Ch. 12

We have already talked a lot about the fact that product differentiation is an important factor contributing to market power. Chapter 12 formalizes the way economists think about heterogeneous products, by identifying ways which economists categorize product differentiation.

Differentiated product = heterogeneous product

Economists identify both horizontal and vertical differentiation.

Horizontal differentiation has to do with appealing to consumers with different tastes.

In other words you may like one attribute, which I actually dislike.

What examples can you think of?

Vertical product differentation has to do with the relative ranking of consumer's tastes.

Although all consumers may agree that a particular characteristic is preferred, some may really feel that a particular characteristic is important, but others may think it less important.

The reason we have everything from SUVs (which clearly rank mileage and pollution reduction at the bottom) to electric cars (at the other end of the spectrum) is that while all consumers would prefer a less polluting car (at least one hopes so...) some are more interested in looks and speed and don't mind creating more externalities (especially since they don't have to pay for them...)

Can you think of another example where consumers rank different qualities differently and therefore there is a lot of variety out there.

Shoes (comfort versus fashion)

How about color of shoes? Is this a matter of horizontal or vertical differentiation?

Because heterogeneous goods cannot necessarily be compared, economists instead can look at the demand for particular characteristics.

They can determine both individuals' willingness to pay for individual characteristics of a good, as well as a type of elasticity for various attributes.

Thus this type of analysis is called the Characteristics approach.

This approach assumes (just as the basic micro approach concerning demand) that:

1. consumers can rank their preference for various characteristics (according to the utility gain for each characteristic).

2. that consumers can 'value' their preference (I would be willing to pay $1000 for 10 mpg more in mileage, while you would only be willing to pay $500 for the same attribute.)

3. that preferences are consistent and transitive. (In other words if you value MPG at $1000 in a VW, you also value it at the same rate in an SUV.)

4. That consumers add up all the values of their preference to make the final decision about which product to buy.

Although all the characteristics may provide positive utility to a consumer, the sum total of all characteristics will vary for different consumers, and thus the outcome is that some will buy sports cars and others will buy mini vans.

Consumers make these kinds of decisions constantly and producers are always trying to capitalize this.

Clearly, the greater the ability of a firm to differentiate their product, the more market power they will have.

Note that horizontal and vertical differentiation are not mutually exclusive. They often work together.

As the book points out, product differentiation based on characteristics is not very different from spatial product differentation. In fact one could merely think of distance as one characteristic.

In terms of firm behavior, by differentiating their products (or niche marketing) firms are trying to take advantage of differences in consumers' elasticities for various characteristics.

In the case of product differentiation, we are again faced with a game.

Firms must decide where to locate (or what characteristics to specialize in, as well as how to price) based on what other firms are going to do.

This is what economists call product positioning (both in terms of physical location and in terms of what characteristics include in their products.)

For instance, we have Payless shoes at one end, specializing in low price, lower quality shoes, while we have Nordstrom at the other end, specializing in high price, higher quality shoes.

Every firm has to decide:

1. What characteristics their product will have?

2. How to price that product?

Each of these decisions can been seen as part of a game, since firms care not only about what characteristics and prices they choose, but also what others choose.

If two firms end up choosing products with very similar characteristics, what will most likely happen in terms of price? They will have to compete more in terms of price - ie less market power. So one thing firms are constantly doing is trying to distinguish themselves.

Look at the athletic shoe market. Firms are always trying to come up with gimmicks that distinguish them from others. (Did you hear about the new shoes which people are fighting over, since they are limited edition - another gimmick to try to suck in customers...)

A key component of marketing is to convince consumers that a product is differentiated, even if it isn't! This is where imperfect information comes in (as well as advertising, which we will discuss later.)

Another factor which leads to product differentiation is switching costs. As the book points out, switching from a Mac to an IBM involves a cost to consumers, therefore each gets some market power from the fact that they have consumers who have already committed to a particular product.

Firms have worked hard to increase switching costs. Can you think of examples of gimmicks firms use to increase switching costs?

1. coffee houses which give you a card so that every 10^th coffee is free.

2. grocery stores which only give you a discount if you have a 'membership' card.

3. frequent flyer programs.

4. dept. store credit cards with rebates and discounts built in.

These are all attempts to get 'loyal' customers, who will perceive there is a cost to switching to another firm. This has two advantages for firms:

1. a loyal customer base - more predictable demand.

2. possibly more inelastic demand - more chance to raise prices

One interesting market to look at is the fast food industry where characteristic strategies have evolved over the years. It used to be that you had fast food restaurants that specialized only in Mexican food or hamburgers or sandwiches. Now you see various chains trying to serve multiple markets. How successful do you think that has been? Why might this be?

How does this example fit into a game theoretical framework?