3: Differentiation in Action
The author begins with a narrative to further illustrate the notion of differentiation. His story is that of a woodworking hobbyist making jewelry boxes.
At first, she charged a flat price to all customers of a basic box. Then, some customers began asking about more upscale items like exotic woods, inlays, and the like which she would have to9 sell at a higher price to cover the more expensive materials. As she got more serious about turning the hobby into a business, she considered the size and segmentation of the market, determining not just how many people would be interested in jewelry boxes, but how many would be interested in different levels of quality and how much they would be willing to pay.
As a small firm, it was necessary to choose one market and ignore the others - but because she wanted to make as much as she could, she diversified the product offerings to serve demand for different levels of quality at different prices. Various charts and graphic are provided to demonstrate how this is the superior strategy to specializing in one product at one price.
Willingness to Pay
A common mistake is to believe that sellers set the prices in the marketplace. This is only true when there is little supply and customers are so desperate to have the product that they will pay the asking price. This was historically the case until the mid-twentieth century, in which supply of goods began to exceed the demand for them and companies had to compete to win customers. Then, it was quickly discovered that it was customers who set the price, and suppliers must offer goods at the price customers are willing to pay - or they would turn to someone else who would. And if it is sustainable and profitable to do so, someone will meet the customer's price.
And what we find in customer research is that not all customers are willing to pay the same price. Some customers cannot afford to pay the price for a mid-range product but would accept a lower quality product if it means they can get it for a lower price. Other customers will gladly pay more for a slightly better version of the product.
If suppliers fail to charge as much as customers are willing to pay, there is a "customer surplus" that suppliers could take in as profit if they raise their prices. If they overcharge, customers will not purchase their products, and they will be left with unsold inventory and miss the opportunity to profit (provided that the item can be profitable at the price customers are willing to pay). So it's a delicate balancing act for suppliers in the market to charge as much as customers are willing to pay - no more and no less - and profit is lost either way.
Here' he gets back to his thesis: that it is best to offer multiple versions of a product to capture as much of the market as possible and make as much off each customer as possible. At minimum, offer a standard, economy, and premium version. From there, see if there is room to further segment the market to offer additional levels of quality.
One common objection is that the low-end products may cannibalize the demand for high-priced products: why would someone be willing to pay more? The answer is that not all customers are satisfied by the same level of quality. The existence of Hyundai does not mean that there is no market for Bentley - as people who want a Bentley will not be satisfied with the Hyundai. The automotive market is a good example of this principle in action: not all customers flock to the cheapest product. In fact, most go for a standard version.
Complements and Substitutions
For the sake of simplicity, most discussions of supply and demand treat products as if they were entirely independent - that their supply and demand is entirely self-contained and is neither helped nor harmed by any other product in the market. This is not always the case.
Complementary goods are typically used together and the supply/demand of one will influence the other. That is, there will be virtually no demand for gasoline in a location in which there are no automobiles, and demand for automobiles (at least gas-powered ones) will drop off if gasoline becomes unavailable. There are many instances in which the use of one product depends on the availability of the other - and in many cases it depends on the price of the other.
Substitute goods are considered functional equivalents by the customer and they will readily change from one to another if there is a significant difference in price. For example, soda and juice are very different beverages, but if the price of one becomes unreasonably high, customers will switch from one to the other. Many companies get a nasty surprise when their customers switch to a substitute good they had not considered: the music industry was completely blindsided when customers switched from CDs to MP3 files - they had assumed that the MP3 was not a competitor, or was at best an "imperfect substitute" because they believed customers valued the physical object.
It's later mentioned that complements and substitutes are often the result of a manufacturer who is customizing or altering their product to suit the needs of a specific customer - someone wants a smaller version with a few additional features, and the firm discovers that there are many other customers who would value the same alterations.
Price Discrimination and Product Differentiation
The author suggests that flat pricing often does more harm than good to customers. When a supplier is forbidden to offer different prices to different customers, they serve the market that will offer the highest price (hence the highest profit) and those who cannot afford the flat price are simply not provided access to the product. However, customers cry "unfair" when they find that someone else has paid a lower price for the same product, so companies attempt to assuage this by differentiating their products.
In some instances, the upscale version of a product has more features, is made of more durable materials, has greater design appeal, comes with additional services, and so on. (EN: in some instances it's just branding. For many years, Ford released identical cars at different price points - the Mercury Lynx was exactly the same as the Ford Escort, the Fairmont and Zephyr were identical, etc. and just the badges were different.)
It's mentioned that product differentiation can also have the ability to create a sense of scarcity. Consider the "limited edition" or "collector's edition" of products that are sometimes produced. They are functionally identical but have a few superficial differences.
Irritated Customers
The author cautions firms against being too imperious in interacting with customers, which they often do when they feel that they have monopolistic power, because the moment the customer has another option, they will take it. For example, cable television companies long had monopolies in certain geographic areas - but the advent of satellite television and digital cable has enabled customers to take other choices. Even though many local cable companies have lowered their prices and improved their service, they find that many customers are still resentful and will not return, even when the cable company's offer is objectively superior.
Price discrimination used to be easier when customers were unable to compare notes. It would be very difficult for people living in different cities to tell one another how much they paid for a room at a vacation resort - but with the Internet and social media, it's quite easy to share information and firms will face greater difficulty in charging different prices to different customers.
However, the voice of the crowd can also help support and defend price discrimination. Customers are very quick to defend the "deal" they received if they feel that they received something better than others got in exchange for paying the higher price, or if the person who received a cheaper deal had to accept compromises or undertake additional hardship to get the deal.
Abritrage
Arbitrage describes the practice of generating profit by purchasing a good at a low price and reselling it at a higher price. This often occurs where distance is involved (a good is cheap in another market so it is imported), but it can also occur simply because the buyer who is willing to pay a higher price is unaware that it can be had at a lower price. The practice is often considered exploitive because the customer feels he should have paid the lower price and the seller feels he should have profited from charging the higher price - and that the arbiter has taken advantage of both.
However, the arbiter's profit is from the research and effort he undertakes to connect buyers and sellers who would not otherwise have found one another. Arbiters often accept risk as well: the individual who transports goods from one market to another assumes the risk of damage in transit, the risk that the buyer will not be interested by the time the goods arrive, or that the buyer and seller have found one another on their own.
In an efficient market in which all buyers and all sellers are aware of one another and can communicate freely, there is no opportunity for arbitrage. And so it follows that if regulars have a problem with arbitrage, the effective solution is not to forbid the practice, but to fix the market inefficiencies that make it possible.
Determining the Optimal Selling Price
There is an extended appendix that returns to the jewelry box example, with many charts and a great deal of mathematics to suggest as method of determining the optimal selling price for a product. (EN: It's very detailed and tedious - and aside of communicating the basic fact that there is a point at which the most profit can be made by selling a certain amount at a certain price, it adds little to the topic of developing new products and services.)