An Index Approach to Measuring Product Differentiation: A Hedonic Analysis of Airfares

• Published date: 01 December 2023
• Author: Charles Howell,Emili Grifell‐Tatjé
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/roiw.12612

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Review of Income and Wealth

Series 69, Number 4, December 2023

DOI: 10.1111/roiw.12612

AN INDEX APPROACH TO MEASURING PRODUCT

DIFFERENTIATION: A HEDONIC ANALYSIS OF AIRFARES

BY CHARLES HOWELL∗

Department of Business, UniversitatAutònoma de Barcelona

College of Business Administration, Universityof Nebraska Omaha

AND

EMILI GRIFELL-TATJÉ

Department of Business, UniversitatAutònoma de Barcelona

The main objective of this paper is to introduce an Allen-type index of differentiation based on cost

functions. With this index, we create an economic measure of product differentiation that quanties

differences between products. Applied research has some generally accepted economic measures, for

example,the Herndahl –Hirschman Index for market concentration, or the Gini coefcientfor inequal-

ity.Product differentiation,however, does not yet havean established measure.Our objective is to ll that

gap and introduce a measure thatcan be used in market-related applied research such as market power,

antitrust, price indexes, or market strategy. To operationalize the index, we introduce the concept of

a core product and use cost functions to measure the degree of differentiation from the core product.

To demonstrate the use of the index,we study the effect of product differentiation on price formation

in the airline industry using an enhanced hedonic model. The model is empirically tested on 103,980

observations of quarterly US domestic airfare data between 2002 and 2016 and shows that product

differentiation has a signicant effecton both price and mark-up.

JEL Codes: D24, D40, D43, L93

Keywords: airline industry, core product, rm heterogeneity, hedonic function, pricing, product differ-

entiation index

1. INTRODUCTION

The concept of product differentiation is generally understood, but not very

well dened. Sharp and Dawes (2001) note that differentiation is a concept that

has vague meanings and is often referenced without a formal denition. Because

empirical work on the subject often uses non-complementary measures and

operationalizations, differentiation is simplied to the point where it has little

practical application or is very case specic. In this paper, we develop a model

that uses an economic measurement of product differentiation that can be applied

to a wide range of products and services and provides sufcient detail to answer

Note: Wewould like to give a special thanks to the two anonymous reviewers,who provided invalu-

able input to this study. Weare also grateful to the Spain’s Ministry of Economy,Industry and Compet-

itiveness PID2020-114460GB-C31, for its generousnancial support of this research.

*Correspondence to: Charles Howell, College of Business Administration, 6708 Pine Street,

Omaha, NE 68182-0048, USA (cbhowell@unomaha.edu).

© 2022 The Authors.Review of Income and Wealth published by John Wiley & Sons Ltd on behalf of

International Association forResearch in Income and Wealth.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-

NoDerivs License, which permits use and distribution in anymedium, provided the original work is

properly cited, the use is non-commercial and no modicationsor adaptations are made.

952

Review of Income and Wealth, Series 69, Number 4, December 2023

relevant economic and business questions. The index we develop can be applied to

market-based questions on topics such as market power, antitrust (Milne, 1992),

or price indexes (Ivancic and Fox, 2013). Our model synthesizes three elements,

two from well-established theoretical literature streams, and the third our own

methodological contribution. After developing the model, we demonstrate its

usefulness in an empirical application of a modied hedonic approach to the study

of airfares.

We use the term “characteristics” to refer to the properties of a good or ser-

vice that create differentiation. Our use of this terminology is rooted in the seminal

work of Lancaster (1966), who assumes that products are valued not only for their

physical attributes but also for their non-physical attributes. In this work, utility is

derived not from the product,but from the properties or characteristics of the prod-

uct and other products and services consumed in conjunction. A different mix of

properties or characteristics generates differentiation.

Tooperationalize the discussion of characteristics, we use a modied version of

a product model proposed by Kotler (1967). In Kotler’s model, the product is com-

posed of different levels. We associatethe concept of core product with the level that

denes the most basic conguration of the product that can be purchased. In the

terminology of Caves and Williamson (1985), this core product denes a product

class of close substitutes that meet the consumer’sneeds. In our airline example, the

core product wouldconsist of a single departure time, a seat, a distance traveled,and

a landing. The next level extends the product beyond core characteristics to include

features that buyers expect when they purchase the product from a particular rm.

These additional features are available to all buyers of the rm’s product and can

create differentiationbetween rms. For airlines, these featuresinclude characteris-

tics such as on-time performance, or frequency of ights.

Our primary methodological contribution in this paper is the introduction of

a product differentiation index based on cost functions that enables the applica-

tion of theory to empirical studies. Applied researchin areas such as market power,

antitrust, or price indexes could employ this index. We demonstrate the use of the

product differentiation index in the applied section with an empirical analysis of

airfares, showing how the measure can be used to enhance the results of the hedo-

nic approach. In this empirical contribution, weanalyze key economic and business

questions regarding product differentiation like: How much will it cost to provide

the characteristic? How much do consumers value the characteristic? Can a prot

be earned by changing the level of the characteristic?

The hedonic pricing model is frequently used to measure consumer valua-

tion of product characteristics. Rosen (1974) denes hedonic prices as the set of

implicit prices of characteristics that are revealedfrom the observed level of charac-

teristics and prices of the product. However, empirical applications of the hedonic

approach often provide contradictory results. The enhanced hedonic approach we

present alleviates some of these issues and provides a more useful tool for practi-

tioners. First, we include the index of product differentiation, and second, we use

the concept of “core product” to disentangle customer valuation for characteristics

correlated with the cost of the product. A key nding in the applied section is that

having more competitors may reduce the basic price, but it increases the value of

differentiation.

© 2022 The Authors.Review of Income and Wealth published by John Wiley & Sons Ltd on behalf of

International Association forResearch in Income and Wealth.

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