Economic theory tells us that companies who sell the same product to the market will ultimately end up in “perfect competition” and each make zero profits. Thankfully, this particular theory (like most others) offers us the starting point so that we can better understand the reality.
Using two ice cream vendors on the beach as our example, and sticking to economic theory, the vendors would be physically located right next to each other in the middle of the beach and they would sell the same ice cream at the same price. Neither one dare try to sell his product at a higher price than his competitor, and a “gentleman’s agreement” to both keep prices high but equal will be short-lived. Temptation for landing greater market share takes over and, sure enough, one of the vendors begins the race to the bottom by lowering his price just a little. We know how that ends!
The reality, of course, is that companies DO make profits, and one of the ways they do it is through Product Differentiation.
The assumptions that are set as a part of the theoretical scenario give way and the market opens up. For example, the vendors wouldn’t sell the same ice cream because different consumers have different tastes. Also, imperfect market transparency exists, meaning that some consumers would only know the prices of one of the vendors. Other assumptions are removed as well, and each plays a role in how the market reacts.
Product Differentiation is beneficial if consumer preferences are heterogeneous. Factors such as technical features (cell phones), durability (shoes), resale value (real estate), taste/image (cars), location (gasoline stations or ice cream vendors!), and time (flights) all help consumers decide which choice is best for them. Customers, after all, determine the value of YOUR products. Not sometime. All the time.
Product can be differentiated along two lines:
- Horizontal Differentiation – given equal prices, some consumers would choose product “A”, whereas others would choose product “B”
- Vertical Differentiation – given equal prices, EVERY consumer would choose product “A” over product “B”
Back on the beach (and who doesn’t like the way THAT sounds!), we may find one ice cream vendor moving away from the middle. This allows him to increase his price because he is more conveniently located for people at one end. Seeing this, the second ice cream vendor follows suit and moves a little further away from the middle also, only in the opposite direction. This example of “Horizontal Differentiation” allows him to raise his prices as well. Each vendor, now selling their products at a higher price than before, is making more of a profit. The supporting factors that are positively influencing prices and profits in this Horizontal Differentiation example are:
- the distance of the vendors from each other
- the magnitude of the consumer’s discomfort from having to walk a certain distance
- the number of consumers on the beach
Applying a Vertical Differentiation element, let’s assume that one vendor is selling a premium ice cream while the other is selling an inferior product. If the prices were the same, all consumers would choose the vendor with the premium brand. Knowing this, the vendor with the inferior ice cream lowers his price. Assuming his costs are also lower, he is still able to make a profit, even at lower prices. The first vendor can increase his prices, considering his target market will pay more for the superior product. And so it goes, the lower end can decrease their product quality (and costs) even further and the higher end can increase as much as their customer base will allow them to. The supporting factors that are positively influencing prices and profits in this Vertical Differentiation example are:
- the difference in the quality of the products
- the degree of heterogeneity in terms of the consumers’ willingness to pay
The end result, and we see it all the time, is that companies offering lower quality products can realize strong profits, just as firms offering higher quality products.
A healthy exercise is for manufacturers to understand if they can be more profitable through the implementation of Horizontal Product Differentiation or Vertical Product Differentiation. There is very real potential for even greater profits to be realized.
If you would like to discuss this further to understand how this approach will benefit YOUR Company, please contact Brand Performance today!