The Incentive to Differentiate

The primary incentive for sellers to differentiate is the reduced substitutability between products as differentiated products become imperfect substitutes for each other. For example, consider two spreadsheet programs with a similar appearance and performance such that the two products are perfectly substitutable. If one of the two companies changes the look and feel of its program, the two products are differentiated and some consumers may choose a program because of the new difference. Therefore, the two products are no longer perfect substitutes. With reduced substitutability between products, retaliatory price-cutting does not result in a complete loss of one's market share. Product differentiation thus gives a firm a certain power within its own market. Such a market is called a monopolistically competitive market.

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