We pointed out in Chapter 14 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. Product differentiation 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.

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 in the chapter. 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, and differentiation by quality.