Product Differentiation

Informative advertising is most desirable when products are differentiated and consumers find it difficult to select the ones that best fit their preferences. This chapter summarizes only the effects of advertising on product differentiation. Products are said to be "vertically differentiated" if all consumers agree on which product is better. If two products differ in terms of quality, for example, all consumers will want a higher quality product if the two products are priced the same. If two products have the same quality but differ only in color, however, some consumers will prefer red whereas others will prefer blue even when the prices are the same. The latter is a case of horizontal product differentiation.

For horizontally differentiated products, informative advertising enables a consumer to find a product that best matches his or her preference. A consumer's preferences can be graphed as locations in a spatial market or city. The distance between the locations of a firm and a consumer represents the difference between a product and the consumer's preference. Therefore, an advertisement about a product's location helps the consumer find out which product is closer to one's location.

The obvious incentives for firms to convey product information to consumers are the increase in sales and the reduced demand elasticity due to consumers' knowledge that competing products do not offer a better match. After consumers find their match, advertising builds brand loyalty and increases the firm's market power. Also, a firm's advertising is bound to inform some consumers that its product does not match their tastes. In a simplified market with two firms, one firm's advertising is beneficial to its competitor— a type of public good have also shown that informative advertising actually reduces price competition among firms; thus consumer welfare is lowered despite a better preference-product matching. The loss to consumers is due to a higher price; as a result, there is an incentive for firms to provide excessive informative advertising.

Does advertising affect product differentiation itself? In some cases, advertising can result in spurious product differentiation by which consumers are persuaded to think, albeit mistakenly, that there are differences in competing products. Many over-the-counter drugs and household chemicals have essentially the same ingredients but consumers perceive them to be different largely because of advertising.

When products are vertically differentiated (for example, by quality), truthful advertising may solve the lemons problem discussed in Chapter 4 by signaling quality. If all customers are informed about product quality, a high- quality good should command a higher price than a low-quality good. If advertising is truthful and credible, higher price means higher quality.