Monopolistic Competition

2. Product Differentiation

Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.

Learning Objectives

Define product differentiation

Key Takeaways

Key Points

Differentiation occurs because buyers perceive a difference between products. Causes of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.
Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.
There are three types of product differentiation: simple, horizontal, and vertical.

Key Terms

product differentiation: Perceived differences between the product of one firm and that of its rivals so that some customers value it more.

One of the defining traits of a monopolistically competitive market is that there is a significant amount of non- price competition. This means that product differentiation is key for any monopolistically competitive firm. Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.

Kool-Aid: Kool-Aid is an individual brand that competes with Kraft's other brand (Tang).

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; differentiation is not the process of creating the differences between the products. Product differentiation is done in order to demonstrate the unique aspects of a firm's product and to create a sense of value.

In economics, successful product differentiation is inconsistent with the conditions of perfect competition, which require products of competing firms to be perfect substitutes.

Consumers do not need to know everything about the product for differentiation to work. So long as the consumers perceive that there is a difference in the products, they do not need to know how or why one product might be of higher quality than another. For example, a generic brand of cereal might be exactly the same as a brand name in terms of quality. However, consumers might be willing to pay more for the brand name despite the fact that they cannot identify why the more expensive cereal is of higher "quality".

There are three types of product differentiation:

Simple: the products are differentiated based on a variety of characteristics;
Horizontal: the products are differentiated based on a single characteristic, but consumers are not clear on which product is of higher quality; and
Vertical: the products are differentiated based on a single characteristic and consumers are clear on which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and 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, particularly advertising; and
Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition. A successful product differentiation strategy will move the product from competing on price to competing on non-price factors.