Maximal or Minimal Differentiation?

Differentiation softens price competition. Given this, does it make sense for firms to always look for the maximum product/service differentiation that is achievable? The answer is that, while more differentiation is usually preferable to less, there are forces which oppose differentiation that need to be considered when determining how much differentiation is optimal.

First, in many cases demand is driven by physical location. Many service providers and some product providers), choose to locate close to their customers, where the demand is. This concentration intensifies price competition and may blunt differentiation. In this case, increasing differentiation, or undertaking horizontal differentiation, may be required.

Secondly, there may be positive externalities between firms. related to the above, there may be externalities that induce firms to locate close to one another. Firms may choose to be closer to their source of supply for input materials to reduce transportation costs, or they may choose to locate close to one another to reduce the search costs of customers. An example of the latter is auto malls, where the dealers of various manufacturers cluster. In these cases, while price competition is intensified, it may be offset with greater differentiation of the product or service being provided.

Thirdly, price competition may be limited by legal or technical reasons. For example, resale-price maintenance agreements imposed by manufacturers may serve to limit the degree of price competition for some products. in these cases, where price competition is softened as a result, firms have less incentive to differentiate fully.

There is no easy to answer to how much differentiation is enough. However, a consideration  of the above three forces may give clues as to the relative amount of differentiation that may be needed in any given setting.

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When More is Less

Increasing efficiency doesn’t always add more value. Doing things faster, producing greater quality, and being more flexible are all great, but if they do not represent utility to customers, then they do not represent value.

To earn profits in excess of the industry average, a firm must strive to be superior to its competitors in the industry. A key to superior performance is creating more value for customers than one’s rivals by exploiting some competitive advantage. the aim of strategy is to create such a comparative advantage.

For each product or service, there is a maximum value the customer is willing to pay. This is the customer’s “willingness to pay.” The difference between this value and the product/service price is the consumer surplus, or utility. In order to maximize utility, firms must offer value that is superior to that of rival offerings.

A problem arises when firms make the assumption that consumers will value things that, in actuality, they don’t. Consumers don’t always perceive additional value in higher quality, faster deliveries, added convenience, and many of the other things that firms assume constitute superior value.

It is always good to remember the following formula:

Total value created = consumer surplus + producer surplus

or, u – c = (u – p) + (p – c) where u is utility, p is price, and c is cost.

This formula simply outlines the necessary conditions for market exchange to take place: the value (utility) that the product/service represents for the consumer (u) must exceed the price (p) and the cost of producing it (c). Only by meeting these conditions can firms create superior value through which both the consumer and the producer gain.