An aspiring entrepreneur notices the heavy foot traffic outside a busy specialty coffee shop near a university. Sensing untapped profit potential, she opens a competing coffee shop across the street. But when the incumbent lowers its prices and the entrepreneur is forced to respond in kind, she finds herself struggling to stay afloat. What could she have done differently to capture a share of the market without causing a price war?
Professor Michael Riordan is using a game theory approach to study how incumbents react to the entry of new firms. “The key issue is designing products to avoid head-to-head competition,” he says, “so that there is not a substantial number of consumers in the market who are more or less indifferent between your product and your competitor’s line. Because if there are, it will be tempting to try to attract them through a lower price.”
Riordan and Yongmin Chen have developed a model for exploring scenarios where firms enter a market with a differentiated product strategy. Unlike Harold Hoteling’s classic 1930s model, which described competition between two stores located at either end of Main Street, Riordan and Chen’s “spokes” model comprises intersecting lines that form a network. In this more complicated marketplace, the researchers found, more competition might actually lead to higher prices.
In markets where consumers have relatively homogeneous preferences, demand is highly elastic. “It’s very likely that if I try to compete head-to-head with a competitor across the street, that competitor will respond by cutting price,” Riordan says. “So even if I do attract half of the consumers in the market, my margins may be lower than I would hope for, and it may be an unprofitable enterprise.”
But what if the entrepreneur opens a specialty tea store, seeking to attract that segment of the coffee shop’s customer base that prefers tea? Consumers with a strong preference for tea will not switch to coffee just because the coffee establishment lowers its prices, so the coffee shop will have less incentive to cut its prices. In fact, it might even raise its prices in order to maximize its profits from coffee loyalists.
“The coffee establishment’s profit maximizing price will depend on the price that the tea establishment is charging, and vice versa,” Riordan says. “What game theory does is provide a method of solving that strategic interaction, characterizing an equilibrium in which firms correctly anticipate what each other is going to charge and settle down on prices that are a stable configuration. And our model analyzes conditions under which that equilibrium is one in which prices are higher than in a market structure in which there’s only a single firm selling in the market.”
So how can you create a product differentiation strategy that maximizes your profits? Before entering a market, consider the following questions:
1. Is there a customer segment that isn’t well served by incumbent firms?
Consumers vary in their willingness to pay for certain products and in their willingness to substitute one product for another. If you can design your product line in a way that creates value for customers who are willing to pay more for particular products, you can capture some of that value in the form of higher profits.
2. How differentiated should the products be within your own product line?
Further segmentation can create more value for your customers, provided your offerings are aligned with their preferences and willingness to pay. But how much variety is cost effective? And how will new variations affect sales of your other products?
3. How will incumbents respond to your entry into the market?
If a lot of customers regard your product and a competitor’s product as close substitutes, the competitor will likely respond to your entry with a price cut. But you can provoke a softer form of price competition by segmenting the market in such a way that most customers have a relatively strong preference for one product or the other.
“What entry ideally does is rearrange consumers in the market,” Riordan says, “so that in the new segmentation of consumers across firms, consumers are less sensitive to price.”
Michael Riordan is the Laurans A. and Arlene Mendelson Professor of Economics and Business.