The Perils of Customization: A Model of Endogenous Segmentation and Product Design

Abstract:     
It has been a popular business practice to use consumers' past product choices as a segmentation variable to offer custom product designs to different segments. This paper suggests one reason why such product customization strategy can hurt the profits of competing firms. We look at a two-period duopolist market. In the early period, each firm offers one product and learns its clientele. In the late period, firms may offer either uniform design to the entire market or custom designs to their own customers and their rivals' customers respectively. We find that in equilibrium both firms would want to offer custom designs although simultaneous customization intensifies competition. To escape the perils of customization, forward-looking firms therefore prefer to have a market leader in the early period occupy the entire market to essentially circumvent segmentation. However, both firms would compete to be the market leader. Furthermore, forward-looking consumers prefer segmentation in order to get a custom design at a lower price in future. Consequently, when firms are patient enough and consumers myopic enough, a market leader emerges in the early period, and firms successfully avoid customization in the late period. Otherwise, firms split the early period market evenly, where firm patience and consumer myopia intensifies competition, contrary to common belief.

Keywords: Customization, Product Design, Segmentation, Behavior-Based Price Discrimination, Competition, Customer Relationship Management

JEL Classifications: L11, M31

Working Paper Series