When and How Should Firms Differentiate? Quality, Advertising and Pricing Decisions in a Duopoly

Abstract One of the hallmarks of competitive interaction is each firm's desire to differentiate from rivals. Although differentiation may be achieved through product related choices, advertising levels may constitute another key mechanism. In this paper, we examine under what conditions firms will elect to differentiate through product quality vs. advertising intensity and characterize the set of equilibria that emerge. Consumers can only purchase from the set of products they are informed about through advertising, and choose the alternative that maximizes their utility. Firms select product quality in a first stage, advertising levels in a second stage, and prices in the last stage. We study two forms of advertising-blanket and targeted. Under blanket advertising, firms communicate indiscriminately and a consumer's probability of seeing an ad depends on the level of ad expenditure. We find that when advertising is ineffective, i.e., the additional awareness generated by a heavy level is modest relative to the cost, both firms choose a light ad spending. This allows them to minimally differentiate in qualities without concern of intense price competition, as each firm expects to have a segment of 'captive' consumers that are only aware of its product. When advertising is moderately effective, one firm shifts to expending heavily on advertising, hence all consumers are aware of its product. However, the rival prefers to differentiate by advertising lightly, while choosing the same maximal quality level. This strategy softens price competition by inducing the heavy-advertiser to price highly more often in order to capitalize on its captive segment and allows the light-advertiser to increase its average price. Interestingly, we show that even if advertising heavily entails no extra cost, one firm will choose to advertise lightly in equilibrium for strategic reasons. When advertising is very effective, both firms advertise heavily. In this scenario, firms must differentiate in qualities in order to achieve positive profits. Under targeted advertising, we let firms choose the segment(s) they wish to inform. We identify conditions such that both firms choose equally high quality products, but advertise to distinct segments; thereby achieving differentiation through ad targeting. We further show that this can result in a pocket of unserved consumers, even though consumers with lower willingness to pay purchase. Generally speaking, we show that allowing market awareness to be determined endogenously suggests far less product differentiation than previously suspected and reveals regions where advertising creates viable differentiation

Adjusting Choice Models to Better Predict Market Behavior

The emergence of Bayesian methodology has facilitated respondent-level conjoint models, and deriving utilities from choice experiments has become very popular among those modeling product line decisions or new product introductions. This review begins with a paradox of why experimental choices should mirror market behavior despite clear differences in content, structure and motivation. It then addresses ways to design the choice tasks so that they are more likely to reflect market choices. Finally, it examines ways to model the results of the choice experiments to better mirror both underlying decision processes and potential market choices.Peer Reviewedhttp://deepblue.lib.umich.edu/bitstream/2027.42/47012/1/11002_2005_Article_5885.pd

Leveraging the customer base: creating competitive advantage through knowledge management

P rofessional services firms (e.g., consultants, accounting firms, or advertising agencies) generate and sell business solutions to their customers. In doing so, they can leverage the cumulative experience gained from serving their customer base to either reduce their variable costs or increase the quality of their products/services. In other words, their "production technology" exhibits some form of increasing returns to scale. Growth and globalization, coupled with recent advances in information technology, have led many of these firms to introduce sophisticated knowledge management (KM) systems in order to create sustainable competitive advantage. In this paper, the authors analyze how KM is likely to affect competition among such professional services firms. In particular, they first explore what type (supply-side versus demand-side) of economies of scale are likely to be exploited in KM systems. In the former case, KM's role is to reduce the operating costs of the firm, while in the latter case, its role is to create added value to customers by significantly increasing product quality. Second, the authors analyze the competitive dynamics and market structure that emerge as a result of firms competing with KM systems. The results shed light on the current literature exploring the deployment of KM systems by suggesting that in a competitive setting, when firms' ability to leverage their customer base is high, KM should lead to quality improvement rather than cost reductions. In a dynamic setting, it is also shown that when firms use their KM system to improve product quality, higher ability to leverage the customer base may actually hurt profits and lead to industry shakeout. Beyond normative insights, the results also support a number of recent market trends in management consulting, including the increased emphasis on knowledge-creating activities in modern KM systems, the wave of mergers between consulting firms, and the recent emergence of "retail consulting" services

Innovation strategy and entry deterrence

We model an incumbent's decision to pursue radical or incremental innovation when facing a rival entrant. The radical innovation may yield lucrative financial returns but entails significant technological and market-related uncertainties. It is also particularly attractive to the rival entrant: if the market for it pans out, such an innovation obsoletes the existing technology and any incremental improvements to it. Each firm has its own assessment of the market potential for the radical innovation, and the reliability of these market forecasts can differ. We show that when the entrant's market-assessment capability is weak, the incumbent will pursue incremental innovation and postpone its plans to develop radical innovation even when it thinks highly of the market potential for the radical innovation. The incumbent does so to avoid validating the high market potential to the entrant, who may otherwise be encouraged to invest aggressively. The incumbent thus prefers to look 'soft' with respect to its innovation strategy in order to discourage entry. Even if its innovation strategy is not observable, we show that an incumbent that assesses the commercial potential for a radical innovation favorably may pursue an incremental path and communicate its plans publicly; this strategy serves to reduce entry by affecting the entrant's beliefs about the market potential of the innovation. Finally, we extend the model to investigate the entrant's decision to communicate its innovation intentions. We find that the entrant communicates its plans to aggressively pursue radical innovation only if the incumbent's market-assessment capabilities are strong. In doing so, the entrant acts preemptively to discourage the incumbent from pursuing the radical innovation, and is less concerned with validating market potential

How Much Does the Market Value an Improvement in a Product Attribute?

A firm contemplating improvements to its product attributes would be interested in the dollar value the market attaches to any potential product modification. In this paper, we derive a measure of market value such that the comparison of the measure against the incremental unit cost of the attribute improvement is key in deciding whether or not the attribute improvement is profitable. Competition from other brands, the potential for market expansion, and heterogeneity in customer preference structures are explicitly modeled using the multinomial logit framework. The analysis yields a closed form expression for the market's value for an attribute improvement (MVAI). A key result we obtain is that customers should be differentially weighted based on their probability of purchasing the firm's product. In particular, customers who exhibit a very high or very low probability of choosing the firm's product should receive less weight in detemining MVAI. Because the probability of choice varies across products, the answer to the question of how much the market values an improvement depends on which firm is asking the question. It is shown that customers whose utilities have a greater random component should be weighted less. Furthermore, the measure developed is robust to the influence of outliers in the sample. An empirical illustration of the MVAI measure in the context of a new product development study is provided. The study illustrates the advantages of the proposed measure over currently used approaches and explores the possibility of competitive price reactions.New Product Development, Product Positioning, Multibrand Competition, Conjoint Analysis

Leveraging the Customer Base: Creating Competitive Advantage Through Knowledge Management

Professional services firms (e.g., consultants, accounting firms, or advertising agencies) generate and sell business solutions to their customers. In doing so, they can leverage the cumulative experience gained from serving their customer base to either reduce their variable costs or increase the quality of their products/services. In other words, their "production technology" exhibits some form of increasing returns to scale. Growth and globalization, coupled with recent advances in information technology, have led many of these firms to introduce sophisticated knowledge management (KM) systems in order to create sustainable competitive advantage. In this paper, the authors analyze how KM is likely to affect competition among such professional services firms. In particular, they first explore what type (supply-side versus demand-side) of economies of scale are likely to be exploited in KM systems. In the former case, KM's role is to reduce the operating costs of the firm, while in the latter case, its role is to create added value to customers by significantly increasing product quality. Second, the authors analyze the competitive dynamics and market structure that emerge as a result of firms competing with KM systems. The results shed light on the current literature exploring the deployment of KM systems by suggesting that in a competitive setting, when firms' ability to leverage their customer base is high, KM should lead to quality improvement rather than cost reductions. In a dynamic setting, it is also shown that when firms use their KM system to improve product quality, higher ability to leverage the customer base may actually hurt profits and lead to industry shakeout. Beyond normative insights, the results also support a number of recent market trends in management consulting, including the increased emphasis on knowledge-creating activities in modern KM systems, the wave of mergers between consulting firms, and the recent emergence of "retail consulting" services.Increasing Returns to Scale, Network Externalities, Knowledge Management, Competition