributed and marketed, or who buys it. The major sources of product differentiation are as follows.
*Differences in quality which are usually accompanied by differences in price
*Differences in functional features or design
*Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing
*Sales promotion activities of sellers and, in particular, advertising
*Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. The term is used frequently when dealing with freemium business models, in which businesses market a free and paid version of a given product. Given they target the same 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 on price 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 a price 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 makes customers in a given segment have a lower sensitivity to other features (non-price) of the product.

History

Edward Chamberlin’s (1933) seminal work on monopolistic 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 by Michael 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 and innovation 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.

Vertical product differentiation

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 the market share for each one will be positive, according to the Hotelling 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 its operating 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. 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.

Horizontal product differentiation

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. 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.

Other types of product differentiation

Whilst Product differentiation is typically broken into two types Vertical and Horizontal, it's 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 is using a geographical lo