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Vertical product differentiation involves the distribution of products in the industry market in accordance with their quality. For example, a more compact and powerful computer is always preferable to a knowledgeable user than a bulky and low-power one. In this case, there are differences in the quality of the product in two parameters. However, the range of tasks that will have to be solved using this computer may be such that the buyer will not give preference to the best example of computer technology.

Many economists have addressed the study of this problem, including, in particular, M. Moussa and S. Rosen, A. Shaked and J. Sutton, J. Gabzevich and J. Tisse. Typically, these authors consider a series of products k, each of which has an index from 1 to P in order of increasing quality. Prices also increase in accordance with the increase in quality. Consumers are expected to:

a) have the same tastes;

b) differ in different incomes;

c) prefer higher quality goods;

D) buy units of goods of the quality that maximizes their utility.

Income (I) buyers vary and are located in a certain range.

Then the utility function can be represented as

Where u n- utility derived from quality n.

Let us derive the income at which consumers are indifferent in choosing between goods n And n-1 :

Similarly, you can withdraw income I n -1 , in which consumers are indifferent to the choice between goods n And n-1 .

Thus, market demand for quality is determined by the number of consumers with income in the range [ I n -1 – I n ].

If we turn to the case of vertical product differentiation (based on duopoly), we can see, based on equilibrium conditions, that prices will rise as the quality of products increases and with an increase in the upper limit of income. Here, too, as the relative difference in utility between two products (goods) increases, prices rise and the intensity of competition decreases.

Given the fact that competition in this market is characterized by the “nearest neighbor” effect, we can also conclude that there is a possibility of collusion, which will lead to higher both aggregate and individual profits of firms. In this case, consumer surplus is reduced, and “dead weight” appears.

Overall, this research suggests that due to the “nearest neighbor” effect and the presence of opportunities for cooperative behavior (collusion), profit margins and overall profits are higher in differentiated product markets.

3.5. Horizontal product differentiation

Models of horizontal product differentiation involve examining competition among products that use equal resources to produce but differ in design, such as a range of standard televisions. In addition, products may be differentiated in terms of different placement or position in space, which entails different transportation costs for the purchase of the product. In this case, we will study the model of spatial product differentiation developed by G. Hotelling.

The goods are characterized by physical homogeneity and are located at points A And V, defined as the distance from the origin (0). It is assumed that the prices of both goods are the same and that consumers are evenly distributed along the line. The only difference between the goods is their distance from the consumer. It can be assumed that the latter will choose the product, covering the distance to which will be accompanied by lower transport costs per unit of goods (t). It is also assumed that consumers purchase a unit of a product over a given period of time.

So, the prices at which goods will be purchased by consumers depend on the maximum willingness to pay ( Ɵ ) and distance from goods (X).

If we take the total length of the street as one, then R A = Ɵ –tX for the first product and R V =Ɵ –t( 1 -X) for the second one.

Volumes of demand for goods A and goods b determined by the location of the ultimate buyer X', for whom it is indifferent which product to buy, since his expenses for both goods, taking into account transport costs, are the same: R A = Ɵ –tX'= P V =Ɵ –t( 1 –X').

Consumers located to the left of the marginal consumer X', will purchase goods A, and to the right - the product b.

Spatial product differentiation suggests the presence of different market segments (Figure 3.3).

In conditions of horizontal differentiation, the buyer’s choice is determined by commitment to a particular brand; the competitiveness of goods in markets of horizontal differentiation depends to the greatest extent on compliance with the preferences of potential customers. The growth of effective demand in the market for a horizontally differentiated product leads to an increase in the diversity of tastes and preferences, to the entry of new firms into the market and a corresponding decrease in the concentration of sellers. On the contrary, a decrease in effective demand leads to a decrease in the number of brands and sellers in the market.

Let's consider an approach to analyzing product differentiation based on the model developed by G. Hotelling.

A property of this model is the location of goods (firms) in a linear city, along a straight street. The basis for product differentiation is the different location of goods relative to consumers, i.e., different distances from them. Products are characterized by physical homogeneity and are located at points a and b, defined as the distance from the origin (0). It is assumed that the prices of both goods are the same and that consumers are evenly distributed along the line. The only difference between the goods is their distance from the consumer. It can be assumed that the latter will choose the product, covering the distance to which will be accompanied by lower transport costs per unit of goods. It is also assumed that consumers purchase a unit of a product over a given period of time.

Spatial product differentiation suggests the presence of different market segments.

From the figure in Appendix 1, it is clear that areas A and B represent areas of local monopoly for the sale of products a and b. Area C is the area of competition between these two goods, since within this zone consumers can choose between goods a and b. With a significant (linear) increase in transport tariffs, demand changes, the competition zone may disappear and a “dead zone” will appear, i.e., “dead weight”. In the “dead zone”, consumers are not ready to buy any of the offered products, since the purchase price significantly exceeds the reserve price, which is determined by the point of intersection of their individual demand curve with the price axis (Appendix 2).

In this case, firms lose some consumers, but can raise prices in areas of monopoly power and receive excess profits. However, this situation will continue until a new company enters the free or “dead” zone, which will receive some of the consumers of both goods, which will lead to a reduction in prices for them and, accordingly, a decrease in profits. Therefore, for producers of goods a and b, a situation where the competition zone disappears may be more preferable.

The behavior of firms in the market is aimed at achieving this goal. In general, the behavior of producers in a given market depends on what goals they are pursuing and at what distance they are located from the ends of the street. If firms are located at different distances from the ends of the street, this may serve as a basis for charging different prices and capturing a larger share of the market. If a firm seeks to sell the maximum quantity of a product at fixed prices, then it will try to capture the market share of another firm, which, in turn, will respond in kind.

Thus, different situations are possible in the location of firms, which are ultimately determined by the specific demand of consumers for spatially differentiated products and result in different efficiencies for producers, consumers and the economy as a whole. If, for example, we imagine the identity of different distances from consumers to supply points of homogeneous goods to the measure of the characteristics of heterogeneous products (hardness of cheese, etc.), we can build another model of differentiation.

Horizontal and vertical product differentiation

Product differentiation can also be associated with two circumstances:

The difference in consumer characteristics of goods that satisfy different tastes - horizontal, or spatial, differentiation;

The difference in the quality of goods that satisfy the same tastes is vertical differentiation.

In product markets, both types of product differentiation are present.

The characteristics of horizontal and vertical product differentiation are presented in Table 5.1.

Table 5.1 – Characteristics of horizontal and vertical product differentiation

Models of horizontal product differentiation involve the study of competition between products that use the same amount of resources to produce, but differ in design. In addition, products may be differentiated in terms of different spatial arrangements, which entail different transportation costs for the purchase of the product. Therefore, models of horizontal product differentiation are often also called models of spatial differentiation. Traditionally, models of horizontal differentiation include:

Model of G. Hotelling;

Salop model.

Hotelling's model is a "linear city" model.

Model conditions:

1) We consider two companies located at opposite ends of the city.

2) The distance between sellers is equal.

3) The products of both sellers are identical in all characteristics except location.

4) At the distance separating the sellers, buyers are evenly distributed.

5) Buyer preferences are identical.

For each firm, the net price it can receive for its product depends on: the maximum willingness to pay for the product and the distance of the buyer from the seller. The further away the buyer is from the seller, the lower the net price the seller can receive.

The linear city model is presented in Figure 5.1.

Figure 5.1 – Model of a linear city

In Figure 5.1:

Мв1 – area of monopoly power of firm 1;

Мв2 – area of monopoly power of firm 2;

Volume of demand is the area of price competition among firms.

Remoteness reduces the ability of firms to compete with each other. Thus, the buyer located closer to the first firm ready to buy goods from her . In order for him to agree to switch to the product of the second seller, he must set a significantly lower price for the product.

The price that the first firm can charge for its product is limited:

The maximum willingness of the consumer to pay for the company's product;

The amount of transportation costs;

The pricing policy of a competing company.

These factors will also influence the price of the second company.

In the spatial differentiation model, consumer transport costs are of great importance. A sufficiently significant increase in transport tariffs will lead to the emergence of a “dead zone” - potential consumers so distant from sellers that firms cannot expect to receive any positive price. For example, consumers will not go from Saratov to Volgograd for milk, even if the price in Volgograd is slightly lower.

Thus, consumer preferences are influenced not only by differences in products, but also by their location. Consumers prefer products that are located closer to them. As a result, firms gain some market power within which they can raise prices. In other words, consumers choose: to buy a product that is more expensive, but located closer to them, or to buy an identical product for less, but pay transportation costs.

This situation will be observed until a new firm enters the “dead” zone, which will receive part of the consumers of both goods, which will lead to a reduction in prices for them and a decrease in the profits of firms.

The Salop model is a “circular city” model.

Model conditions:

1) The street encircles the city.

2) The transport tariff rate measures brand loyalty.

3) Firms are located along a circle (street) at the same distance from each other.

4) The marginal costs of firms are constant, the same for all firms.

The possibilities of price competition in the Salop model depend on:

Maximum willingness to pay;

Number of sellers in the market;

Transport tariff rates.

If there are few sellers in the market, each of them has monopoly power, up to the complete impossibility of price competition. “Dead losses” arise in the market - the unsatisfied effective demand of buyers who are willing to pay for a product an amount that exceeds the marginal cost of its production.

If the maximum willingness of buyers to pay for a product is high enough and allows for economic profit, then in the long run, unsatisfied demand will cause new sellers to enter the market, between whom price competition arises. For example, the feasibility of opening large retail stores “Ikea” and “Auchan” in a particular city is assessed.

The circular city model is shown in Figure 5.2.

Figure 5.2 – Model of a circular city

With spatial product differentiation, the potential for price competition in the differentiated product market is reduced by building brand loyalty. Brand loyalty, in turn, reflects consumer preferences. Methods of price and non-price competition in the market with vertical differentiation are combined somewhat differently.

The process of differentiation is used in marketing to increase the competitiveness of a company's product in the market and consists of endowing the product with special distinctive properties that are important to the target audience. The concept of differentiation was first proposed by Edward Chamberlin in 1933 in his theory of monopolistic competition. The concept has been fully integrated into marketing theory and is by far the most commonly used.

In the article we will consider in detail the existing types of product differentiation of goods and give examples of the successful use of the theory of product differentiation in practice.

The real meaning of the theory

By correctly using a product differentiation strategy, any company can ensure the required level of sales and profits even in a highly competitive market. Let's take a closer look at how this method works.

A highly competitive market is characterized by a large number of players, the presence of leading players and the constant emergence of new companies. If all companies sold a homogeneous product with the same characteristics on the market, then as a result of competition, only those players who have access to cheaper resources or those who are able to make a high level of investment in supporting the product would survive. In practice, in highly competitive markets, small companies that produce differentiated products for a certain part of consumers can also easily exist.

What does this mean? A product differentiation strategy allows even small companies to become successful in competitive industries by reducing the impact of high resource endowments on a company's market share. It is enough for a company to correctly define its product (based on knowledge of the company’s strengths and existing resource capabilities), find a group of consumers for whom the selected competitive advantage of the product will be significant and set a price that will ensure the required level of profit.

Product differentiation reduces direct competition, makes it difficult to compare products with each other, and allows any company to become a mini-monopoly in its segment, setting a price for a product that will cover all the costs of its production and ensure the required profitability of sales. The higher the product differentiation in an industry market, the wider the consumer choice and the more difficult it is to literally compare products.

Types of Product Differentiation

In practice, there are two types of product differentiation: vertical and horizontal differentiation. Horizontal differentiation means “different products for different needs,” while vertical differentiation means “different products for the same need.” Both types of differentiation complement each other and can exist in the company’s product portfolio simultaneously.

Fig. 1 Types of product differentiation using the example of the shampoo market

Using a horizontal type of product differentiation, the company identifies consumer segments in the market with different needs and begins to produce a specific product for each audience need.
Using vertical product differentiation, a company focuses on one consumer need and seeks to offer different ways to satisfy that need.

How to differentiate a product?

Let's move on to the practical application of the concept, namely the process of product differentiation itself. In order to correctly apply the model in practice, three conditions must be met:

First, determine the “must” product characteristics: the minimum that all market products must have. Such characteristics will represent the starting point for differentiation.
Secondly, conduct a detailed analysis of the properties of competitors’ products
Thirdly, compile a list of important consumer properties of the product for each consumer market segment. The list is easily compiled using a simple survey. The resulting characteristics will represent possible forms of product differentiation.

After fulfilling the three conditions described above, all you have to do is find free niches using the most suitable one for your product. In practice, there are 7 successful product differentiation strategies that can be combined or used separately. Let's look at each of the seven strategies in more detail.

Differentiation at the product level

This strategy can be called a “pure product differentiation” strategy. Using it, you must convey to the consumer one single idea: “Your product offers the consumer something that no other product on the market can offer.”

This strategy is based on the presence of truly unique properties and characteristics of the product, on the absolute innovation of the product. Thanks to the use of such a competitive strategy, a separate category in the market is created in which your product acts as an absolute monopolist. An example of such differentiation would be the emergence of a light beer category under the Miller brand on the market. This product founded the Lager beer category, which subsequently included other brands.

Differentiation by product characteristics

By using this type of product differentiation strategy, you convince the consumer that your product has the best functionality for them. This strategy is often used in the information technology and electronics industries. For example, a manufacturer claims that its product has a higher resolution, a brighter monitor, and a more powerful processor. In consumer goods, this strategy manifests itself in endowing the product with additional properties. For example, juice containing 20 essential vitamins, baby food with the addition of beneficial microelements (which competitors do not have).

Differentiation by price

The price differentiation strategy is constantly used by manufacturers. It means selling a product to satisfy the same need, but at a lower or higher price. Low price is important when the consumer wants to save on purchasing a product; a high price is used when it is necessary to attract an audience for whom status, prestige, design, high quality, high speed of service and high efficiency are important.

Going into a niche

The strategy of focusing on a specific niche is suitable for small companies. They concentrate all their efforts on the target audience, which in its preferences differs significantly from the market as a whole, and therefore has very specific requirements for the product. For such an audience, an “ideal product” is created that will not be of interest to the entire market, but will gain incredible success among a specific target audience.

Differentiation through additional services

There are situations when the product on the market is very homogeneous and it is impossible to find significant criteria for differentiating the product. In this case, the company has another way to distance itself from competitors: to include additional services with the purchase of goods. For example: a product with free delivery to your home, with free assembly and installation.

Differentiation through communication

Another way to differentiate a homogeneous product is through special communication with the consumer. Communication can evoke certain emotions, establish closer contact with the audience, and evoke special loyalty. For example, SPLAT toothpastes have chosen a special way of communicating with consumers: the manufacturer includes letters in each product package, which creates closer communication between the brand and its audience.

Differentiation through packaging

And lastly, one of the most common ways to differentiate a product is through the design and shape of the packaging. You can create a unique design that will attract attention and make the product stand out on the shelf. You can also give your product an interesting, memorable shape, release the product in a unique volume, etc.

Pros and cons of differentiation

A differentiation strategy has its advantages and disadvantages. The advantages are that the strategy:

helps reduce pressure from substitute products
ensures survival even for small companies
allows you to increase audience loyalty
increases the profitability of the product due to the ability to set a higher price

The disadvantages of the strategy include: increased costs for the production of heterogeneous goods (small batches of different materials and packaging are required), the need for investment in communicating the distinctive properties of the product (sometimes quite high), the development of cannibalization and competition within the company’s assortment (when one product begins to compete and eat selling a similar product to the company rather than competitors), creating a confusing, wide range.

When deciding to use a differentiation strategy, you should remember one important idea: product differentiation should be based on product characteristics that are important to the consumer.

As has already been shown above, product differentiation is an important element of the economics of industry markets in conditions of the dominance of personalized production of homogeneous products.

Vertical differentiation - This is the differentiation of goods, in which the distribution of goods on the scale of consumer preferences is carried out in accordance with their quality.

When selling mass-produced goods, the company expands its presence in the market, taking into account the characteristics of consumer preferences. Moreover, it becomes possible to set a price that is more favorable for the seller, while the buyer receives the most desired set of product characteristics (color, size, taste, smell, texture, quality).

With vertical differentiation, the segmentation of market demand depends on the solvency and quality characteristics of the product. For example, a new, comfortable, powerful, but economical car is always preferable to a knowledgeable consumer than a used, expensive-to-maintain analogue. Here there are several parameters that differ in the quality of the product, but not everyone needs and not everyone has access to a more expensive option, since the choice depends on the purpose of use and the level of the available budget. As a rule, prices rise in proportion to the increase in the quality of the product, and as material boundaries and possibilities expand, the final choice is made. Therefore, the seller of low-quality goods focuses on a category of buyers who are ready to choose his product because of low income or because of relative indifference in preferences. Accordingly, the seller of a high-quality product gains advantages over a competitor precisely due to differentiation, which is associated with higher costs and a higher price of the product.

Many economists have addressed the problem of vertical differentiation, including M. Moussa and S. Rosen, S. Moursi, N. Economides, J. Sutton, J. Gabzewicz and J.-F. Tiss and many others.

Moussa and Rosen examined graphs of the optimal price-quality combination, and found that most consumers predominantly buy one category of goods, the costs of production of which are relatively low and constant, while the marginal costs of producing products of higher quality will increase, and a limited number of people will buy it. Thus, the higher the price of a product category, the more limited the buyer pool, and the quality of the product sold to the average customer tends to be lower.

Morsi examined the role of consumer preferences, costs, and price competition. It was based on a study of the company's competitive product strategy using the example of two identical companies competing in the field of product quality and price. His idea was that the equilibrium product strategy of a firm, on the one hand, consists in bringing two competing enterprises closer together, and on the other, in moving them away from each other. On the one hand, in order not to lose market share, both firms strive to provide approximately the same set of product characteristics, while focusing on consumer preferences and taking into account their own costs. But, on the other hand, they differentiate their products because they view differentiation as a competitive advantage and a source of additional profit.

Economides considered a two-dimensional vertical-horizontal differentiation model in which companies compete on quality, variety, and price. He suggested that horizontal (by assortment) choice occurs before vertical (by quality) choice under conditions of increasing marginal costs as quality improves. In his study, he showed that the existence of quality technology leads to maximum differentiation in assortment and minimum in quality, regardless of whether price and quality are simultaneous or sequential strategic variables. This is because maximum differentiation in the assortment allows for higher price and profit levels to be achieved.

Sutton discovered that a firm that produced a better product could capture significant market share. That is, the production structure is optimal when the technological solutions of firms are aimed at improving the quality of the product with a slight increase in variable costs per unit of production. Thus, producing better products is the way to gain greater market share and increase profitability.

Gabzhevich and Thiess allow for the long-term presence of low-quality goods on the market if they can be sold at a low price. Also, according to the results of their study, vertical differentiation (all other things being equal) creates a more stable market situation in terms of price and product competition.

Assessing the real market within the framework of vertical differentiation, a product can be classified relative to price and category as follows (Fig. 4.8).

Rice. 4.8.

Everyone determines for himself the quality of the products consumed, depending on the needs that arise and current circumstances. But it is obvious that the better the product, the higher its price, which is associated with increased costs for more expensive raw materials, packaging, higher quality work, etc. Many people prefer to pay more because they expect higher quality.

Differentiation has certain advantages and disadvantages for both producers and consumers.

The degree of consumer loyalty is increasing due to the provision of a wide range of goods and services on the market. Through differentiation, firms produce unique products that satisfy people's needs, as opposed to a homogeneous good. It becomes possible to choose a wide range of products from different price segments.

Creative development occurs because in order to survive in a global competitive market it is necessary to invent new products that allow the company to update its activities. A company can modernize existing products, make them more efficient and useful, or offer a completely new product that meets changing needs and technologies. All this ultimately has a positive effect on economic growth.

A certain negative factor is that the constant development of companies in search of new solutions to meet consumer needs requires high costs. For example, market research for customer preferences, product development, increased prices for raw materials and materials, its launch, advertising and further monitoring of its sales in order to improve. All of this is reflected in the resulting higher cost that the consumer pays.

Another negative consequence of differentiation is the emergence of obstacles and barriers to entry for new companies. The reason is that most consumers stick to their previous tastes and preferences, and tend to buy established products from well-known brands, while purchasing new products less often and with some caution, which, of course, gives a significant advantage to companies already in the market. It is difficult for newcomers to overcome product differentiation, as the problem arises of insufficient resources to create a competitive product, both in cost and in terms of properties and functionality.

Naturally, other things being equal, consumers prefer goods of higher quality. The question is to what extent the increase in quality is related to the increase in costs to ensure it.

If costs grow in proportion to the increase in quality, vertical differentiation begins to strongly resemble horizontal differentiation: you can enter the market with the production of such a modification of the product that will correspond to the choice of a certain group of consumers, i.e. costs are covered by the group of consumers who buy this particular modification of the product.

If costs grow slightly as quality increases (a flat function of costs), the market price will be approximately the same for goods of different quality. High-quality goods replace low-quality goods. Manufacturers of lower quality goods can then increase advertising costs.

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