Product differentiation as the basis for establishing a downward-falling demand curve was first introduced in economic theory by Sraffa.
Yet it was Chamberlin who elaborated the implication of product differentiation for the pricing and output decisions as well as for the selling strategy of the firm.
Chamberlin suggested that the demand is determined not only by the price policy of the firm, but also by the style of the product, the services associated with it, and the selling activities of the firm.
Thus Chamberlin introduced two additional policy variables in the theory of the firm: the product itself and selling activities. The demand for the product of the individual firm incorporates these dimensions. It shows the quantities demanded for a particular style, associated services, offered with a specific selling strategy.
Thus the demand curve will shift if:
(a) The style, services, or the selling strategy of the firm changes;
(b) Competitors change their price, output, services or selling policies;
(c) Tastes, incomes, prices or selling policies of products from other industries change.
Product differentiation is intended to distinguish the product of one producer from that of the other producers in the industry. It can be real, when the inherent characteristics of the products are different, or fancied, when the products are basically the same, yet the consumer is persuaded, via advertising or other selling activities, that the products are different. Real differentiation exists when there are differences in the specification of the products or differences in the factor inputs, or the location of the firm, which determines the convenience with which the product is accessible to the consumer, or the services offered by the producer.
Fancied differentiation is established by advertising, difference in packaging, difference in design, or simply by brand name, (for example, aspirins made by various manufacturers). Whatever the case, the aim of product differentiation is to make the product unique in the mind of the consumer. Yet differentiation must leave the products closely related if they are to be included in the same ‘product group’: the products should be close substitutes with high price and cross-elasticities.
The effect of product differentiation is that the producer has some discretion in the determination of the price. He is not a price-taker, but has some degree of monopoly power which he can exploit. However, he faces the keen competition of close substitutes offered by other firms. Hence the discretion over the price is limited.
There are elements of monopoly and competition under the above market conditions, hence the name of this model as ‘monopolistic competition’. Product differentiation creates brand loyalty of the consumers and gives rise to a negatively sloping demand curve. Product differentiation, finally, provides the rationale of selling expenses. Product changes, advertising and salesmanship are the main means of product differentiation.