If all goods in a market were exactly the same, sales would distribute evenly among them. However, manufacturers try to get more than just an equal share and so they compete on price. A lower price in a market where all goods are identical would attract all sales to that cheaper product. Eventually all suppliers would cut their prices to the lowest possible level and sales would be evenly distributed. This state of equilibrium is called “perfect competition.” However, it almost never happens because of a factor called “differentiation.”
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Suppliers can only cut their prices so low. Beyond that level there is no incentive to produce. Perfect competition almost never happens because no two products are exactly the same. Even when two products, filling the same need, are manufactured by the same factory on behalf of two different brands, those products are differentiated by their packaging and brand value. Differentiation is the process of giving a product distinctive features that identify it in a market of similar, but not identical products.
Vertical differentiation is a status where products are ranked. In the car market, for example, car A could be judged as the best car on offer, car B is the next best and car C is the next. The ranking of these cars could be based on one feature, or a points system covering a range of features. For example, in terms of fuel consumption, car C might be number one, and car A the next best. Car B might rank highest in terms of reliability and prestige, with car C coming second. Car A might not be the best car in any single category, but score sufficiently high in all categories to be the best overall. Vertical differentiation ranks goods and can be a matter of personal taste of the individual consumer. That is why different brands exist. They all have a chance of selling to a sector of the public and none of them will ever take all market share.
Some products are just different and cannot be ranked. For example, chocolate ice cream is not better than strawberry ice cream. The two are the same in terms of their composition and value, but different in terms of their flavour. Another example of horizontal differentiation is the stance of political parties. They are all elected in the same manner, there is no price to enter the voting booth, but they make themselves look and sound different. Horizontal differentiation encourages changes in style and format in an industry producing essentially the same item, such as the fashion industry.
Many products are involved in both horizontal and vertical differentiation simultaneously. Take the ice cream example: a manufacturer may decide to manufacture chocolate, strawberry and vanilla ice cream, which is horizontal differentiation. It then introduces a “premium” brand and spends lots of money on advert production in order to entice the potential customer. It prices the premium ice cream higher than its regular product. The factory then enters into an agreement with a supermarket to produce a discount brand under the supermarket’s name. Then the factory produces three different levels of chocolate ice cream sold to the public at different prices. This is vertical differentiation, but as the factory also produces strawberry and vanilla ice cream at those three different price levels, it is also engaging in horizontal differentiation on the same products.
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