Product differentiation is a marketing process that has the objective of making customers perceive the product of a specific firm as unique or superior to any other product belonging to the same group, and so creating a sense of value. Differentiation does not always imply changing the product, sometimes it is enough just by simply creating a new advertising campaign or by changing its packaging. This term was introduced in economics by Edward H. Chamberlin in his book “Theory of Monopolistic Competition”, 1933.
What a firm achieves by differentiating its product from competitors is to create a market in which it can act as a monopoly, enabling them to have price-making power. However, since products are also similar enough and there are plenty of customers, this type of market structure is also considered as perfect competition. This market is therefore characterized by a group of related products that can be considered to be close substitutes amongst each other which is reflected by their high crossed elasticity. Nevertheless, product differentiation can also be a way to avoid or to create entry barriers and thus become a source of competitive advantage. As a product becomes more differentiated and unique for consumers, it will become more difficult to compare it to other products and it will move competition with other products to non-pricing factors.
There is an important distinction to be made between different differentiation strategies. Product differentiation can be subject to subjective or objective preferences. Two categories are distinguished from this division, horizontal and vertical differentiation. The former is given when consumers base their purchasing decision on subjective preferences when comparing products, e.g. colours or flavours. The latter occurs when a product can be evaluated against the other ones in terms of measurable and qualitative factors, e.g. technological differences or technical properties in engines. Several models have been developed to analyse these two strategies, the most famous being Hotelling’s linear city model and its extension, the Salop’s circular city model, for horizontal differentiation and the Shaked-Sutton’s model for vertical differentiation.