Economic theory tells us that firms selling the same product on the market will ultimately end up in “perfect competition” with each making zero profit. Fortunately, this particular theory (like most others) gives us the starting point so that we can better understand reality.
Using two ice cream vendors on the beach as an example, and following economic theory, the vendors would be physically located next to each other in the middle of the beach and would sell the same ice cream at the same price. Neither dares to try to sell their product at a higher price than their competitor, and a “gentleman’s agreement” for both to keep prices high but equal will be short-lived. The temptation to grab a larger market share gets the better of him, and sure enough, one of the sellers starts 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 a profit, and one of the ways they do so is through product differentiation.
The assumptions that are established as part of the theoretical scenario give way and the market opens. For example, vendors would not sell the same ice cream because different consumers have different tastes. Furthermore, there is imperfect market transparency, which means that some consumers would only know the prices of one of the sellers. Other assumptions are also removed, each playing 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 (gas stations or ice cream parlors), and weather (flights) help consumers decide what the choice is. better for them. After all, customers determine the value of YOUR products. Not at some point. All the time.
The product can be differentiated into two lines:
- horizontal differentiation – given equal prices, some consumers would choose product “A” while others would choose product “B”
- vertical differentiation – given equal prices, EVERY consumer would choose product “A” over product “B”
Back at the beach (and who doesn’t like how THAT sounds!), we can find an ice cream vendor walking away from the middle. This allows you to increase your price because it is more conveniently located for people at one end. Seeing this, the second ice cream vendor does the same and moves a bit further out of the middle as well, only in the opposite direction. This “Horizontal Differentiation” example also allows you to raise your prices. Each seller, who now sells his products at a higher price than before, is making more profit. The supporting factors that positively influence prices and earnings in this horizontal differentiation example are:
- the distance of sellers from each other
- the extent of consumer discomfort from having to walk a certain distance
- the number of consumers on the beach
Applying an element of vertical differentiation, suppose one supplier sells a premium ice cream while the other sells an inferior product. If prices were the same, all consumers would choose the seller with the premium brand. Knowing this, the vendor with the inferior ice cream lowers the price of it. Assuming his costs are lower as well, he can still make a profit, even at lower prices. The first seller can increase his price, assuming that his target market will pay more for the superior product. And so it goes, the lower end can further decrease the quality of their product (and costs) and the higher end can increase as much as their customer base allows them to. The supporting factors that positively influence prices and earnings in this example of vertical differentiation are:
- the difference in the quality of the products
- the degree of heterogeneity in terms of consumer willingness to pay
The end result, and we see it all the time, is that companies that offer lower quality products can make as strong profits as companies that offer higher quality products.
A healthy exercise is for manufacturers to understand whether they can be more profitable by implementing horizontal product differentiation or vertical product differentiation. There is a very real potential for even bigger gains.
If you would like to discuss this further to understand how this approach will benefit YOUR business, please contact brand performance today!