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LECTURE 4 & 5: PRODUCT DIFFERENTIATION
AEM 4550:
Prof. Jura Liaukonyte
Lecture Plan
 LI and Dorfman Steiner revisited
 Taxonomy of product attributes
 Search
 Experience
 Credence
Lerner Index
Definition
Formula
 Measures the market power of a
company based on the price it
can charge
 The higher the number, the more
pricing power the firm has
 Mark-up power reflects monopoly
power
 PUNCHLINE: If elasticity
increases, mark-up will decline.
If the product becomes less
elastic, mark-up will increase.
L = (p - MC)/p = 1/|EP|
 Assume a firm faces a downward-sloping demand
inverse curve but one that shifts depending on the
amount of advertising A that the firm does
 P=P(Q, A)
Recall, the Lerner Index, LI
L = (p - MC)/p = 1/|EP|
Where |EP| is the price elasticity of demand
 The elasticity of output demand with respect to advertising
EA 
A
P *Q

Q / Q
A / A
EA
| Ed |

A Q
Q A
Dorfman-Steiner Condition
For a profit-maximizing monopolist, the advertising-tosales ratio is equal to the ratio of the elasticity of
demand with respect to advertising relative to the
elasticity of demand with respect to price.
A
Intuition Behind D-S
A
P *Q

EA
| Ed |
 Recall: the greater the demand elasticity, the lower the
optimal price.
 Price-cost margin is smaller when elasticity is higher.
 Since the price-cost margin is smaller with elastic demand,
the gain from advertising is also smaller even if the increase
in quantity demanded is the same.
 The marginal gain from advertising is greater the greater the
price-cost margin.
Dorfman-Steiner
 The Dorfman-Steiner formula relates the advertising-to-
revenues ratio to price-cost margin and elasticity.
 The advertising-to-sales ratio is greater the greater the
advertising elasticity of demand and lower the price elasticity
of demand (or the greater the price-cost margin).
Example
 Suppose you have been hired to marker a new music
recording that is expected to have target sales of \$20
million for upcoming year
 The marketing department has estimated that 1%
Scenario
increase in advertising will translate to 0.5% increase in
sales
 And that 1% increase in the price of the recording would
reduce the number sold by about 2%
Question
 How much money should you commit to advertising the
recording in the coming year?
 This ratio varies between industries
 Salt industry: a-s-r = 0 to .5%
 Breakfast cereals industry: a-s-r= 8% to 13%
 The type of product
 Price elasticity of demand
Example: Credit Card Industry
35.00%
30.00%
Percentage
25.00%
Bank of America
20.00%
JP Morgan Chase
Citigroup
15.00%
American Express
Industry
10.00%
5.00%
0.00%
2010
2009
2008
Year
2007
2006
• Industry Average is 7.6% and has grown
over the last few years
Example: Airline Industry
3
2.5
2
AMR
Delta
1.5
Southwest
US Airways
1
0.5
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
 High or low?
 Transportation/Travel industry =1.9
 Consumer Products, Books, PayTv, Communications, all > 5
 Downward Trend
Market Concentration
 Numbers and size distributions of firms
 Ready-to-eat breakfast cereals: high concentration
Different Market
Structures
Measurements of
market structures
 Newspapers: low concentration



Concentration ratio,
Herfindahl-Hirschman Index (HHI)
Lerner Index (LI)
Industry Concentration
 Four-Firm Concentration Ratio
 The sum of the market shares of the top four firms in the defined
industry. Letting Si denote sales for firm i and ST denote total industry
sales
C 4  w1  w 2  w 3  w 4 , where w1 
 Herfindahl-Hirschman Index (HHI)
Si
ST
 The sum of the squared market shares of firms in a given industry,
multiplied by 10,000: HHI = 10,000  S wi2, where wi = Si/ST.
Measure of concentration
Firm Rank
Market Share
(%)
Squared Market
Share
1
25
625
2
25
625
3
25
625
4
5
25
5
5
25
6
5
25
7
5
25
8
5
25
Concentration Index
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Concentration Index
Σ
25
25
25
5
5
5
5
5
Squared Market
Share
Σ
625
625
625
25
25
25
25
25
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Σ
Assume firms 4
and 5 merge
Concentration Index
25
25
25
5
5
5
5
5
10
Squared Market
Share
Σ
625
625
625
25
25
25
25
25
100
Measure of concentration
Market Share
(%)
Firm Rank
1
2
3
4
5
6
7
8
Σ
The
concentration
indices change
Concentration Index
25
25
25
5
5
5
5
5
10
Squared Market
Share
Σ
CR4 = 80 85
625
625
625
25
25
25
25
25
100
H = 2,000 2050
HHI
 The Herfindahl-Hirschman Index – the square of the percentage
market share of each firm summed over the largest 50 firms in
the industry (or all of the firms if there is less than 50)
Definition
Properties

In perfect competition, the HHI is small

In monopoly, the HHI is 10,000 (100 squared)

A popular measure with the Justice Dept in the 1980’s

Example

HHI < 1000 characterized competitive markets

HHI > 1800 would bring Justice Dept challenge to proposed
mergers
E.g. The cigarette industry is highly concentrated with only 8 firms
and a Herfindahl-Hirschman Index (HH1) of 2623
Example: Candy and Chocolate Industry
Candy v. Chocolate
CANDY
1.00%
Mars Incorporated
HHI (for top 4) = 1141
CR ₄ = 59%
Medium level concentration
->Concentration is increasing!
The Hershey Company
1.00%
2.00%
Tootsie Roll Industries
2.00%
2.50%
13.40%
3.00%
4.00%
49.50%
21.60%
Ferrara Pan Candy
Company
Jelly Belly Candy
Company
Russell Stover Candies Inc.
Kraft Foods
CHOCOLATE
Nestle Inc.
HHI (for top 4)= 2941.81
Cr ₄ = 78.1%
High level of concentration
Mars Incorporated
The Topps Company
Other
25.00%
39.00%
20.00%
0.50%
0.50%
Nestle
Russel Stover
10.00%
overall!!
The Hershey Company
Lindt & Sprungli
Guittard Chocolate
Company
See's Candies
4.00%
1.00%
Other
CR₄ and HHI: Candy Industry
 The HHI for just the top 4 companies in the industry is 2941.81.
 The CR ₄ for the industry is 78.1%.
 Therefore, the industry is highly concentrated with only a few
major firms holding a majority of the market share.
CR ₄ = 49.5 + 21.6 + 4 + 3= 78.1%
*Hershey and Mars Inc. alone hold 71.1% of the market share.
-Note that students calculated HHI incorrectly (need to add
squared market shares for top 50 companies, not only top
4)
Example: Credit Card Industry
Market Definition
 All Credit Lending Institutions with their own card
 27.2%
 19.2%
 18.9%
 17.2%
 4.0%
J.P. Morgan Chase & Co.
Bank of America Corporation
Citigroup Inc.
American Express Company
Capital One
 CR4: 83.2
 HHI: 1810-1850
MARKET SHARE
J.P. Morgan Chase
Bank of America Corporation
American Express Company
Capital One
 Total Number of Companies: 192
5%
20%
31%
22%
22%
Citigroup Inc.
 Volume of advertising expenditures is large. For the
Facts
US, advertising expenditures total to over 2% of GDP
 Underneath this national total is a wide variety in firm
 Car makers (e.g., GM) and household product firms
(e.g., Proctor & Gamble) spend the most on advertising
 Basic patterns that emerge are:
Patterns
 Correlation between advertising & market power
 Consistency of advertising behavior within industries—big
advertisers remain big over time and across countries
Worldwide Ad Spending by Region (2013)
Advertising by Media in the US
TOP 10 Brands in 2012
Product Differentiation
 Products are different if there is some objective characteristic
Definition
Variation
or property, real or perceived, that provides a basis for buyers
to choose one over the other.
 Product differentiation may lead to reduced own -price
elasticity. As the degree of differentiation increases, the price
elasticity will decrease.
 Product Brand
 Service Provided
 Packaging
 Location
 Condition of Sale
 Product Differentiation as an Entry Strategy
Strategy
 Product differentiation to create a niche market.
 Product differentiation to deter entry.
1
Each firm’s advertising elasticity decreases as concentration
decreases.
2
The more fragmented the industry is, the lower the benefit
from advertising that is captured by the firm that pays for it.
3
With more firms in the industry, a firm’s "split of the pie" is
smaller.
 Advertising product characteristics increases product differentiation.
 Firms can create some sort of subjective product difference.
 Advertising in this case softens competition due to heightened
awareness of product differentiation.
 Soften competition: the industry is less competitive and firms have more
market power.
 Strengthen competition: the industry is more competitive and firms have
less market power.
 Firms are able to avoid Bertrand competition by advertising.
Perceptual Maps
Perceptual Map: Credit Cards
Perceptual Map: Credit Cards
Uniformity
American
Express
Chase
Accessibility
Selectivity
B of A
Citi
Variety
Product Positions in Characteristics Space
What could advertising do to change these positions?
Are perceived and real characteristics the same thing?
On the other hand…
 Advertising can increase price competition when firms
 If prices were artificially high due to imperfect price
their prices to attract more consumers.
lower prices.
 Advertising in this case strengthens competition due to
heightened awareness of prices.
Taxonomy of Products and
Their Attributes
Understanding Customer
Search Attributes
Experience Attributes
Credence Attributes
 Determine prior to
 Can be discerned only
 Any aspects of a good or
and/or services.


service that the
after purchase or
customer must believe in
during consumption or
Like color, price,
use.
 But cannot personally
freshness, style, fit,
evaluate even after
 Examples: Friendliness,
feel, hardness, and
purchase and
taste, wearability, fun,
smell.
consumption.
and customer
Examples: supermarket
satisfaction.
 Examples: the expertise
food, furniture,
of a surgeon or
clothing, automobiles,
and houses are high in
mechanic, the
search attributes.
knowledge of a tax
of tax preparation
software.
Taxonomy of Goods-Nelson (1974), Lieberman and Flint-Goor (1996)
Search
Goods
Non-Durable
Exp. Goods
Durable
Exp. Goods
Experience
Services
Credence
Services
Clothing
Furniture
Footwear
Carpets
Mattresses
Health/Beauty
Cigarettes
Food
Cleaners
Newspapers
Office Supplies
Housing
Autos
Hardware
Drugs
Glass
Software
Signs
Books
Sporting
Goods
Hobbies
Utilities
Transportation
Vacations
Education
Training
Tours
Banking
Car Rentals
Entertainment
Direct Mail
Real Estate
Cargo
Job Placement
Information
Nursing Homes
Sports Clubs
Hotels
Waste Collection
Landscaping
Investments
Trusts
Portfolio
Management
Mutual Funds
Insurance
Health Care
Weight
Control
Car Repairs
Key Point
 Firm (Brand) Reputation is
more important for
experience goods than
search goods and most
important for credence
goods.
 Has implications on
demand.
Product Attributes
Most Goods
Most Services
Difficult
to evaluate
Easy
to evaluate
Clothing
Restaurant meals
Computer repair
Chair
Lawn fertilizer
Education
Motor vehicle
Haircut
Legal services
Foods
Entertainment
Complex surgery
High in search
attributes
High in
experience
attributes
High in credence
attributes
How the Internet affects …
 Search goods:
 Can facilitate consumers' ability to obtain attribute information.
 Experience goods:
 Difficult to provide enough experience for consumers to assess
the benefits of the product  Offline trial & Online purchase
 Credence goods:
 How to help consumers form a set of beliefs about the quality of
of the product such as product testimonials
 Why do consumers respond to advertising?
 An economic theory of advertising can proceed only after this
question is confronted.
 As economists have struggled with this question, 3-4 views
have emerged, with each view in turn being associated with
distinct positive and normative implications.
 Persuasive
 Informative
 Complimentary
 Memory Jamming (Reminder)
Life Cycle of Product
 The persuasive view holds that advertising alters consumers'
tastes and creates spurious product differentiation
 The demand for a firm's product becomes more inelastic
 Advertising results in higher prices.
 Such advertising by established firms may give rise to a
barrier to entry, which is naturally more severe when there are
economies of scale in production and/or advertising
differentiation and brand loyalty.
 Recall, reputation is more important for experience goods
than search goods and most important for credence goods.
 Reputation and Persuasion are close synonyms in this case.
 Among which type of products will we observe high levels of
 Search, Experience or Credence?
The Pervasiveness of Persuasion
 The average person is exposed to
300-400 persuasive messages
per day from the media alone
(Rosseli, Skelly, & Mackie, 1995)
 The average person is exposed to
1,000 commercials per week
(Berger, 2004)
 An average of \$800 per person is
spent on advertising in the U.S.
each year (Berger, 2004)
Obvious Forms of Persuasion
 A 30 second spot for Super
Product
Placement on
American Idol
Bowl costs \$3-4 million for a
30 second spot.
 Product placements in
movies and TV amounted to
\$2.5 billion in 2005 (PQ
Media).
 Morgan (2005) “between
15-30 products are inserted
in every half hour of
television programming”.
Product Placement
 http://www.brandchannel.com/brandcameo_film
s.asp
Featured Brands: Apple, Bell, Cadillac, Chock Full
O’Nuts, Chrysler, Cisco, Ford, Ford Mustang, Hill-Rom, HP,
Lacoste, Listerine, Los Angeles Dodgers, Mercedes,
Motorola, Pepsi, Philips, Pontiac, Pyrotect, Rolls Royce, San
Francisco Giants, Sharp, The North Face, The Riviera Hotel
and Casino, Timberland, Toyota, United States Parachute
Association


Featured brands: Apple, Belstaff, BMW, Citibank,
Datascope, Ford, Ford Mustang, Hamilton, Honda,
Hummer, JVC, Kleenex, Loews, Magnavox, McDonald's,
MetLife, Mobil, Nautilus, NBC, Nissan, Panasonic,
Ronzoni, Salvatore Ferragamo, Sbarro, Spam, Staples, Tic
Tac, Time, Verizon, Viking, XM Satellite Radio
 Total of N consumers in the market.
 Each consumer will buy only one unit of the primary good.
 Each consumer has a different value, vi, for the primary good.
 Advertising increases each consumer’s value by the same
factor, , regardless of their initial value. Thus each
consumer’s value with advertising is  * vi.
Model of Advertising and Crowd Appeal
*
\$
Demand with

Profit
Demand without
MC
Quantity
 Increase in consumers’ willingness to pay, , is a function of
the amount spend on advertising, s.
 As s increases, (s) increases, as does consumer demand
and profit.
 Firms will select the level of advertising that maximizes profit,
i.e., the level of s where the marginal revenue from s is equal
to the marginal cost of s.
 In this model, higher levels of advertising lead to higher prices
because the advertising increases the consumers’
willingness to pay.
 Also, advertising can increase consumer surplus as well as
firm profit, since advertising increases a consumer’s value.
/
Complementary View
 Consumers possess stable preferences
 Advertising directly enters these preferences in a manner that
is complementary to the consumption of the advertised
product
 Advertising may contain information and influence consumer
behavior for that reason
 The consumer may value “social prestige” that is created by
Complementary vs. Persuasive
 The lines between complementary and persuasive are
blurred, because it is hard to know whether ads change
preferences or are part of consumer’s utility.
Complementary View
 Associated with the Chicago School
 When a firm advertises more, its product becomes more
attractive to the consumer
 “The household is made to believe – correctly or incorrectly
Definition
– that it gets a greater utility of the commodity from a given
 Consumer may value social prestige and advertising thus
positions the product so that its consumption provides
social prestige
 Firms may compete in the same commodity (e.g., prestige)
Implication
market even though they produce different market goods
(e.g., jewelry and fashion) and advertise at different levels.
Mission Statement
“Louis Vuitton must continue to be
synonymous with both elegance and
creativity. Our products, and the cultural
values they embody, blend tradition and
innovation, and kindle dream and fantasy.”
Price
 Luxury image
 Selling Point
 Never on sale!!
 Price range:
 Handbags: \$550 - \$3,700
 Wallets: \$200 - \$700
LVMH Moët Hennessy • Louis Vuitton
French holding company
and one of the world's
largest luxury goods
conglomerate.
Mass-Commercialization of Luxury
 Many luxury handbags are mass-produced in
China.
 The average markup for a luxury handbag is ten
to 12 times production cost (marginal cost!).
 Louis Vuitton's markup is up to 13 times
production cost.
 Family-owned companies that used to create
exquisite bags, shoes and clothes, have been
taken over by multi-billion dollar conglomerates.
Luxury Markets
 Asia is now the biggest market for luxury brands
 Strange? the U.S. and Europe are wealthier (per capita)
 Luxury market in Japan is most alive:
 40 % of all Japanese own a Vuitton item
 Why such a global discrepancy?
 Not all
 E.g. Hermes Kelly and Birkin bags are painstakingly made in
workshops in France;
 Classic perfume Chanel No.5 is still created using the finest
ingredients in a small scale operation.
Example: Credit Card Industry