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What If Marketers Put Their Customers ahead of Profits?

  • Shriver, Scott K.

    (Stanford University)

  • Srinivasan, V. Seenu

    (Stanford University)

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    We examine a duopoly where one of the firms does not maximize profit, but instead maximizes customer surplus subject to a profit constraint. (Customer surplus for a firm is the sum of its customers' individual consumer surpluses, i.e., the dollar value the customer attaches to the product minus its price.) For the surplus-maximizing firm, profit is constrained to be at least X percent (where X% might be, say 80-90%) of the profit it would have obtained under a profit maximization objective. The model assumes customer willingness to pay for quality is uniformly distributed and that customers follow a simple decision rule: when presented with two products of known quality and price, purchase one unit of the product which maximizes surplus, or if surplus is negative for both products, elect not to purchase any product. We further assume that firms' marginal cost of production is convex (quadratic) in quality. Competition between firms is modeled as a two-stage game, which is solvable by backward induction. In the first stage, one of the firms, whose identity is exogenously specified, moves first and decides its quality level, fully anticipating the quality response of the second firm and the subsequent price competition. The second firm observes the first firm's quality level and then decides its own quality level, anticipating the subsequent price competition. In the second stage, firms take qualities as given and choose prices simultaneously in accordance with a Nash equilibrium. Two possibilities are considered: (a) the first mover is the profit-maximizing firm, and (b) the first mover is the customer surplus-maximizing firm. We compare the results to the corresponding base case of Moorthy (1988) where both firms are profit-maximizing. We find that firms can deliver significant additional value to their customers by forgoing small amounts of profit. However, the effectiveness of this strategy depends upon which firm is the first mover. When the surplus-maximizing firm moves first, a 1% increase in its customers' surplus "costs" the firm approximately 2% of its potential profits. By contrast, when the profit-maximizing firm chooses quality first, we find that sacrificing 20% of profits is sufficient for the surplus-maximizing firm to more than quadruple the customer surplus it would have provided under a profit-maximizing objective. This outcome results from the surplus-maximizing firm leap-frogging its competitor to become the high quality producer.

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    Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 2091.

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    Date of creation: Dec 2011
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    Handle: RePEc:ecl:stabus:2091
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    1. Hauser, John R. & Shugan, Steven., 1981. "Defensive marketing stategies," Working papers 1243-81., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Dranove, David, 1988. "Pricing by non-profit institutions : The case of hospital cost-shifting," Journal of Health Economics, Elsevier, vol. 7(1), pages 47-57, March.
    3. Steinberg, Richard & Weisbrod, Burton A., 2005. "Nonprofits with distributional objectives: price discrimination and corner solutions," Journal of Public Economics, Elsevier, vol. 89(11-12), pages 2205-2230, December.
    4. Richard Steinberg, 1986. "The Revealed Objective Functions of Nonprofit Firms," RAND Journal of Economics, The RAND Corporation, vol. 17(4), pages 508-526, Winter.
    5. K. Sridhar Moorthy, 1988. "Product and Price Competition in a Duopoly," Marketing Science, INFORMS, vol. 7(2), pages 141-168.
    6. John R. Hauser, 1988. "Note—Competitive Price and Positioning Strategies," Marketing Science, INFORMS, vol. 7(1), pages 76-91.
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