Product Differentiation and Advertising Micro: Econ: 32 68 Module Product Differentiation and Advertising KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How and why oligopolists and monopolistic competitors differentiate their products. The economic significance of advertising and brand names. The purpose of this module is to broadly cover how firms differentiate their products so that higher prices can be charged to consumers. The module also looks at the economics of advertising and branding of products.

Product Differentiation Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry. Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry (either by making them different or just convincing buyers that they are). If firms can convince buyers, they can charge a higher price. In monopolistic competition, firms engage in product differentiation because it allows the firms some degree of pricing (market) power. In oligopolies, firms differentiate their products as a form of nonprice competition to take market share from close rivals.   How is this done? Differentiation can be real (a truck with four-wheel drive is different from a truck without) or perceived (bleach is bleach, no matter what Proctor and Gamble tries to tell you). The point is that it does not matter. If a consumer believes your firm’s product is better, your firm can charge a higher price and reap higher profits.

Differentiation by Style or Type As long as consumers have different tastes, producers will be able to increase profits by differentiating their products to suit those tastes. A pepperoni pizza with deep-dish crust is different from the same pizza on thin crust, or with a crust stuffed with cheese. If a consumer really wants the crust stuffed with cheese, then he/she believes this is an imperfect substitute for a regular pepperoni pizza with a regular crust. This allows the seller to charge a higher price for the stuffed crust.  

Differentiation by Location Many monopolistically competitive firms differentiate their product by location – particularly in service industries The grocery store and gas station closest to your house is usually your preferred store and gas station. Because of its location, near your house, it is different and better than stores and gas stations across town. And because shopping closer to home saves you money (and time), you are probably willing to pay a little bit more for the convenience of this location.

Differentiation by Quality Even if quality differences are mostly perceived, consumers are often willing to pay a higher price for a product they perceive to be of higher quality. A Mercedes sedan and a Kia sedan will both get you to the prom or to the mall, but one is generally agreed to have a higher quality. Because most consumers agree that a Mercedes sedan has superior quality to a Kia sedan, prices are higher for the Mercedes. Even if quality differences are mostly perceived, consumers are often willing to pay a higher price for a product they perceive to be of higher quality.

Is Product Differentiation Efficient? Gets mixed reviews from economists: Product differentiation can increase product variety which can benefit consumers. Product differentiation can be a waste of resources if there is no real benefit from the differentiation. The formula for household chlorine bleach is NaClO, sodium hypochlorite. This is the key bleaching ingredient in every single brand that one can find at the grocery store. The leading brand, Clorox, has about 65% of the market share for household bleach, and spends millions of dollars to maintain this dominance. Economists wonder if advertising dollars are the best use of economic resources.  

Is Advertising Efficient? Gets mixed reviews from economists. Advertising can: Provide useful information which can benefit consumers. Signal the quality of a product. Mislead consumers which can be an inefficient use of resources. The formula for household chlorine bleach is NaClO, sodium hypochlorite. This is the key bleaching ingredient in every single brand that one can find at the grocery store. The leading brand, Clorox, has about 65% of the market share for household bleach, and spends millions of dollars to maintain this dominance. Economists wonder if advertising dollars are the best use of economic resources.