Product differentiation is a term from economics and marketing. In most markets, there will be some form of competition: Several companies offer products or services, which are very similar. Using product differentiation, a company can change a product or a service, so that it becomes more attractive to a given market. This means the product or service must be different from the product of the competitors. It also means, it must be sufficiently different from the other products of the company.  Edward Chamberlin first proposed the idea, in his book The Theory of Monopolistic Competition, published in 1933

Rationale 

Firms have different ways  that enable them to construct specific competitive advantages over competitors.  Resource endowments allow firms to be different which reduces competition and makes it possible to reach new segments of the market. For this reason, differentiation is the process of distinguishing the differences of a product or offering from others, to make it more attractive to a particular target market.

Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences.  This is done to demonstrate the unique aspects of a firm's product and create a sense of value.  Marketing textbooks are firm on the point that any differentiation must be valued by buyers (a differentiation attempt that is not perceived does not count).  The term unique selling proposition refers to advertising to communicate a product's differentiation.

In economics, successful product differentiation leads to competitive advantage. This is inconsistent with  perfect competition. One of the requirement for perfect competition is that the producrs or servces are  perfect substitutes. There are three types of product differentiation:

 Simple: based on a variety of characteristics
 Horizontal: based on a single characteristic but consumers are not clear on quality
 Vertical: based on a single characteristic and consumers are clear on its quality

Most of the time, the brand diffferences are small: the can be as little as  different packaging or an advertising theme.  The physical product need not change, but it may.  Differentiation is about the buyers seeing a difference. Causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it.  The major sources of product differentiation are as follows.

 Differences in quality which are usually accompanied by differences in price. 
 Differences in functional features or design
 Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing
 Sales promotion activities of sellers and, in particular, advertising
 Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. The term is used frequently when dealing with freemium business models, in which businesses market a free and paid version of a given product. Given they target the same group of customers, it is imperative that free and paid versions be effectively differentiated.

Differentiation primarily affects performance through reducing directness of competition: As the product becomes more different, categorization becomes more difficult and hence draws fewer comparisons with its competition.  A successful product differentiation strategy will move your product from competing based primarily on price to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).

Most people think that companies differentiate their products to be able to charge more for their product. This is a very simpliticx view, that does not cover all aspects. If customers like what the firs has to offer, they will be less sensitive to the offers of other compamies. Price may not be one of these aspects. Differentiation makes customers in a given segment have a lower sensitivity to other features (non-price) of the product.

Vertical product differentiation 
Vertical product differentiation can be measured objectively by a consumer, for example when comparing two similar products the quality and price can clearly be identified and ranked by the customer. If both A and B products are charged the same price to the consumer, then the market share for each one will be positive, according to the Hotelling model. The major theory in this is all consumers prefer the higher quality product if two distinct products are offered at the same price. A product can differ in many vertical attributes such as its operating speed. What really matters is the relationship between consumers willingness to pay for improvements in quality and the increase in cost per unit that comes with such improvements. Therefore, the perceived difference in quality is different with different consumer, so it is objective. A green product might be having a lower or zero negative effect on the environment, however, it may turn out to be inferior than other products in other aspects. Hence, it also depends on the way it is advertised and the social pressure a potential consumer is living in. Even one vertical differentiation can be a decisive factor in purchasing.

Horizontal product differentiation 
Horizontal differentiation seeks to affect an individual's subjective decision-making. The difference cannot be measured in an objective way. For example, different color versions of the same iPhone or MacBook. A lemon ice cream is not superior to a chocolate ice cream, is completely based on the user's preference. A restaurant may price all of its desserts at the same price and lets the consumer freely choose its preferences since all the alternatives cost the same. A clear example of Horizontal Product Differentiation can be seen when comparing Coca Cola and Pepsi: if priced the same then individuals will differentiate between the two based purely on their own taste preference.

Other types of product differentiation 
Usually, product differentiation is seen as either vertical or horizontal. Most forms of product differentiation have both horizontal and vertical product differentiations. Those two are not the only way to differentiate products. Another way to differentiate a product is through spatial differentiation. Spatial Product Differentiation is using a geographical location as a way to differentiate. An example of Spatial Differentiation is a firm locally sourcing inputs and producing their product.

References

Other webistes 

 Spring 1997 - Jonathan B. Baker Director, Bureau of Economics Federal Trade Commission on Product Differentiation
Economics
Marketing