1.5 Module 35: Product Differentiation and Advertising

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In previous modules we learned that product differentiation often plays an important role in oligopolistic industries. In such industries, product differentiation reduces the intensity of competition between firms when tacit collusion cannot be achieved. It plays an even more crucial role in monopolistically competitive industries. Because tacit collusion is virtually impossible when there are many producers, product differentiation is the only way monopolistically competitive firms can acquire some market power.

In this module, we look at how oligopolists and monopolistic competitors differentiate their products in order to maximize profits.

How Firms Differentiate Their Products

How do firms in the same industry—such as fast-food vendors, gas stations, or chocolate makers—differentiate their products? Sometimes the difference is mainly in the minds of consumers rather than in the products themselves. We’ll discuss the role of advertising and the importance of brand names in achieving this kind of product differentiation later. But, in general, firms differentiate their products by—surprise!—actually making them different.

The key to product differentiation is that consumers have different preferences and are willing to pay somewhat more to satisfy those preferences. Each producer can carve out a market niche by producing something that caters to the particular preferences of some group of consumers better than the products of other firms. There are three important forms of product differentiation:

• differentiation by style or type
• differentiation by location
• differentiation by quality.

Differentiation by Style or Type

Recall our discussion of Leo’s Wonderful Wok in an earlier module. The sellers in Leo’s food court offer different types of fast food: hamburgers, pizza, Chinese food, Mexican food, and so on. Each consumer arrives at the food court with some preference for one or another of these offerings. This preference may depend on the consumer’s mood, her diet, or what she has already eaten that day. These preferences will not make consumers indifferent to price: if Wonderful Wok were to charge $15 for an egg roll, everybody would go to Bodacious Burgers or Pizza Paradise instead. But some people will choose a more expensive meal if that type of food is closer to their preference. So the products of the different vendors are substitutes, but they aren’t perfect substitutes—they are imperfect substitutes.

For industries that differentiate by location, proximity is everything.

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Vendors in a food court or the restaurant chains in Times Square (shown in the photo at left) aren’t the only sellers who differentiate their offerings by type. Clothing stores concentrate on women’s or men’s clothes, on business attire or sportswear, on trendy or classic styles, and so on. Auto manufacturers offer sedans, minivans, sport-utility vehicles, and sports cars, each type aimed at drivers with different needs and tastes.

Books offer yet another example of differentiation by type and style. Mysteries are differentiated from romances; among mysteries, we can differentiate among hard-boiled detective stories, whodunits, and police procedurals. And no two writers of hard-boiled detective stories are exactly alike: Raymond Chandler and Sue Grafton each have devoted fans.

In fact, product differentiation is characteristic of most consumer goods. As long as people differ in their tastes, producers find it possible and profitable to offer variety.

Differentiation by Location

Gas stations along a road offer differentiated products. True, the gas may be exactly the same. But the location of the stations is different, and location matters to consumers: it’s more convenient to stop for gas near your home, near your workplace, or near wherever you are when the gas gauge gets low.

In fact, many monopolistically competitive industries supply goods differentiated by location. This is especially true in service industries, from dry cleaners to hairdressers, where customers often choose the seller who is closest rather than cheapest.

Differentiation by Quality

Do you have a craving for chocolate? How much are you willing to spend on it? You see, there’s chocolate and then there’s chocolate: although ordinary chocolate may not be very expensive, gourmet chocolate can cost several dollars per bite.

With chocolate, as with many goods, there is a range of possible qualities. You can get a usable bicycle for less than $100; you can get a much fancier bicycle for 10 times as much. It all depends on how much the additional quality matters to you and how much you will miss the other things you could have purchased with that money.

Chocolate lovers know that there’s ordinary chocolate and then there’s extraordinary chocolate.

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Because consumers vary in what they are willing to pay for higher quality, producers can differentiate their products by quality—some offering lower-quality, inexpensive products and others offering higher-quality products at a higher price.

Product differentiation, then, can take several forms. Whatever form it takes, however, there are two important features of industries with differentiated products: competition among sellers and value in diversity.

Competition among sellers means that even though sellers of differentiated products are not offering identical goods, they are to some extent competing for a limited market. If more businesses enter the market, each will find that it sells a lower quantity at any given price. For example, as we saw in the previous chapter, if a new gas station opens along a road, each of the existing gas stations will sell a bit less.

Value in diversity refers to the gain to consumers from the proliferation of differentiated products. A food court with eight vendors makes consumers happier than one with only six vendors, even if the prices are the same, because some customers will get a meal that is closer to what they had in mind. A road on which there is a gas station every two miles is more convenient for motorists than a road where gas stations are five miles apart. When a product is available in many different qualities, fewer people are forced to pay for more quality than they need or to settle for lower quality than they want. There are, in other words, benefits to consumers from a greater diversity of available products.

ANY COLOR, SO LONG AS IT’S BLACK

The early history of the auto industry offers a classic illustration of the power of product differentiation.

The modern automobile industry was created by Henry Ford, who first introduced assembly-line production. This technique made it possible for him to offer the famous Model T at a far lower price than anyone else was charging for a car; by 1920, Ford dominated the automobile business.

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Ford’s strategy was to offer just one style of car, which maximized his economies of scale in production but made no concessions to differences in consumers’ tastes. He supposedly declared that customers could get the Model T in “any color, so long as it’s black.”

This strategy was challenged by Alfred P. Sloan, who had merged a number of smaller automobile companies into General Motors. Sloan’s strategy was to offer a range of car types, differentiated by quality and price. Chevrolets were basic cars that directly challenged the Model T, Buicks were bigger and more expensive, and so on up to Cadillacs. And you could get each model in several different colors.

By the 1930s the verdict was clear: customers preferred a range of styles, and General Motors, not Ford, became the dominant auto manufacturer for the rest of the twentieth century.

Controversies About Product Differentiation

Up to this point, we have assumed that products are differentiated in a way that corresponds to some real desire of consumers. There is real convenience in having a gas station in your neighborhood; Chinese food and Mexican food are really different from each other.

In the real world, however, some instances of product differentiation can seem puzzling if you think about them. What is the real difference between Crest and Colgate toothpaste? Between Energizer and Duracell batteries? Or a Marriott and a Hilton hotel room? Most people would be hard-pressed to answer any of these questions. Yet the producers of these goods make considerable efforts to convince consumers that their products are different from and better than those of their competitors.

No discussion of product differentiation is complete without spending at least a bit of time on the two related issues—and puzzles—of advertising and brand names.

The Role of Advertising

Wheat farmers don’t advertise their wares on TV, but car dealers do. That’s not because farmers are shy and car dealers are outgoing; it’s because advertising is worthwhile only in industries in which firms have at least some market power.

The purpose of advertisements is to persuade people to buy more of a seller’s product at the going price. A perfectly competitive firm, which can sell as much as it likes at the going market price, has no incentive to spend money persuading consumers to buy more. Only a firm that has some market power, and which therefore charges a price that is above marginal cost, can gain from advertising. Some industries that are more or less perfectly competitive, like the milk industry, do advertise—but these ads are sponsored by an association on behalf of the industry as a whole, not on behalf of a particular farm.

Given that advertising “works,” it’s not hard to see why firms with market power would spend money on it. But the big question about advertising is, why does it work? A related question is whether advertising is, from society’s point of view, a waste of resources.

Not all advertising poses a puzzle. Much of it is straightforward: it’s a way for sellers to inform potential buyers about what they have to offer (or, occasionally, for buyers to inform potential sellers about what they want). Nor is there much controversy about the economic usefulness of ads that provide information: the real estate ad that declares “sunny, charming, 2 bedrooms, 1 bath, a/c” tells you things you need to know (even if a few euphemisms are involved—“charming,” of course, means “small”).

But what information is being conveyed when a TV actress proclaims the virtues of one or another toothpaste or a sports hero declares that some company’s batteries are better than those inside that pink mechanical rabbit? Surely nobody believes that the sports star is an expert on batteries—or that he chose the company that he personally believes makes the best batteries, as opposed to the company that offered to pay him the most. Yet companies believe, with good reason, that money spent on such promotions increases their sales—and that they would be in big trouble if they stopped advertising but their competitors continued to do so.

Why are consumers influenced by ads that do not really provide any information about the product? One answer is that consumers are not as rational as economists typically assume. Perhaps consumers’ judgments, or even their tastes, can be influenced by things that economists think ought to be irrelevant, such as which company has hired the most charismatic celebrity to endorse its product. And there is surely some truth to this. Consumer rationality is a useful working assumption; it is not an absolute truth.

However, another answer is that consumer response to advertising is not entirely irrational because ads can serve as indirect “signals” in a world where consumers don’t have good information about products. Suppose, to take a common example, that you need to avail yourself of some local service that you don’t use regularly—body work on your car, say, or furniture moving. You can go online, as many of us do, or turn to the Yellow Pages, where you see a number of small listings and several large display ads. You know that those display ads are large because the firms paid extra for them; still, it may be quite rational to call one of the firms with a big display ad. After all, the big ad probably means that it’s a relatively large, successful company—otherwise, the company wouldn’t have found it worth spending the money for the larger ad.

The same principle may partly explain why ads feature celebrities. You don’t really believe that the supermodel prefers that watch; but the fact that the watch manufacturer is willing and able to pay her fee tells you that it is a major company that is likely to stand behind its product. According to this reasoning, an expensive advertisement serves to establish the quality of a firm’s products in the eyes of consumers.

The possibility that it is rational for consumers to respond to advertising also has some bearing on the question of whether advertising is a waste of resources. If ads work by manipulating only the weak-minded, the $140 billion U.S. businesses spent on advertising in 2013 would have been an economic waste—except to the extent that ads sometimes provide entertainment. To the extent that advertising conveys important information, however, it is an economically productive activity after all.

Brand Names

You’ve been driving all day, and you decide that it’s time to find a place to sleep. On your right, you see a sign for the Bates Motel; on your left, you see a sign for a Motel 6, or a Best Western, or some other national chain. Which one do you choose?

Unless they were familiar with the area, most people would head for the chain. In fact, most motels in the United States are members of major chains; the same is true of most fast-food restaurants and many, if not most, stores in shopping malls.

Motel chains and fast-food restaurants are only one aspect of a broader phenomenon: the role of brand names, names owned by particular companies that differentiate their products in the minds of consumers. In many cases, a company’s brand name is the most important asset it possesses: clearly, McDonald’s is worth far more than the sum of the deep-fat fryers and hamburger grills the company owns.

Advertising and brand names that provide useful information can be valuable to consumers.

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In fact, companies often go to considerable lengths to defend their brand names, suing anyone else who uses them without permission. You may talk about blowing your nose on a kleenex or googling data for a research project, but unless the product in question comes from Kleenex or Google, legally the seller must describe it as a facial tissue or a search engine.

As with advertising, with which they are closely linked, the social usefulness of brand names is a source of dispute. Does the preference of consumers for known brands reflect consumer irrationality? Or do brand names convey real information? That is, do brand names create unnecessary market power, or do they serve a real purpose?

As in the case of advertising, the answer is probably some of both. On the one hand, brand names often do create unjustified market power. Consumers often pay more for brand-name goods in the supermarket even though consumer experts assure us that the cheaper store brands are equally good. Similarly, many common medicines, like aspirin, are cheaper—with no loss of quality—in their generic form.

On the other hand, for many products the brand name does convey information. A traveler arriving in a strange town can be sure of what awaits in a Holiday Inn or a McDonald’s; a tired and hungry traveler may find this preferable to trying an independent hotel or restaurant that might be better—but might be worse.

In addition, brand names offer some assurance that the seller is engaged in repeated interaction with its customers and so has a reputation to protect. If a traveler eats a bad meal at a restaurant in a tourist trap and vows never to eat there again, the restaurant owner may not care, since the chance is small that the traveler will be in the same area again in the future. But if that traveler eats a bad meal at McDonald’s and vows never to eat at a McDonald’s again, that matters to the company. This gives McDonald’s an incentive to provide consistent quality, thereby assuring travelers that quality controls are in place.

Module 35 Review

Check Your Understanding

When is product differentiation socially efficient? Explain. When is it not socially efficient? Explain.