Consumer-Producer Interaction: A Strategic Analysis of the Market for Customized Products
47 Pages Posted: 5 May 2002
Date Written: August 23, 2001
This paper focuses on the process by which consumers and producers interact to create better value for consumers. This happens in many situations but is arguably most prominent in mass-customization, an area that has recently gained a lot of popularity among manufacturers (Business Week, March 20, 2000). In terms of communications, such interaction entails a shift from the one-way communication (usually from seller to buyer) of traditional markets, to a two-way communication. Specifically, potential producers need to elicit preference (and other) information from consumers. They then have to provide a product that correctly incorporates such information. This brings up many strategic issues.
In particular, we are interested in answering the following questions: (1) What is the "economic value" of consumers' information? (2) Are there any strategic implications for producers, if they depend on consumer input and have to pay for consumers' information? (3) In what way does pricing for customized products differ from pricing for similar standardized products? (4) Is the strategic relationship between consumers and producers different in the market for customized goods as compared to more traditional markets? The main contribution of this paper is to bring into focus the issues surrounding mass-customization via an analysis of consumer-producer interaction, which is the facilitating process. This paper is the first attempt in marketing to analytically model this emerging area and should be of interest to academics. Practitioners should be interested in the marketing and strategic perspective on mass-customization that this paper adopts. The trade press has approached mass-customization from a manufacturing/production cost angle, while its marketing implications have largely been left open (Wind and Rangaswamy, 2000).
To answer the above questions we build a game-theoretic model, which analyses the interaction between consumers and producers in an agency-theoretic framework. The main features of our model are the following. Consumers vary in their desire for customization, with some consumers having a higher need for and willingness to pay for customized goods. Producers vary in the ability to "successfully customize" according to consumer specifications. Producers first solicit consumers' suggestions/preferences and attempt to screen consumers who are willing to pay for customized products (stage 1: 'Information market'). They then try to provide a product, which correctly incorporates consumers' input and set prices for such customized products (stage 2: 'Product market'). The main question for consumers at this stage is whether the producer has been able to successfully incorporate their input given in the first stage. We start first with the monopoly case to isolate the strategic issues in consumer-producer interaction. Later we incorporate competition between firms. In the latter case, both the information market (where firms compete for consumers' information) and the product market (where firms compete to sell the final product) come into their own and have interesting interactions.
We find that, in equilibrium, firms will pay consumers for their information in the first stage. Intuitively, consumers provide costly input, but any commitment by the firm to provide surplus through a lower price of the product in the second stage, lacks commitment. Moreover, the producer's payment can act as a signal of high quality for the skillful customizer who tries to separate from a "ghost firm", which cannot customize well. Under monopoly, the price of customized products is the same as that of non-customized products, contrary to common wisdom as reflected in the trade press (Anderson, 1997). Thus, our analyses could explain why some manufacturers find that they cannot charge a premium for customized products (Wind and Rangaswamy, 2000). We find that equilibrium prices of customized products are at the high end of the price range for similar non-customized products, consistent with casual observation.
Under duopoly, when firms compete for consumers' information, the prices of customized products are in fact less than the price of non-customized products. This counter-intuitive result occurs because firms try to avoid being heldup by consumers who may withhold purchase, after first getting the firm to produce a very individually tailored product which the firm might not be able to sell to other consumers. Since, first stage competition for information gives consumers a high price for their information, it increases their incentive to holdup the firm. The firm, therefore, has to charge a lower price to induce consumers to purchase the product.
Finally, we show that, in the market for customized goods (stage 2), consumers can be better off with less competition between firms. When firms compete in the product market in the second stage, they earn less equilibrium profits. Thus, they compensate consumers less for their information in the first stage, and this may yield consumers less overall utility. This finding could be of interest to manufacturers who increasingly attempt to build deep, long lasting ties with consumers. Often such ties are perceived as conflicting with the consumers' desire to retain the flexibility to compare and opt for the offerings of different producers. Our results suggest that such misalignment of interests need not exist, at least in the market for customized goods.
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