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Without seeing the pages, url structure and how similar/different the products are its a bit hard to advise.

However in general if you already have a page ranking, and it is possible to overcome the confusion issues (which can probably be done through design?) I would probably leave the page there, and tweak the content to include your 'blue widget' (but remember part of the reason you are ranking for the term 'red widget' is due to the content on your page so it will still need to be optimised for this.

I've done 301 redirects a few times and when done internally they usually don't cause any long-term drops, however they may cause short-term (which can last a while) your page to disappear while Google re-ranks the new page (and the exact ranking will depending on the new page URL structure, content, page hierarchy etc).

Hope that helps and makes sense

What is the purpose of the 2nd site?

The age of the domain a ranking factor, but one of many.

If he wants to change the domain your client can tell Google about a change of address in GWT and do a 301 redirect from the old site to the new site.

If the purpose is to have two sites ranking on the first page, a quicker and easier tactic would be to do some barnacle SEO (see http://moz.com/blog/barnacle-seo-whiteboard-friday) and get some of their citation / profile pages ranking on the 1st page for their mold related keywords.

With the recent updates and focus on quality it has become more difficult to try and operate multiple sub-niche sites, and will be much better to focus attention on creating one quality site which is seen as an authority.

Agree with the previous comments, and I know from personal experience how 'tempting' it can be especially when your competitors are using these to rank higher than you...

...but know that some day (probably not too far away) they'll be scrambling because the links are devalued and you will rise higher (and most importantly stay there)

Have you redirected the two sites that were causing duplicate links using a 301 redirect (& told Google about the change of address through GWT?

Links can take quite a while to be removed from GWT, but it does happen..eventually!

The fact that the ads are showing and not your pages on your domain sounds like you either have very low domain authority, and the domain authority of the ad websites is higher and therefore ranking above you, or you still have an issue/algo penalty from your duplicate content (or something else).

How long ago did you remove the duplicate content?