A Model of Vertical Differentiation for Online Retailing
41 Pages Posted: 3 Oct 2006 Last revised: 3 Aug 2014
Date Written: August 1, 2007
The Internet has changed the nature of doing business as well as the nature of competition in many industries. The number of online transactions has seen a steady increase as more consumers turn to online retailing (e-tailing) for a wide range of product choices and shopping convenience.
Yet, despite the availability of online comparison shopping sites and the ease of finding alternative e-tailers for a given product, the persistent and substantial price dispersion has not been fully understood.
In this paper, we view the online purchase of a product as a bundle of utilities consisting of the satisfaction with the product itself, the service received from the purchase experience, as well as the assurance and trust associated with the e-tailer's brand recognition. E-tailers, accordingly, can differentiate themselves in the service, brand recognition, and price dimensions. We extend the two dimensional competitive model to three dimensions in which e-tailers sequentially decide on a recognition level, then a service quality, and finally compete on price. We solve the model analytically and obtain closed-form equilibrium solutions. By explicitly incorporating differentiation costs, we show the existence of previously unknown equilibria, among which an asymmetric Max-Max equilibrium that is frequently observed in practice. In addition, the e-tailer's optimal competitive strategy is determined by the structure of the differentiation costs.
Keywords: e-service, service quality, price competition, vertical differentiation, competitive strategy
JEL Classification: C70, D40, L12, L82
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