In the first part of this double-header, I looked at Pareto efficiency and used the concept of a frontier curve to explain why competitors tend to offer similar products at similar prices over time. I have put a link to part one in the comments below if you want to read that first.
This second and final part looks at a concept developed by Harold Hotelling, a statistician and economic theorist. Known as Hotelling’s law, it is an observation in economics that it is rational, in many markets, for producers to make their products as similar as possible. It is sometimes referred to as the principle of minimum differentiation.
Unlike the example, from part one, of a Pareto efficiency, where the common behaviours of businesses lead to similarity as an unintended consequence, Hotelling’s law is a rational behaviour that seeks to minimise differentiation as a conscious act.
As with the previous article, the intent is not to simply explain why products tend to become similar over time but to create a platform of knowledge that will help to create meaningful differentiation. If you understand the forces, you are up against you have a better chance of winning.
Let’s go to the beach
To explain this idea, imagine that we are looking at two ice cream vendors plying their trade on a beach. This beach is 2000m wide and is evenly populated along its length by 500 people enjoying a day in the sun. Our ice cream sellers pitch their stalls at opposite ends of the beach. Rationally, nobody will walk further to get ice cream than they have to, so each seller will have 250 people who will rationally choose them over their rival and consequently each ice cream vendor enjoys 50% market share by being maximally differentiated, in terms of location.
One of our sellers gets his calculator out figures that if he moves his stall 500m down the beach he will be the nearest option to 312 potential customers leaving his competitor with just 188. A 62% to 38% market split. So that’s what he does. He wheels his cart through the soft sand under a baking sun for 500m and re-opens for business. He is hot and sweaty but it will soon be worth the effort.
Now, this move doesn’t go unnoticed by his rival. This is a very transparent market. He decides he isn’t going to just sit there and accept this aggressive land grab. So he takes his cart and pushes it 500m down the beach to match his competitors move. The net result is the 50% market share is re-established, although both vendors are now slightly less differentiated than they were before.
Incidentally, this solution, with each vendor pitching their ice cream cart a quarter of the way down the beach is the best solution for everyone – the average distance customers need to travel for their ice cream is at its lowest with this configuration. It is the perfect balance between convenience for the customers and differentiation for the competitors.
Unfortunately, as Adam Smith pointed out in 1776, business isn’t driven by benevolence; it’s driven by self-interest, it doesn’t care about the greater good, it cares about the greater profit. So our first-mover decides to move for a second time. He makes another bold strategic move and shifts another 500m to be right in the middle of the beach. He is a little hotter and a little sweatier but his market share advantage has been restored. For now.
His rival, who has just about got his breath back from the last herculean relocation effort, once again notices what’s going on. He mutters something under his breath as he starts to push his cart to match his competitors move.
Now they are right next to one another. Their differentiation is zero. At this point, I was tempted to develop the story into a direct confrontation leading to upended ice cream carts and the two competitors beating the crap out of each other in the sand while bemused beachgoers looked on. But that would detract us from the point of the story.
The point is this, the two competitors have made their competitive situation worse by both pursuing entirely rational profit-maximizing behaviour. Which is exactly what you would expect to happen in contested markets and why you don’t tend to see long term sustained differentiation between competitors.
Obviously, the beach is a simple metaphor for product differentiation; in the specific case of the ice cream vendors, they differentiate themselves from each other solely by location. But the example can be generalised to all other types of horizontal product differentiation for almost any product characteristic.
Any advantage you create by improving your offer will generally be copied by your competitors. The more transparent and obvious the move, the quicker your competitors will react. It makes perfect sense to meet your competitor’s improvements by copying them and it is logical to expect them to do the same if you move first.
This is the myth of differentiation, whether you change an element of your offer or adjust your price your competitors will follow suit. Over time products don’t become more differentiated they become more similar.
So thanks to Pareto’s optimality and efficiency (covered in part one), and Hotelling’s law of minimal differentiation we can see why most businesses compete with similar products at similar prices. The good news is you don’t have to shrug your shoulders and say, “oh, well – that explains that then”. There is plenty you can do to break out of this relentless gravitational pull towards homogeneity – it’s just that the traditional methods that many businesses pursue are not the best way to achieve this.
So, what to do
These two articles could be seen as a great excuse. A way to explain why it is impossible to break out of the similarity trap. But that isn’t the purpose. It is intended to create a level of comprehension as to why traditional differentiation is an insufficient strategy for sustained growth.
It should go without saying that continually improving your offer over the long term is not optional. It is a necessary condition of survival but an insufficient one for growth. Once that is understood then you have to consider additional strategies.
In the first article, I discussed three options – to invest in the intangible elements of your offer such as your brand or positioning, to look for opportunities outside of your current value offer, essentially a move to a budget or a premium offer, and to look to segmentation to create a more meaningful offer to a subset of the market rather than a general offer to the whole market.
In addition to those perhaps the biggest opportunity lies in increasing the mental and physical availability of your offer to your target market. Most markets are not super efficient and buyers tend to gravitate to whichever solution comes to mind when the need arises. This is usually because they have prior experience or familiarity with a particular supplier. Making sure you are at least considered at that critical moment should be the backbone of your strategy.
Obviously, the investing in brand and positioning option from earlier does that. In addition, having a more effective sales process or simply adding resources can achieve a similar outcome. Align your efforts with an integrated commercial execution model that doesn’t just rely on the myth of differentiation or building the better mousetrap.