Commoditization occurs when products become undifferentiated and customers make purchase decisions based purely upon whichever product has the cheapest price.
According to Wikipedia:
Commoditization is defined as the process by which goods end up becoming simple commodities in the eyes of the market or consumers. It is the movement of a market from differentiated to undifferentiated price competition, and from monopolistic competition to perfect competition. Hence, the key effect of commoditization is that the pricing power of the manufacturer or brand owner is weakened: when products become more similar from a buyer’s point of view, they will tend to buy the cheapest.
Ironically, it is the competitors themselves that often drive this “race to the bottom” commoditization process.
Harold Hotelling observed that, in many markets, it is rational for producers to make their products as similar as possible (Stability in Competition, Economic Journal, 1929). This has come to be known as Hotelling’s Law or the principle of minimum differentiation.
This Market Simulation workflow traces the commoditization process and follows what happens when competitors develop products that are more and more similar.
As this workflow begins, Customers have the same average Willingness To Pay (WTP) for both the Spacely Sprockets and Cogswell Cogs Products.
Although average WTP is the same, Customers still have their own individual preference for either Spacely Sprockets or Cogswell Cogs. In fact, the WTP Customer Distribution for each Product is completely uncorrelated, and the two Products are said to have ‘Horizontal Differentiation’.
But over time, Spacely Sprockets and Cogswell Cogs change their Products so that they are increasingly similar. This drives commoditization, and Customers become more Price Sensitive as the two Products become more and more similar.
The changing degree of Correlation between Spacely Sprockets and Cogswell Cogs is set by this Customer Distributions node.
The Correlation between each Product iterates over 21 steps from 0.0 (differentiated and uncorrelated) to 1.0 (undifferentiated commodity).
Each Correlation value is selected within a loop that calculates the Profit Maximizing Price for each Product.
The Matrix Distributions node generates a WTP Matrix for the Products based upon their Mean and SD value, and their Correlation.
The Simulate Market node calculates the starting Quantity, Revenue, and Profitability of both Products.
An Outer Loop works to identify a steady-state for the Market where each Competitor has no incentive to raise or lower Price.
The two Competitors run their Profit Maximization Pricing algorithms in series.
The Profit Maximizing Price loop comes from the workflow BB-121 Monopoly Optimization Loop.
The charts predict how Price and Profitability change over the commoditization process.
As the Products become increasingly similar, Prices (red) are driven down to Marginal Cost (blue).
When Prices drop so does Profitability. When the Products are undifferentiated commodities, Profits drop all the way to zero.