Search

We present a theory of price and quality decisions by managers who are self-serving. In the theory, firms stress the price or quality of their products, but not both. Accounting for this, managers exploit any uncertainty about the cause of market outcomes to credit positive results to the dominant, “strategic” factor and blame negative results on the other—as doing so is psychologically rewarding. The problem with biased attributions, however, is that they prompt biased decisions. We motivate this argument with evidence from one experiment and then develop a model to understand the cost of the bias under different market conditions. Counter to intuition, we find that firms in a competitive setting can profit from the self-serving nature of their managers.

Driven by the low transaction costs and interactive nature of the internet, customer participation in the price-setting process has increased. These changes were first brought about by the rise of online auctions in the early 2000s, followed by the emergence of newer participative mechanisms. Today, platforms such as eBay have popularized online auctions on a global scale, Priceline has made headlines with its name-your-own-price (NYOP) business model, and Humble Bundle has enabled independent musicians and game developers to market their works through pay-what-you-want (PWYW) pricing. Advertising exchanges conduct several hundred million individual auctions per day to sell online advertising slots. These are just a few examples of participative pricing in transactions among consumers or businesses. In parallel, academic research on participative pricing has blossomed in recent years, with an overarching concern over the profitability and other marketing implications these mechanisms have on sellers and buyers. The present paper contributes to this literature in three ways. First, we propose a definition of participative pricing mechanisms, as well as a useful taxonomy. Second, we discuss the current understanding by synthesizing conceptual and empirical academic literature. Third, we outline promising research questions with a key focus on the related behavioral aspects of buyers and sellers.

Should a provider deliver a reliable service or should it allow for occasional service failures? This paper derives conditions under which randomizing service quality can benefit the provider and society. In addition to cost considerations, heterogeneity in customer damages from service failures allows the provider to generate profit from selling damage prevention services or offering compensation to high-damage customers. This strategy is viable even when reputation counts and markets are competitive.

Some firms use a curious pricing mechanism called “pay as you wish” pricing (PAYW). When PAYW is used, a firm lets consumers decide what a product is worth to them and how much they want to pay to get the product. This practice has been observed in a number of industries. In this paper, we theoretically investigate why and where PAYW can be a profitable pricing strategy relative to the conventional “pay as asked” pricing (PAAP) strategy. We show that PAYW has a number of advantages over PAAP such that it is well suited for some industries but not for others. These advantages are as follows: (1) PAYW helps a firm to maximally penetrate a market; (2) it allows a firm to price discriminate among heterogenous consumers; (3) it helps to moderate price competition. We derive conditions under which PAYW dominates PAAP and discuss ways to improve the profitability of PAYW.

Driven by the low transaction costs and interactive nature of the internet, customer participation in the price-setting process has increased. Today, platforms such as eBay have popularized online auctions on a global scale, Priceline has made headlines with its name-your-own-price (NYOP) business model, and Humble Bundle has enabled independent musicians and game developers to market their works through pay-what-you-want (PWYW) pricing. Advertising exchanges conduct several hundred million individual auctions per day to sell online advertising slots. The present paper contributes to the literature on participative pricing in three ways. First, we propose a definition of participative pricing mechanisms, as well as a useful taxonomy. Second, we discuss the current understanding by synthesizing conceptual and empirical academic literature. Third, we outline promising research questions with a key focus on the related behavioral aspects of buyers and sellers.

This article presents a model of the design and introduction of a product line when the firm is uncertain about consumer valuations for the products. We find that product line introduction strategy depends on this uncertainty. Specifically, under low levels of uncertainty the firm introduces both models during the first period; under higher levels of uncertainty, the firm prefers sequential introduction and delays design of the second product until the second period. Under intermediate levels of uncertainty the firm's first product should be of lower quality than one produced by a myopic firm that does not take product line effects into consideration. We find that when the firm introduces a product sequentially, the strategy might depend on realized demand. For example, if realized demand is high, the firm's second product should be a higher-end model; if demand turns out to be low, the firm's second product should be a lower-end model or replace the first product with a lower-end model.

This paper studies the strategic interaction between firms producing strictly complementary products. With strict complements, a consumer derives positive utility only when both products are used together. We show that value-capture and value-creation problems arise when such products are developed and sold by separate firms (“nonintegrated” producers). Although the firms tend to price higher for given quality levels, their provision of quality is so low that, in equilibrium, prices are set well below what an integrated monopolist would choose. When one firm can mandate a royalty fee from the complementor producer (as often occurs in arrangements between hardware and software makers), we find that the value-capture problem is mitigated to some extent and consumer surplus rises. However, because royalty fees greatly reduce the incentives of the firm paying them to invest in quality, the arrangement exacerbates the value-creation problem and leads to even lower total quality. Surprisingly, this result can reverse with competition. Specifically, when the firm charging the royalty fee faces a vertically differentiated competitor, the value-creation problem is greatly reduced—opening the door for the possibility of a Pareto-improving outcome in which all firms and consumers benefit. It is worth noting that this outcome cannot be achieved by giving firms the option of introducing a line of product variants; competition serves as a necessary “commitment” ingredient.

This article outlines recent methods and applications directed at understanding the profit and consumer welfare implications of increasingly prevalent price discrimination strategies in the service sector. These industries are typically characterized by heterogeneity in consumers’ valuation and usage of the service, resale constraints, and a focus on price as the service’s key attribute. The article focuses on how firms use nonlinear pricing or bundling strategies to benefit from the heterogeneity in consumer demand. We describe the basic economic model commonly used in the literature to analyze such strategic choices and present recent methodological improvements to this benchmark. A discussion of existing applications and future research opportunities concludes the article.

Firms are increasingly seeking to harness the potential of social networks for marketing purposes. Therefore, marketers are interested in understanding the antecedents and consequences of relationship formation within networks and in predicting interactivity among users. The authors develop an integrated statistical framework for simultaneously modeling the connectivity structure of multiple relationships of different types on a common set of actors. Their modeling approach incorporates several distinct facets to capture both the determinants of relationships and the structural characteristics of multiplex and sequential networks. They develop hierarchical Bayesian methods for estimation and illustrate their model with two applications: The first application uses a sequential network of communications among managers involved in new product development activities, and the second uses an online collaborative social network of musicians. The authors’ applications demonstrate the benefits of modeling multiple relations jointly for both substantive and predictive purposes. They also illustrate how information in one relationship can be leveraged to predict connectivity in another relation.

The use of a durable good is limited by both its physical life and usable life. For example, an electric-car battery can last for five years (physical life) or 100,000 miles (usable life), whichever comes first. We propose a framework for examining how a profit-maximizing firm might choose the usable life, physical life, and selling price of a durable good. The proposed framework considers differences in usage rates and product valuations by consumers and allows for the effects of technological constraints and product obsolescence on a product's usable and physical lives. Our main result characterizes a relationship between optimal price, cost elasticities, and opportunity costs associated with relaxing upper bounds on usable and physical lives. We describe conditions under which either usable life or physical life, or both, obtains its maximum possible values; examine why a firm might devote effort to relaxing nonbinding constraints on usable life or physical life; consider when price cuts might be accompanied with product improvements; and examine how a firm might be able to cross-subsidize product improvements.

In many industries firms have to make quantity decisions before knowing the exact state of demand. In such cases, channel members have to decide which firm will own the units until demand uncertainty is resolved. The decision about who should retain ownership depends on the balance of benefit and risk to each member. Ownership, after all, is costly. Whichever member owns the units accepts the risk of loss if more units are produced than can be sold. But ownership also grants firms the flexibility to respond to demand once it becomes known by adjusting price. In this study, we analyze ownership decisions in distribution channels and how those decisions are affected by demand uncertainty. We model demand based on micro-modeling of consumer utility functions and capture demand uncertainty related to market size and price sensitivity. This study shows that as long as the degree of uncertainty about market size is intermediate, the retailer and the manufacturer both benefit when the manufacturer maintains ownership of the units. But when there is substantial uncertainty about market size, the retailer and the channel are better off if the retailer takes ownership but the manufacturer still prefers to maintain ownership. Thus, there is potential for channel conflict regarding ownership under high levels of uncertainty. We show that, using product returns, the manufacturer can achieve the same outcome under retailer ownership as under manufacturer ownership. This provides an additional new rationale for the prevalence of product returns. The first-best outcome (from the perspective of total channel profit), however, is under retailer ownership without product returns when uncertainty is high (i.e., product returns reduce the total channel profit). Negotiations between the manufacturer and the retailer can lead to the first-best outcome but only under quite restrictive constraints that include direct side payments by the retailer to the manufacturer and the retailer being pessimistic about its outside option (when an agreement cannot be reached) during the negotiation.

Conventional wisdom in marketing holds that (1) retailer forward buying is a consequence of manufacturer trade promotions and (2) stockpiling units helps the retailer but hurts the manufacturer. This article provides a deeper understanding of forward buying by analyzing it within the context of manufacturer trade promotions, competition, and demand uncertainty. The authors find that regardless of whether the manufacturer offers a trade promotion, allowing the retailer to forward buy and hold inventory for the future can, under certain conditions, be beneficial for both parties. Disallowing forward buying by the retailer may lead the manufacturer to lower merchandising requirements and change the depth of the promotion. In competitive environments, there are situations in which retailers engage in forward buying because of competitive pressures in a prisoner's-dilemma situation. Finally, when the authors consider the case of uncertain demand, they find further evidence of strategic forward buying. In particular, the authors find cases in which the retailer orders a quantity that is higher than what it expects to sell in even the most optimistic demand scenario.

Firms selling goods whose quality level deteriorates over time often face difficult decisions when unsold inventory remains. Since the leftover product is often perceived to be of lower quality than the new product, carrying it over offers the firm a second selling opportunity, a product line extension to new and unsold units, and the ability to price discriminate. By doing so, however, the firm subjects sales of its new product to competition from the leftover product. We present a two period model that captures the effect of this competition on the firm's production and pricing decisions. We characterize the firm's optimal strategy and find conditions under which the firm is better off carrying all, some, or none of its leftover inventory. We also show that, compared to a firm that acts myopically in the first period, a firm that takes into account the effect of first period decisions on second period profits will price its new product higher and stock more of it in the first period. Thus, the benefit of having a second selling opportunity dominates the detrimental effect of cannibalizing sales of the second period new product.

easyJet, one of Europe’s most successful low-cost short-haul airlines, has a simple pricing structure. For a given flight, all prices are quoted one-way, a single price prevails at any point, and, in general, prices are low early on and increase as the departure date approaches. We observe from these policies and from the empirical section of this paper that easyJet employs three distinct strategies: 1) it does not offer last-minute deals, 2) it offers a single class and lets price be the sole variable that controls demand, and 3) it varies the time at which tickets are first offered for sale (duration of sale). The first two policies are in stark contrast to traditional airline pricing strategies. Many airlines offer last-minute deals, either directly or via resellers. Second, the current prevailing practice is to control demand via seat allocation to various classes rather than by offering a single class and letting price be the sole variable that controls demand. The main objective of this research is to study the conditions under which offering a last-minute deal is optimal under the single-price policy. We also learn how the duration of ticket sales is affected by consumer characteristics. We find that, for an intermediate capacity level, uncertainty with respect to the arrival of the business segment will cause the firm to offer last-minute deals and thus partially price-discriminate within the tourist segment. The same is true for uncertainty with respect to the actual behavior of the firm: if consumers are uncertain whether the firm will offer last-minute deals, then, in equilibrium, both in a one-shot game and in a repeated game, the firm will, with some probability, offer such deals. In addition, we found that for an intermediate capacity level, the larger the number of segments (that differ in price sensitivity), the longer the duration of the period in which tickets are offered for sale.

Firms often have to make their production decisions under conditions of demand uncertainty. This is especially true for product categories such as automobiles and technology goods where the lead time needed for manufacturing forces firms to make production decisions well in advance of the selling season. Once the firm has produced the goods, the available production volume affects the firm’s subsequent marketing decisions. In this paper, we study the relationship between the firm’s production and marketing decisions for a durable goods manufacturer. We develop a dynamic model of a durable product market in which the demand functions are developed from a micromodeling of consumer utility functions and an equilibrium analysis of consumer strategies. After taking into account the demand uncertainty as well as the potential for cannibalization of future sales, the manufacturer makes its production and sales decisions. We find that the firm’s optimal inventory level is U-shaped in the durability of the product and that the firm suffers a larger loss due to uncertainty when it is leases rather than sells its products. Furthermore, unlike the case for nondurables, for durable goods we find that the effect of uncertainty persists even after the uncertainty has been resolved.

In this paper, we show that under certain conditions, strategic decentralization through the addition of a retailer in the distribution channel can increase a manufacturer's profits. The specific case on which we focus is the quantity coordination (double marginalization) problem for a manufacturer selling durable goods in a two-period setting. We show that the standard solution that coordinates a channel for non-durables does not coordinate the channel for durables. In particular, even though a manufacturer can achieve channel coordination by offering per-period, two-part fees, the equilibrium wholesale price in the first period is strictly above the manufacturer's marginal cost. This is in stark contrast to the two-part solution for non-durables where the equilibrium wholesale price is equal to marginal cost. We also identify a strategy that solves both the channel coordination and the Coase problem associated with durable goods. In this strategy, at the beginning of period 1, the manufacturer writes a contract with the retailer specifying a fixed fee and wholesale prices covering both periods. We show that by adding a retailer and using this contract, the manufacturer makes higher profits than it could if it were to sell directly to consumers.

Advertising supported content sampling is ubiquitous in online markets for digital information goods. Yet, little is known about the profit impact of sampling when it serves the dual purpose of disclosing content quality and generating advertising revenue. This paper proposes an analytical framework to study the optimal content strategy for online publishers and shows how it is determined by characteristics of both the content market and the advertising market. The strategy choice is among a paid content strategy, a sampling strategy, and a free content strategy, which follow from the publisher's decisions concerning the size of the sample and the price of the paid content. We show that a key driver of the strategy choice is how sampling affects the prior expectations of consumers, who learn about content quality from the inspection of the free samples. Surprisingly, we find that it can be optimal for the publisher to generate advertising revenue by offering free samples even when sampling reduces both prior quality expectations and content demand. In addition, we show that it can be optimal for the publisher to refrain from revealing quality through free samples when advertising effectiveness is low and content quality is high. To illustrate, we relate our framework to the newspaper industry, where the sampling strategy is known as the “metered model.”

To many managers, the idea of involving customers in pricing decisions seems counterproductive. For most companies, pricing is a sensitive, private affair. But it may be time to reexamine those ideas. Letting customers have input on prices provides opportunities for customization and can promote greater customer engagement. Opening up customer participation also offers a way for companies to create a new sense of excitement.

Managers like to think well of themselves, and of the firms that employ them. However, positive illusions can bias a manager's evaluation of market outcomes, self-servingly crediting success on the superior quality of one's own product but blaming failure on the aggressive price of a competitor's offering. These distorted attributions stem from the idea that product quality better serves the manager's motivation for self-enhancement and self-presentation than price: product quality is seemingly more central to the firm, less susceptible to external market forces, and more stable over time. We position our theory in the psychology of attribution, define self-serving behavior and provide experimental and survey evidence of this phenomenon, and develop a model of price-quality competition that incorporates the empirical findings. In particular, we first study the natural benchmark equilibrium provided by unbiased decision makers. We then introduce self-serving behavior in the presence of myopic principals, or of forward-looking principals who anticipate the limitations of managers and set first-period decisions accordingly.

We describe a model examining how a firm might choose the package size and price for a product that deteriorates over time. Our model considers four factors: (1) the usable life of the product, (2) the rates at which consumers use the product, (3) the relation between package size and the variable cost of the product, and (4) the minimum quantities consumers seek to consume for each dollar they spend (we call these reservation quantities). We allow heterogeneity in the usage rates and reservation quantities for the consumers. We show that when the cost increases as a linear or convex function of the package size, the firm should make packages of the smallest possible size. Smaller packages reduce waste and allow consumers to more closely match their purchases with desired consumption. This in turn allows the firm to charge a higher unit price and also sell more unit volume. The results imply that in a market with multiple package sizes (produced by the same or competing firms), at least one of the packages must have the smallest possible size, provided the fixed cost of making the product is sufficiently low. For concave cost functions, the firm may find it optimal to make larger than smallest-size packages.