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

46 Pages Posted: 11 Dec 2018

See all articles by Dominique Olie Lauga

Dominique Olie Lauga

University of Cambridge - Judge Business School

Elie Ofek

Harvard Business School - Marketing Unit

Zsolt Katona

University of California, Berkeley - Haas School of Business

Date Written: November 28, 2018

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.

Keywords: quality differentiation, advertising, targeting

JEL Classification: M31, C72

Suggested Citation

Lauga, Dominique Olie and Ofek, Elie and Katona, Zsolt, When and How Should Firms Differentiate? Quality, Advertising and Pricing Decisions in a Duopoly (November 28, 2018). Available at SSRN: https://ssrn.com/abstract=3292664 or http://dx.doi.org/10.2139/ssrn.3292664

Dominique Olie Lauga

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Elie Ofek

Harvard Business School - Marketing Unit ( email )

Soldiers Field
Boston, MA 02163
United States
617-495-6301 (Phone)
617-496-5853 (Fax)

Zsolt Katona (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States

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