When and how should firms differentiate? Quality and advertising decisions in a duopoly

Abstract

One of the hallmarks of competitive interaction is the desire to differentiate from rivals. In this paper, we examine under what conditions firms will elect to differentiate through product quality vs. advertising intensity. Consumers purchase from the set of products they are informed about through advertising, and choose the alternative that maximizes their utility. In the main model analyzed, firms select product quality in a first stage, advertising level in a second stage, and price in the last stage. The probability a consumer is informed of a firm’s product depends on the level of its advertising expenditure. We find that when advertising is not cost-effective 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 who are only informed of its product. When advertising is moderately cost-effective, one firm shifts to expending heavily on advertising. 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 high more often to capitalize on its large captive segment. When advertising is very cost-effective, both firms advertise heavily and prefer to differentiate in qualities. Three extensions are examined. In the first, we assume upfront fixed costs of choosing quality. While our results generalize in some parts of the parameter space, we are also able to sustain an equilibrium with both quality and advertising differentiation. In the second, we allow for continuous advertising levels and discrete product qualities. We find that varying the cost-effectiveness of advertising in this set up produces directionally similar results as those in the main model. In the third, advertising and pricing decisions are simultaneous rather than sequential. Our main-model results qualitatively hold in this setting, although mixed-strategies in advertising levels can arise in equilibrium. Taken together, our work shows that letting market awareness be determined endogenously suggests far less product differentiation than previously suspected and reveals regions where advertising actions are differentiated.