Product differentiation is the term for variations in characteristics of products within the same market. Without differentiation, products are commodities. Corn is corn, oil is oil, and so forth. Most consumer products aren’t like that. Corn flakes are not the same as raisin bran, but they compete with one another in the breakfast cereal market.
The concept is fuzzy. It’s a continuum really. When do the differences between two products cause them to be in different markets altogether? It comes down to the degree of substitutability. Post’s version of corn flakes is highly substitutable from Kellogg’s (presuming they both make such a thing). But it is slightly less substitutable for General Mill’s Cheerios, or so the thinking goes. (Really, product characteristics are multidimensional so it’s possible General Mill’s Cheerios are actually closer to Post’s corn flakes in some sense.)
But they’re all breakfast cereals. They are designed to fill the same consumer desire to eat something crunchy with milk. One could argue whether bagels, waffles, and eggs are in the same market or not. They are substitutes, but maybe they’re so different that the degree of substitutability is weak enough that they shouldn’t be lumped together with breakfast cereals. What about oatmeal? (See, complicated!) We can say for sure that iPods don’t belong. You can’t eat them for breakfast (or shouldn’t).
So, it gets complicated. That’s a challenge for economics theory and econometrics. In a world of perfectly substitutable commodities, theory is relatively easy. It is also the world we tend to imagination when we contemplate markets. That’s where some of our intuition can go awry.
Take hospitals, for example. If they’re perfect substitutes then the market power of any one of them is a function of the number of competitors and consumer demand for hospital services. There’s no heterogeneity in market power. One hospital is just like another. Reasoning is easy.
But that’s not how the market works. Hospitals distinguish themselves from one another (differentiate) in many ways, as do other products. Location is a simple distinguishing feature. Specialization in a particular type of care is another. The list is long.
Such differentiation gives rise to the possibility of “star” hospitals, those that have brand power. They are the ones that are hard for insurers to exclude from their networks. They command high prices. In fact, they have monopoly pricing power and can charge markups over marginal costs.
So, that’s reality. And it’s relatively harder to model it, though many techniques exist to do so. They tend not to fit well on the back of an envelope. They’re more complicated than a commodities market.
(All of the above applies to the health insurance market too. Products differ and are not perfect substitutes.)
For further reading in the health economics literature on hospital differentiation, below are a few references that point to others. I grabbed these from Abraham, Gaynor, and Vogt (2007). I know there are many more and am not claiming these represent the full complement of approaches to the issue. It’s a place to start.
Further Reading on Hospital Product Differentiation
Abraham, J.; Gaynor, M. and Vogt, W., 2007, Entry and Competition in Local Hospital Markets, The Journal of Industrial Economics, Vol. LV (2), pp. 265-288.
Capps, C.; Dranove, D. and Satterthwaite, M., 2003, Competition and Market Power in Option Demand Markets, Rand Journal of Economics, Vol. 34 (4), pp. 737–763.
Gaynor, M. and Vogt, W. B., 2000, ‘Antitrust and Competition in Health Care Markets,’ in Culyer, A. J. and Newhouse, J. P. editors, Handbook of Health Economics, Vol. 1B, chapter 27, (Elsevier Science B.V., Amsterdam). pp. 1405–1487.
Gaynor, M. and Vogt, W. B., 2003, Competition Among Hospitals, Rand Journal of Economics, Vol. 34 (4), pp. 764–85.