Good afternoon and welcome to the seventh lesson of Industrial Organization: Strategy and Competition in Business. In this lesson, we'll talk about product differentiation. Product differentiation is an effort to make your product to seem different to the consumer than the rest of the competitive products. Differentiation is in the eye of the beholder. It means that it doesn't matter if your product is indeed different than the other products. What matters is that consumers see your product as different. To some of us, some products, they just look the same. For example, when I go to the supermarket and I want to buy detergent for washing my clothes, I look in the shelf, and all of them, they look the same to me. When my mom goes to the supermarket and she see the same detergents, she knows which one is better, which one is worse, which is better for colored clothes, which one is better for black, which is better for white. So, to her, products are different. To me, are not. So, companies, they go into a race of innovation and advertisement and R&D and everything in order to try to make their products better. Differentiation, in other words, is an alternative form of competition. Once you compete in trying to make your product better, then this may ease price or quantity competition in later stages. Consumers, they care not only about the price of the product. When they go shopping, they look, of course, at the price. They, of course, try to economize in how much money they will spend on several products, but price is not the only thing that they look. They look at the characteristics of the product. They look at the quality of the product, whatever that means, we will see it later. They look even at the brand name of the product. The same exact product, if it has a different label, it will do different in sales. They look at location. Location is a very usual form of competition and differentiation. And they also look in services, both presale and after sale. You buy the same product from the one firm and the same product from another firm, and because they give you a different amount of service, you may prefer a particular firm just because of this exact service. Differentiation yields market power. Once you differentiate successfully your product in the market to the eyes of your consumers of course, then this will give you the opportunity to charge a little more than your rival firms, than your competition, and still, your consumers will keep buying for you, provided, of course, that you have successfully differentiated your product in their eyes. Now, it's very important for you to understand that differentiation can occur in two different dimensions. We have, first of all, the horizontal dimension, horizontal differentiation, and then we have the vertical differentiation. And you will see that these two forms of differentiation will make perfect sense to your intuition once we explain them. So, in a horizontal differentiation, the perceived difference of the products is subjective. That is, different consumers, they pick different products when prices are equal. When price is not the factor, they will prefer different products. And differentiation, in this case, is usually in what we call in the style of the product or in the characteristics of the product. For example, some people prefer iOS devices from Apple, and some other people prefer Android devices from Google and Samsung and other firms that they make phones, that they follow Android operating system. Now, the reason that they do that is that some people like the characteristics of Apple. They say, "This is minimalistic. It works all the time. It's easy to understand what is going on. It doesn't have a lot of flexibility, but I don't care for that. I care for the other things." On the other hand, there are users that they care for flexibility much more, and they will prefer Android because it's versatile, they can do more things in that, but it's not as easy to interpret and to understand as iOS. So, you have people that when price is not an issue, which is not in this case because these products come into similar price ranges, then, in this case, some people prefer one product, some other people prefer the other product. In vertical differentiation now, the difference is objective. So, most of the people consider that one product is definitely better than the competition. Everyone picks the same product therefore when price is not an issue. If prices are the same, every consumer will prefer the same exact product. So this is what we usually call the differentiation in quality. If everyone believes that the product is better, it means that this product has better quality. Now, what is an example in this case? Let's consider the case in cars. You have BMW and Mercedes. These cars, they are horizontally differentiated, meaning that some people prefer BMW, some people prefer Mercedes. If now you have Rolls-Royce and Kia, these two brands, they are vertically differentiated. Kia cars may not be as bad, but not even Kia itself will come out and tell you, "Take our cars because they are better than Rolls-Royce." What they tell you is that, "Yeah, Rolls-Royce is better than us, but we are also good, but we are much, much cheaper than them." So, if Rolls-Royce and Kia was at the same price, everyone, of course, would get Rolls-Royce. But because they are in different prices, the both firms have a chance in competition, and don't be surprised if Kia has a higher profit than Rolls-Royce in the end. Now, in today's lecture, I have to warn you for a few things. First of all, we will start from horizontal differentiation. We will present two different models. And then, we'll have a model on vertical differentiation. Today's lecture will be a little bit technical, but this is inevitable. We can't do without these technicalities because of these three models that I will show you. They have very rich intuition behind them that you will not be able to understand and interpret if you do not know these models. So, bear with me, we are going to go through the models, and you will see that today's lecture in the end, it's going to be very interesting. Stay with us.
