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This paper examines firms' product policies when they sell an add-on (e.g., Internet service) in addition to a base product (e.g., hotel rooms) under vertical differentiation (e.g., four- versus three-star hotels). I show that the role of an add-on differs; higher-quality firms prefer to sell it as optional to discriminate consumers, and lower-quality firms trade off discrimination and differentiation, trying to lure consumers from higher-quality rivals with a lower-price add-on. Equilibrium policies of lower-quality firms are more sensitive to the cost-to-value ratio of an add-on. If the ratio is sufficiently small, then they sell it to all consumers, potentially explaining why lower-end hotels are more likely than higher-end ones to offer free Internet service. Contrary to consensus in the literature, optional add-ons can intensify price competition over consumers who trade off a higher-quality base product versus a lower-quality base including an add-on. Hence, higher-quality firms are incentivized to commit to bundling, while lower-quality firms prefer to commit to not selling it. Add-ons can further reduce lower-quality firms' profits if consumers cannot observe the prices, because holding up consumers ex post encourages them to switch to higher-quality rivals, which then become better off. Therefore, lower-quality firms are incentivized to advertise add-on prices, and higher-quality firms are not. The online appendix is available at . [ABSTRACT FROM AUTHOR]

When match uncertainty is resolved via costly evaluation, the first product sampled by a customer is more likely to make the sale. This prompts firms to lower their products' evaluation costs to attract customers to sample their products first. Such efforts by firms are called customer learning investment (CLI). When product quality is freely observable but horizontal match is not, we examine how CLI choices interact with quality and price competition in a duopoly. CLI has a competition effect in that a higher CLI of a firm increases its demand but decreases that of its rivals. In the market-covered duopoly, both qualities will decrease (increase) when the high-end (low-end) firm invests more in customer learning, and remain unchanged when they invest equally, relative to when neither firm invests. We further show that the firm with a higher relative production efficiency invests more in customer learning than the competitor. In the market-not-covered duopoly, CLI by the low-end firm also creates a market-expansion effect by inducing some additional low-end customers to sample and purchase its product. This may induce it to invest more than the high-end firm, even when the latter has a higher relative production efficiency. [ABSTRACT FROM AUTHOR]

Recent business research points to the fortune awaiting to be tapped in low-end markets. In this paper, we investigate how the size of the low-end market influences a firm's profits and the pioneering firm's quality choice. As low-valuation consumers increase in a market, on average, consumers' willingness to pay decreases. This may lead us to expect firms' profits to decrease as the size of the low-end market increases. Our analysis shows that, if the size of the low-end market is below a threshold, an increase in the size of the low-end market may actually dampen price competition and improve profits, as firms can then strategically choose their quality levels such that their products are more differentiated. Conventional wisdom also suggests that the pioneering firm will offer a higher-quality product and earn more profits compared with the later entrant. In contrast to this notion of quality advantage, our analysis identifies circumstances in which a pioneer can offer a lower-quality product and yet earn more profits. An experimental test lends support for some of our model's predictions. We further extend the model to consider markets with multiple firms, firms with multiple products, and consumers with limited purchasing power. [ABSTRACT FROM AUTHOR]

We study the bidding strategies of vertically differentiated firms that bid for sponsored search advertisement W positions for a keyword at a search engine. We explicitly model how consumers navigate and click on sponsored links based on their knowledge and beliefs about firm qualities. Our model yields several interesting insights; a main counterintuitive result we focus on is the "position paradox." The paradox is that a superior firm may bid lower than an inferior firm and obtain a position below it, yet it still obtains more clicks than the inferior firm. Under a pay-per-impression mechanism, the inferior firm wants to be at the top where more consumers click on its link, whereas the superior firm is better off by placing its link at a lower position because it pays a smaller advertising fee, but some consumers will still reach it in search of the higher-quality firm. Under a pay-per-click mechanism, the inferior firm has an even stronger incentive to be at the top because now it only has to pay for the consumers who do not know the firms' reputations and, therefore, can bid more aggressively. Interestingly, as the quality premium for the superior firm increases, and/or if more consumers know the identity of the superior firm, the incentive for the inferior firm to be at the top may increase. Contrary to conventional belief, we find that the search engine may have the incentive to overweight the inferior firm's bid and strategically create the position paradox to increase overall clicks by consumers. To validate our model, we analyze a data set from a popular Korean search engine firm and find that (i) a large proportion of auction outcomes in the data show the position paradox, and (ii) sharp predictions from our model are validated in the data. [ABSTRACT FROM AUTHOR]

In a model of vertical differentiation, the principal concern of this paper is to identify sufficient conditions for producing a higher- or lower-quality good to be more profitable (in terms of profits and profit margin). Our basic model considers a short-run scenario where the firms' quality levels are fixed and they engage in price competition. Here, our results are three. First, we develop the notion of relative cost efficiency and show that its (increasing or decreasing) monotonicity in product quality implies that of firm profitability in equilibrium. A firm's relative cost efficiency refers to its quality-adjusted cost (dis)advantage relative to its immediate competitors, for a given distribution of consumer tastes. Second, selling a higher-quality good is more profitable when absolute cost efficiency (defined as the ratio between a firm's quality and unit cost) is increasing in quality. Third, we also establish a set of lower and upper bounds on each firm's profitability. The basic model is then extended in two directions. We examine unit cost functions that demonstrate monotone profitability, even when both quality and price are endogenous variables. We also show that the spirit of relative cost efficiency and its associated sufficient condition hold valid for a logconcave consumer distribution. [ABSTRACT FROM AUTHOR]

Durable goods manufacturers often design product lines by segmenting their markets on quality attributes--attributes that exhibit a 'more is better' property for all consumers. Since products within a product line are partial substitutes, and consumers can self-select the products they want to purchase, multiproduct firms have to carefully consider the cannibalization problem in designing their product lines. Existing research has analyzed the cannibalization problem for a monopolist who faces consumers who differ in their quality valuations. If lower-quality products are sufficiently attractive, higher-valuation consumers may find it beneficial to buy lower-quality products rather than the higher-quality products targeted to them. That is, lower-quality products can potentially cannibalize higher-quality products. The cannibalization problem forces the firm to provide only the highest-valuation segment with its preferred (efficient) quality. All other segments get qualities lower than their preferred (efficient) qualities. When the cannibalization problem is very severe, the firm may not serve some of the lowest-valuation segments. However, not much is known about how and when the cannibalization problem affects product line design in an oligopoly. Also, consumers may differ not only in their quality valuations but also in their taste preferences. The objective of this paper is to fill these gaps by examining whether the cannibalization problem affects a firm's price and quality decisions in a model with consumer differences in quality valuations, as well as in their taste preferences, in both monopoly and duopoly settings. The paper addresses questions such as the following. With both types of consumer differences, should a firm, even a monopolist, provide efficient quality only to the top segment? Are there conditions under which other segments can also get their preferred quality levels? If so, how do consumer and firm... [ABSTRACT FROM AUTHOR]