It's different, but is it better?
Assistant Professor Mike Mazzeo seeks to quantify the value of differentiation

by Rebecca Lindell

Assistant Professor Michael Mazzeo had been driving all night. As he turned off the South Dakota interstate to look for a place to sleep, he spied three economy motels -- two on the other side of the highway, and one on his side.

At that time of night, most people would have made a beeline to the closest motel, checked into the first available room and fallen asleep before their heads hit the pillow. Mazzeo, an industrial organization economist, was suddenly wide awake.

"I thought, 'I wonder if I'd get a better price if I crossed the street, because of the effort I'd have to make to get there?'" says the assistant professor of management and strategy. "Then I began wondering about product differentiation, and what happens in markets where products are very similar. I thought, 'Let's measure the price differences between competitors offering similar products. How important is it for products to be different from each other, and when does it pay off?'"

Thus began Mazzeo's research foray into how firms decide to make their products unique.

"Firms think about this all the time, down to the minute level," he says. "Where should they locate branch offices? What type of products should they offer? Say you want to cut the fat content in your product, but it will cost you more to put in a certain sort of oil, instead of butter. Under what circumstances will it be worth it to you to do so? Does it depend on whether your competitors use oil or butter? What I'm trying to do is quantify how important it is to differentiate."

To address this, Mazzeo set up a mathematical model that analyzes the impact additional competitors will have on the profitability of a particular firm. The model also explores how the effects will vary if the competition¹s product is different in some way from that of the company in question.

Plenty of research has analyzed the effects of competitors, Mazzeo notes. But the models other researchers have created have not taken into account the product types of competing firms.

"What one firm does isn¹t the only thing that affects outcomes, because other firms will respond," he says. "If they all offer the exact same product, the competition will be very intense. If the new product is slightly different, more can be successful."

To illustrate his findings, he turned to the market that had inspired his late-night musings: the motel industry. His results suggested that motel firms can earn substantially higher payoffs by differentiating themselves -- that is, offering lodging at differing levels of quality. However, the demographics that affect demand -- the population of the town in which the motel is located, the traffic that passes by the motel and the distance between highway exits -- can be significant, to the point that firms can have no incentive to offer something unique. The result: motel after identical motel.

"The motel project was kind of a way to test out the methodology and work out the statistical analysis involved," Mazzeo explains. "This is a fun type of research field to be in, because it¹s really data-intensive. I can collect data from a large number of markets and get as many observations as possible to reach conclusions about what happens in other industries."

So where did Mazzeo decide to stay on that late-night drive across South Dakota?

"I went with my economic intuition," recalls the professor. "I went to the side of the highway that had the two motels on the same side, assuming that prices would be lower on that side. Later I collected data from this market, and just as you¹d expect, the less differentiated motels have the lower prices!"