Unit 7 The firm and its customers

7.9 How firms differentiate their products

Product differentiation is a feature of many markets beyond manufactured goods such as cars or breakfast cereals. Retail shops are intermediaries between manufacturers and consumers, and each one offers a distinctive service: they are differentiated by their location, the products they select and the way they display them, and the additional services, such as packing or delivery or insurance, that they provide. Consumers may be willing to pay more for products sold in a convenient location, or the experience of shopping in a pleasant environment. Similarly, some people have strong preferences between the services offered by different hairdressers, day nurseries, dentists, plumbers, entertainment venues, or tour operators—enabling service providers to differentiate themselves from others and gain market power.

In selecting and designing a product, a firm determines the demand curve that it will face. To maximize profit, it would like to find a product that is both attractive to consumers and has different characteristics from products sold by other firms. Then demand would be high (many consumers would wish to buy at each price) and elasticity low. Of course, this is not easy. A firm designing a new car model knows that there are already many brands on the market. But technological innovation may provide opportunities to get ahead of competitors. After Toyota developed the first mass-produced hybrid car, the Prius, in 1997, there were very few comparable cars available for around 15 years. Similarly, Tesla established itself as a market leader in all-electric vehicles, and in 2022 sold 18.2% of battery-electric cars worldwide.

Innovative ideas and technology can put firms ahead of the competition in services, too. Online training providers develop new educational and assessment tools to differentiate themselves. Consultants establish a niche in the market by developing particular areas of expertise. Day nurseries have introduced online videos to keep parents informed about their child’s activities. Health and personal care providers offer new treatments and technological solutions to customers’ problems.

Advertising

Having selected a product, a firm may be able to increase demand through advertising: that is, to move its demand curve outwards, so that more consumers will buy at each price. This strategy is widely used by producers of differentiated products, to inform consumers about their existence and characteristics, attract them away from competitors, and create brand loyalty.

Market analysts Schonfeld and Associates estimated that advertising on breakfast cereals in the US was about 5.5% of total sales revenue—about 3.5 times higher than the average for manufactured products. Figure 7.23 shows the relationship between market share and advertising expenditure for the highest-selling breakfast cereal brands in the Chicago area in 1991 and 1992. For breakfast cereals, market share is not closely related to price. But it is clear from Figure 7.23 that the brands with the highest share are those that spend the most on advertising. Matthew Shum, an economist, analysed cereal purchases in Chicago using this dataset, and showed that advertising was more effective than price discounts in stimulating demand for a brand. Since brands that were already well known spent most on advertising, he concluded that its main function was not to inform consumers about the product, but rather to increase brand loyalty, and encourage consumers of other cereals to switch.1

In this scatterplot, the horizontal axis shows quarterly national advertising expenditure in millions of dollars, and ranges from 0 to 8. The vertical axis shows the percentage market share, and ranges from 0 to 6. Coordinates are (expenditure, market share). There is a weak positive correlation between these two variables. Data for specific firms is as follows: Quaker Oats (1.8, 2), Raisin Brain (4.3, 1.5), Grape Nuts (6.6, 2), Cornflakes (6.7, 5.7), Cheerios (6.8, 4.4) and Frosted Flakes (8, 4.8).
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Figure 7.23 Advertising expenditure and market share of breakfast cereals in Chicago (1991–92).

Figure 1 in Matthew Shum. 2004. ‘Does Advertising Overcome Brand Loyalty? Evidence from the Breakfast-Cereals Market’. Journal of Economics & Management Strategy 13 (2): pp. 241–72.

Exercise 7.4 Identifying product differentiation

Choose two out of the following markets:

  • fast food
  • subscription streaming services (such as Netflix)
  • smartphones
  • introductory economics textbooks.

For each market, give some examples of how the firms in that market differentiate their products. You may find it helpful to conduct some internet research on the products offered and advertising conducted by the firms in that market (either in your country or globally).

  1. Matthew Shum. 2004. ‘Does Advertising Overcome Brand Loyalty? Evidence from the Breakfast-Cereals Market’. Journal of Economics & Management Strategy 13 (2): pp. 241–72.