Competition in a Status Goods Market

Dmitri Kuksov and Ying Xie Washington University in St. Louis April, 2012

We would like to thank the Editor, the Associate Editor, and the three anonymous reviewers for helpful suggestions which greatly improved the manuscript. We would also like to thank Nanda Kumar, Vithala Rao, Hema Yoganarasimhan, the participants of QME 2011 and of the marketing seminars at the University of Southern California and the University of California, Davis.

Abstract Consumers value status goods due to the impression status-product ownership makes on other consumers and this impression depends on the actual distribution of ownership in population. Explicitly modeling consumer value of status products as coming from the information the product ownership conveys to other consumers, this paper shows that a status-product manufacturer can benet from a competitors cost reduction due to the competitors price reduction associated with it. In other words, it shows that two status products which are (imperfect) substitutes in the consumer utility function may be complements in the prot functions. As a consequence, competition could lead to higher prices than the optimal ones under monopoly ownership of both products. The authors conrm the assumptions that consumer value of a status good depends positively on the proportion of desirable type among owners and negatively on the proportion of the desirable type among non-owners in one experiment and nd empirical support for the positive eect of a price reduction of one product on the demand for the other product from another experiment.

Keywords: Competitive Strategy, Pricing, Self-Expressive Goods, Status Goods, Fashion

While consumers value some products for their utilitarian qualities, such as the taste and nutritional value of food, warmth of clothes, or convenience a car provides, many products are also valued for the status they are supposed to bestow on their owners. One can easily argue that the value of precious stone and metal jewelry, designer handbags (e.g., Louis Vuitton, Prada or Gucci), ne watches (e.g., Rolex), luxury cars (e.g., Mercedez, BMW), or even premium beer (e.g., Heineken in the US) comes mainly from the perception that using these products would elevate the person in the eyes of the onlookers. Furthermore, competing status products dierentiate from each other in a horizontal dimension. For another example, consider the luxury car market. BMW, Audi, Mercedes-Benz, and Lexus cars competing in the luxury car segment all in some extent convey status, but consumers dier in their preferences for these brands. Dan Pankraz, a senior planner at DDBO, describes the dierences between these brands by what the car says about the driver: for example, he claims, an Audi says I improve with the times and a BMW says Im on the way to the top, while Mercedes-Benz says I made it, and a Lexus says Im condent in my own skin.1 Similar opinions are expressed about competing brands of Prada vs. Gucci and Omega vs. Rolex. For example, Menkes (1999) begins her NY Times article about Gucci vs. Prada by characterizing the dierences between these two brands in the following way: They are the fashion titans of the 1990s. In one corner, a streak of blood red across the sleek hair, scarlet sequins dripping on the jacket and the crescendo from Psycho on the soundtrack. On the other side, a khaki-clad gure, bag strapped to the chest, ready to stride out on biker boots into the urban jungle. Unlike the value of utilitarian products, the value of status products depends not only on the physical attributes of the product, but also on the distribution of ownership of the product in the consumer population (Veblen 1899). Specically, the value of a status product to a consumer comes from the comparison between the value of the perception other people will

have of this consumer if she does not own a particular status product and the value of the perception other people will have of this consumer if other people observe she owns this status product. Therefore, the value of a status product is aected by its sales both due to the eect of the change in the distribution of consumers who own it and due to the eect of the change in the distribution of consumers who do not own it. Furthermore, as the above examples illustrate, competition is ubiquitous in status goods markets. The complexity of inter-dependence of value and price raises the question of whether what we know about the eects of competition in regular goods markets would also apply in status goods markets. To better illustrate the issue of competitive implications of the endogenous value of a status product, consider a market with two status products, A and B, competing for demand from the high-class consumers who would like to use status goods to signal their identity to each other. In this case, the consumer value of product A increases when either i) the proportion of the high-class consumers in the total customer base of product A increases, or ii) the proportion of the high-class consumers among the people not owning either product decreases. The rst eect is due to the increasing utility of the consumer if she buys product A, while the second eect is due to the decreasing consumer utility if she does not buy either product. Consider now what happens if the price of product B decreases and as a result, product B sells to more high class consumers. Assume for the moment that product Bs price is high enough and the lower price does not attract many consumers from outside the high-class segment. Then the increased sales of product B have two eects on the demand for product A: a negative eect of potentially taking away demand from product A by improving the value of product B, and a positive eect of increasing consumer value of each of the products, since the proportion of high class consumers among those who do not buy either product decreases. If the second eect dominates the rst, it could lead to the the counter-intuitive outcome that a decrease in price

of one product would result in an increase in the demand for both products. In other words, while the two status products could act as substitutes in the consumer utility function, they can be compliments in the rms prot functions. This paper illustrates the validity of the above intuition through a formal model of two products competing in a market with two high-type consumer segments and one low-type consumer segment. We assume that consumers value how they are perceived by other consumers and thus their value of a product depends on how possession of this product will aect other consumers beliefs about them.2 We then derive that one products price reduction could lead to increased demand for both products and further validate this counter-intuitive result through an experiment where participants act as consumers and choose which of the two products they would buy given the prices and their social payos in the subsequent matching game. In this experiment, by keeping the price of one product constant while changing the price of the other product, we focus on examining the change in the demand of one product as a result of the price change of the other one. Consistently with the model predictions, we nd a signicant increase in the average demand for the product with constant price when the price of the other product increased. The above comparative statics can lead to the equilibrium result that a lower cost of one rm benets both competitors when the prices are set to optimally account for the demand and cost factors. Another result we obtain is that a monopoly owner of both products should set both of their prices lower than competitors who each own one product would. Therefore, in a status goods market, horizontal integration may lead to lower rather than higher prices, as the case with utilitarian products would be. Comparing the equilibrium outcomes in the market with a single-product monopoly and in the market with a duopoly, we nd that competition, i.e., entry of another rm, may either increase or decrease prots of the incumbent. Furthermore, competitive entry may benet the incumbent even when the entrant poaches away half of the

customers who would buy from the incumbent in the absence of entry. RELATION TO EXTANT LITERATURE Consistently with Veblens idea that certain conspicuous consumption may signal belonging to the high society, we dene status products as products that help consumers identify themselves as members of a desirable type. This is a common denition used in literature. For example, Grossman and Shapiro (1988) dene status goods as goods for which the mere use or display of a particular branded product confers prestige on their owners, apart from any utility deriving from their function. An early treatment of social aspects of consumption belongs to Leibenstein (1950), who speculated that either small or high market share may be valued by consumers due to the value of uniqueness and conformity, as well as that some consumers could value a high price. Becker (1991), Amaldoss and Jain (2005a, 2005b, 2010) and Balachander and Stock (2009) also explore the implications of consumer value for uniqueness and conformity. However, it is appealing to understand where the status meaning of a product or brand is coming from in a framework where consumers rationally infer the signal from the environment. In this regard, Muniz and OGuinn (2001) argue that consumers derive the symbolic meaning of a brand from the type of consumers who buys that brand. Similarly, Escalas and Bettman (2005) nd experimental support for the hypothesis that the symbolic properties of reference groups become associated with the brands those groups are perceived to use. In other words, they argue that people derive brand associations from their use by the people they desire to appear to be (the in group in Escalas and Bettmans terminology). They further show, through an experiment, that the reverse holds as well: the brand desirability declines if more people from undesirable group (the out group) use it. Similar arguments are also given by White and Dahl (2006) and Han, Nunes and Dreze (2010). Applying these ndings to status products, one then expects that the meaning and value of a status product comes from the prevalence of more desirable types of people among its owners. As Bagwell and Bernheim (1996) argue, such

denition also directly follows from the classical and often cited essay by Veblen (1899). In the context of a status goods market, a number of game-theoretic papers have dened the consumer value of a product as coming from the value of projecting the image consistent with the products distribution of ownership (e.g., Karni and Schmeidler 1990, Wenerfelt 1990, Pesendorfer 1995, Bagwell and Bernheim 1996, Yoganarasimhan 2012, Kuksov and Wang 2012).3 This is also the approach we adopt in this paper. Note that status goods in this denition are a special case of self-expressive goods, with the distinctive characteristic being that they separate high from low class, i.e., they signal a characteristic that is perceived as desirable by everybody. The consumer use of status products we consider is akin to communication through costly signaling. Although Spence (1973) introduced the idea of people signaling their types to rms, the extensive marketing literature on costly signaling concentrated on studying the eects of rms signalling to each other or to the consumers (e.g., Balachander and Srinivasan 1994, Desai and Srinivasan 1995, Moorthy and Srinivasan 1995, Simester 1995, Anderson and Simester 1998, Kalra et al. 1998, Desai 2000, Soberman 2003). In contrast, this paper analyzes costly signalling of consumers to other consumers. As we have noted above, in the economics literature, implications of consumer product use to signal their types to other consumers were considered by Pesendorfer (1995) and Bagwell and Bernheim (1996). In particular, Pesendorfer (1995) considers implications of a durable-good monopoly selling status goods in a dynamic model and nds that innovation cycles would endogenously occur. The idea is that when a product penetrates the high-type consumer segment, the rm then has an incentive to sell to the low-type consumers, which degrades the signalling value of the product and a new product (new fashion design) is then needed. In equilibrium, a new product is therefore periodically introduced when the old design suciently penetrates the low-type consumer segment. Bagwell and Bernheim (1996) ask a more general question of when a market for status products may exist and derive general conditions. Since they concentrate

on the demand side, they assume a perfectly competitive supply of the status goods. The current paper extends this analysis to consider competitive implications of a product being a status good when competition is non-trivial, i.e., when rms are dierentiated. Note that while Amaldoss and Jain (2005b) also model dierentiated competition, they assume that some consumers derive value from exclusivity and some from conformity. They show that the demand from those who value exclusivity may increase with the price. However, in their model, the total demand for a product always decreases in own price and increases in the competitors price. We are able to show that demand for a product could decrease in the competitors price because we derive the consumer value as endogenously coming from what the product possession signals to other consumers relative to what others would assume if neither product would be purchased. This competitive implication of our model is unique in the literature on status goods. The intuition behind the above result in our model is that when either product penetrates the market, it rst penetrates the high-type segment. Therefore not owning either product becomes more indicative of belonging to the low type and thus, the dierential value of owning either product increases. This eect is akin a category-wide network externality eect. In that, our paper is related to the extensive literature on network externalities starting from Katz and Shapiro (1985) and Farrell and Saloner (1986). Although that literature normally assumed that network externality is product- rather than category-specic, similar results to ours could be obtained in a market with category-wide network externality. When network externalities are present, the value of a product also depends on the pattern of ownership and this can lead to interesting eects (for example, Chen and Xie (2007) show how a larger size of loyal segment can end up being detrimental to a rm in the presence of network externality). However, the mechanism behind our results is dierent: in the case of network externality, the value of owning a product increases when there are more products like it, while the value of not owning a product is independent of the product penetration. In contrast, in a status goods market, the value of

having a product does not change with the penetration of the competitors product, but the value of not owning either product decreases. An increasing body of marketing literature utilizes experiments to test theoretical predictions of the consumer or rm behavior, including the predictions of interdependence of consumer choices. For example, Amaldoss and Jain (2005a, 2005b) use laboratory experiments to show empirical support for the key results of their theoretical models that the desire for uniqueness and conformity can lead to an upward sloping demand curve from one of the consumer segments. In other settings, experiments have been used by marketing researchers to validate their models of consumer sweepstake design and contest promotions (Kalra and Shi, 2010), timeshare exchange mechanisms (Wang and Krishna, 2006), sales contests (Lim et al., 2009), and contracting issues between supply chain partners (Ho and Zhang, 2008). Following these researchers, we provide empirical support from a lab experiment for one of the key results of the theoretical model. MODEL A unit mass of consumers consists of high (H ) and low (L) consumer types. The hightype consumer segment consists of two subsegments, which we will call H1 and H2 segments, each of mass . Thus, the low-type consumer segment has mass = 1 2. Consumers have preferences over what other consumers think their type is. Given the above three-type consumer distribution, a belief about consumer is type can be dened by a triple (qH1 , qH2 , qL ) of probabilities that this consumer is of type H1 , H2 , and L, respectively (qH1 + qH2 + qL = 1). We will call this triple of probabilities by which a consumer is known to other consumers as the consumers image (in the eyes of other consumers). Assume that consumer i values an image at (1)
H1 H2 L Vi (qH1 , qH2 , qL ) = qH1 vi + qH2 vi + qL v i ,

T where vi is the weight consumer i places on being perceived as type T . In the next section, we

clarify how these consumer valuations for projecting images of themselves to other consumers can be derived from a matching game. The conceptual meaning of high type is that all 9

consumers prefer to be perceived as a high-type consumer than as a low-type consumer, i.e., vi

Hj L > vi for j = 1, 2. Without loss of generality, normalize the utility of each consumer so

L that vi = 0. Consumers would then have value for a product if it allows them to project an

image more desirable than the image represented by the population of consumers who do not buy either product. To obtain non-trivial (dierentiated) competition, we assume that Hj -type consumers prefer being perceived as Hj type rather than as H3j type, i.e., H1 and H2 type consumers are horizontally dierentiated in their preferences for the image to project. Namely, let vi vi
H3j Hj

+ t for consumer i of type Hj . This assumption is similar to the in-group preference

argued for by some researchers (e.g., Escalas and Bettman 2005, White and Dahl 2006 and Han, Nunes and Dreze 2010; for a theoretical argument in the context of a marriage market, see also Becker 1973). Furthermore, to obtain a non-degenerate demand function, we assume that consumer valuations are heterogeneous within each Hj segment. Specically, assume that the weight vh that Hj -type consumer places on being perceived as Hj type is uniformly distributed on U [v h , v h ]. Thus, Hj -type consumers value of perception (qH1 , qH2 , qL ) is V = qHj vh + qH3j (vh t) with vh U [v h , v h ]. If low-type consumers derive higher value from projecting a high-type image than their high-type counterparts, there may be no equilibrium in which a product can be valued solely for the image it allows consumers to project of themselves. Intuitively, this is because if low-type consumers would have higher value of projecting high-type image than high-type consumers do, low-type consumers would be buying any product with desirable image in higher proportions than the high-type consumers thus degrading the products image until it is no longer valuable. For a formal argument, see Bagwell and Bernheim (1996). We therefore assume that vi
Hj

is

lower for a low-type consumer than it is for a high-type consumer. Note that this assumption can also be justied through an in-group preference. Formally, denoting vi
Hj

= vL for a low-type

10

consumer i, assume that this value is the same for all low-type consumers. For simplicity, we assume that if consumer i is of low type, her weight vi
Hj

is lower than a rm could reasonably

consider, e.g., it is lower than marginal product cost. This assumption greatly simplies the technical derivations, but is not strictly necessary. Given this assumption, the assumptions of no heterogeneity of low-type consumer valuations and that low-type consumers do not distinguish between H1 and H2 segments are not essential. Although we have virtually assumed an inert low-type consumer segment, the existence of this segment is still essential. This is because the presence of this segment implies that a consumer buying a product signals to other consumers that she is of one of the high types. In other words, the existence of low-type consumers makes the product ownership imply status rather than only a horizontally dierentiated image. Our main results would not hold if the low-type consumer segment does not exist or is not large enough. If Hj -type consumers are not heterogeneous in their valuations, either all or none of them would buy a product and thus the demand curve would be degenerate. Furthermore, a small degree of consumer heterogeneity does not resolve this issue since as we will see in the following section, when the consumer demand from the high type consumer segment increases, the value increases as well. Therefore, with small degree of consumer heterogeneity, one would obtain that all high-type consumers buying and all high-type consumers not buying could both be equilibrium outcomes at the same time. Therefore, to ensure unique equilibrium in consumer choice we need sucient heterogeneity in high-type consumer valuations. Formally, we assume (2) v h t > vL , and v h + t > v h ,

where the rst inequality is the condition on low-type consumer value of being perceived as a high type being lower than that of a high-type consumer, and the second inequality is the above discussed condition on sucient heterogeneity of high-type consumers and sucient mass of low-type consumers. It turns out that the second assumption is equivalent to assuming that 11

when prices are equal, it is possible to have in equilibrium some but not all H1 and H2 segment consumers buy. If this condition is not satised, reducing price from a level that has non-zero sales never increases revenue and thus price would not be continuously changing in costs, which would make the analysis of the pricing decision not interesting. Two rms, named Firm 1 and Firm 2, produce one product each at marginal costs c1 and c2 , respectively, and simultaneously set prices p1 and p2 . Then, consumers make purchase decisions observed by other consumers. Then consumers receive payos based on the other consumers beliefs about their type as discussed above. Note that in equilibrium, these beliefs have to be consistent with the buying behavior and are derived according to the Bayes rule from the prior beliefs determined by the relative segment sizes and the equilibrium buying behavior. If in equilibrium, no consumers buy product k , we assume that consumer belief about someone who deviates and buys this product is an arbitrary probability mix over Hj types. This assumption can be justied by the ability of rms to target a few select (high-type) consumers at product introduction to establish an image and is needed to rule out the trivial equilibrium where no consumers buy either product because the belief is that whoever buys a product is of the low class. Furthermore, when pk > vL , as we will consider, such beliefs also follow from the Intuitive Criterion. Although, technically, it could be important to postulate how a consumer payo depends on which consumers think what about her, since all consumers have the same information, they must all have the same beliefs about a given consumer. Also note that consumers do not need to observe all other consumer choices to make an inference about a given consumer, since consumer can fully derive their beliefs about aggregate consumer behavior from the equilibrium. Before turning to the model analysis, in the following section, we discuss how the abovedened consumer valuations may be derived from a more primitive assumptions on consumer interaction. This analysis shows, in particular, that the utility function dened in Equation (1)

12

may be a reduced-form representation of how product choices aect a customers image and how this image value can be justied through more primitive values. We also further relate some of the assumptions to the relevant literature. A MATCHING GAME MICRO-FOUNDATION FOR IMAGE VALUE The main departing point of our model from the standard models of competition is that we consider products whose value is endogenously determined by the value consumers derive from what they can convey to others through their product use. It is therefore important to understand the assumptions made on this value. In this section, we discuss how the consumer value of projecting a certain image may be justied through the interaction consumers have with each other. The idea is that each consumer is ultimately interested in interacting with another consumer and the payos of this interaction depend on the type of the consumer she interacts with. This justication is not novel to our paper: in the case of two consumer segments, it has been oered by Pesendorfer (1995) and later also used by Kuksov (2007) and Yoganarasimhan (2010). Although previous research examined such matching game in the context of marriage market, one can see that it could be applicable in other situations, such as when consumers are interested in forming teams to perform a certain task and the consumer ability to contribute depends on her type. To justify the consumer value of projecting a certain image of themselves, let us assume that consumers are interested in social interaction with other consumers. To be specic, assume that each consumer is interested in pairing up with another consumer with the payo from the pairing depending on the consumer types (this assumption can be extended to consumers interested in forming a group of certain size N where the payo from forming a group to an individual depends on the individuals type and the group composition). Specically, normalize each consumers payo from pairing with a low-type consumer to zero and denote the low-type consumers payo of pairing with a high-type consumer by vL . Let the Hj -type consumers payo

13

of pairing with an Hj -type consumer be vh and that of pairing with an H3j type consumer be vh t, where vh U [v h , v h ], and t > 0 is a parameter. Further, assume consumers are risk neutral in their search for a partner and pairing occurs when two consumers agree to form a pair. While consumers know their own type, they only observe the purchase decisions but not the types of other consumers. Therefore, they have to make the pairing decision based on the product ownership alone. The consumers can then be segmented into groups of consumers who made the same purchase decision. From the point of view of an Hj -type consumer, these groups can be ordered by the expected utility to this consumer of pairing with a random member of each group. Moreover, all Hj -type consumers order the groups in exactly the same way. Thus, Hj -type consumers who belong to the highest group will desire to be matched within the same group, and they will be preferred for matching by members of their group. This means that Hj -type consumers in a lower group do not have a chance of matching with the higher group and repeating the argument across the two lower groups, we conclude that they end up pairing within their own group. The Hj -type consumers of the lowest group are then only able to match within their own group as well. The same consideration applies to L-type consumers as well. Thus, all consumers end up pairing within their own group, either by choice or by availability, and the pairing outcome is equivalent to consumers using the same product randomly matching with each other.4 To complete the matching model formulation, it remains to dene what happens if only a single consumer buys a product. This is important for consideration of the purchase when in equilibrium nobody may end up buying this product. Similarly to the model described in the previous section, to avoid this ambiguity and the possibility that a consumer is in a group of her own, we can assume that a zero-mass but innitely many high-type consumers own each product j . One can easily see that the above dened game leads to the utility of projecting an image

14

as we dened in the previous section. MODEL ANALYSIS Solving the model through backward induction, we rst discuss the consumer choice subgame, which is the stage of consumer product choice taking prices as given, and then the price setting stage. By solving the consumer choice subgame, we obtain the comparative statics results about the response of demand for one product to the price change of the other product. Based on this result, we then derive the optimal rms response to a change in one of the rms costs and the equilibrium results of the full game. Consumer Choice Subgame and Comparative Statics with Exogenous Price Changes Let pk be the price of product k , and let djk be the proportion of Hj -type consumers among buyers of product k . Then Hj -type consumer prefers product 1 to product 2 if and only if (3) dj 1 v + (1 dj 1 )(v t) p1 > dj 2 v + (1 dj 2 )(v t) p2 ,

where v is the consumers payo from projecting Hj -type image. The above inequality simplies to (dj 1 dj 2 )t > p1 p2 . Since v does not enter this condition, we have that either all consumers of the same subtype prefer product 1 to product 2 or vice versa, or all of them are indierent. Consider rst a potential equilibrium where the demand for each product comes from both high-type segments. Then, indierence equation (dj 1 dj 2 )t = p1 p2 must hold for each j = 1, 2. Using d2k = 1 d1k , we obtain (d11 d12 )t = p1 p2 and (d12 d11 )t = p1 p2 , which is only possible when p1 = p2 and d11 = d12 = 1/2. It will be clear from the consideration below that in this case at least one of the rms should strictly prefer to change its price. Also, this equilibrium is not asymptotically stable in the sense of t atonnement (see Fudenberg and Tirole 1991, pp. 23-25), because if an arbitrarily small mass of consumers of either high-type segment deviates to either not buying a product or buying the other product, then all consumers from that segment would prefer the other product to the rst one and all consumers of the other hightype segment would prefer the rst product to the other one. Therefore, a one-step iteration of 15

optimal response from this deviation would result in each product receiving demand only from one of the high-type segments. The demands would then adjust to satisfy Equation (5) below, since as shown in the appendix (see proof of Proposition 1), the left and right hand sides of each equation diverge as the demands diverge from the unique solution to the system. Consider next a potential equilibrium where demand for one of the products comes from both Hj segments, but the demand for the other comes only from one Hj segment. Without loss of generality, let the latter segment be H2 and the product they prefer be Product 2. Then d11 = 1 and the system of equations on the equilibrium similar to Equation (8) of the monopoly case yields d2k d1k . Therefore, such equilibrium is only possible when p1 p2 t/2. Thus, when prices are not equal and not too dierent (|p1 p2 | < t/2) and both products receive positive demand, the only possible equilibrium is for H1 -type consumers to only buy one of the products and for H2 -type consumers to only buy the other one. In the case one of the products, say product 2, receives no demand, the other products demand is then derived similarly to the single-product monopoly case (see below). As established there, we have d11 = d12 = 1/2. It is then optimal for consumers in both of the high-type subsegments not prefer product 2 to product 1 only if the price of product 1 is higher (regardless of the beliefs about the consumer who deviates and buys product 1 as far as the belief is that this consumer is from a high-type subsegment). This outcome is not asymptotically stable when |p1 p2 | < t/2, as the t atonnement with deviation of arbitrarily small mass from one of the high-type subsegments to buy product 1 would converge to the separating equilibrium discussed below (similarly to the argument in the case p1 = p2 ). Also, this can only be an equilibrium of the full game if p2 c2 . With this rationale, let us concentrate on the possibility for both products to have positive demand. Without loss of generality, let us assume that H1 -type consumers buy Product 1, and let Dk be the demand for product k . Then the mass D0 = 1 D1 D2 of consumers who are not

16

buying consists of H1 , H2 , and L type consumers in proportions ( D1 )/D0 , ( D2 )/D0 , and /D0 , respectively, while d11 = d22 = 1. Consider an Hj -type consumer who faces payo v from pairing with an Hj -type consumer. This consumer then nds it optimal to buy product j rather than not buy either product if (4) v pj > ( Dj )v + ( D3j )(v t) . 1 D1 D2

Thus, the equilibrium conditions on the consumer demands are (5) v1 p1 = v2 p2 =

(D1 )v1 +(D2 )(v1 t) , 1D1 D2 (D2 )v2 +(D1 )(v2 t) , 1D1 D2

where vj denotes vh of the marginal Hj -type consumer in the decision to buy product j and (6) Dj = max 0, v h max{vj , v h } vh vh , j = 1, 2.

This system of equations turns out to be linear in vj (the quadratic terms cancel). For its solution to represent an equilibrium consumer choice, it is also necessary that incentive compatibility constraints are met: none of the consumers of type Hj should prefer buying product 3 j to buying product j , and consumers of type L should not nd it optimal to buy either of the products. The former condition requires pj p3j < t, and the latter is satised if vj > vL . We summarize the equilibrium conditions and the important comparative statics they imply as the following proposition. Proposition 1. Equations (5) and (6) dene a (unique asymptotically stable) consumer choice equilibrium when the solution to these equations satises vj [vL , v h ] and |pj p3j | < t/2 for j = 1, 2.5 Under the above conditions, a reduction in price of either product results in the increased demand for both products as far as vj > vh for each j = 1, 2, i.e., as far as neither high-type subsegment is fully penetrated. Proof. See Appendix. 17

The comparative statics result in the above proposition are essential to make possible the equilibrium result we show in the next subsection. The rst part of the comparative statics results is that if a price reduction of one product would not lead to an increase in its own demand, decreasing price could never be optimal. This part of the comparative statics result is intuitive but important, since it ensures that the own-price elasticity for a status good behaves as one would expect in the case of utilitarian products. The second part of the comparative statics results is more interesting and counter-intuitive since it says that the cross-price elasticity can be negative as well, i.e., the products may act as complements. The intuition for this result is that when the price of one product decreases, this product converts some of the high type population from non-buyers to buyers. Although this does not change the consumer payos when buying either product, it decreases the payos when not buying either product. Therefore, the willingness to pay of all consumers for either product increases. Since product images are dierentiated in the equilibrium and the price dierence is not high enough, consumers still prefer to buy the product with a matching image to the other product, and thus, the demand for each product increases. Note that the above mechanism of sales of a product beneting from the sales of the other one is not the same as that for products that are complementary in the usual sense. In the usual case of complementary products, a consumers valuation of a product increases if the consumer also owns the other product. In our case, the marginal consumer in the decision to buy or not to buy a product views the two products as (imperfect) substitutes even though the incentive compatibility constraints are not binding. Note that if one would like to have a model with the same results but where incentive compatibility is binding for some consumers, so that a price reduction of one product would draw some demand from the other product, one can easily do this as follows. To the setup of the model we have, add a small fraction of high type consumers of each subtype whose vh part of the payo is distributed the same as for the

18

rest of the high type consumers, but whose t part of the preference is replaced by uniformly distributed on [0, t]. Keeping the mass of these added consumers small would ensure that they have very little eect on the equilibrium demands from the other consumers, but some of these new consumers would be switching products no matter what the price change is. Moreover, if v h >
1 t, 1 2

all consumers view the two products as (imperfect) substitutes. To

see this, rst note that product 2 has no value for H1 -type consumer if she already possesses product 1. Further, consider an H1 -type consumer with payo vh of matching with another H1 -type consumer. If she does not own either product, obtaining product 1 would increase her utility by (7) U (buy) U (not buy) = vh D2 D1 vh + (vh t) . D0 D0

However, if she owned product 2, her replacing it with product 1 would increase her utility by vh (vh t) = t. Substituting D1 = (v h vh )/(v h v h ), which holds if the consumer with the payo vh is a marginal consumer, and D0 = 1 D1 D2 in Equation (7), one obtains that owning product 2 decreases marginal H1 -type consumers value of product 1. To see when this holds for all consumers, note that Equation (7) is smallest when D1 = D2 = 0 and D0 = 1. Substituting these, one obtains that owning product 2 decreases the H1 -type consumers value of product 1 as far as vh >
1 t. 1 2

Therefore, Proposition 1 can be summarized as implying that

two status goods which are substitutes in the consumer utility functions can act as compliments in the prot function. Equilibrium Prices and the Eect of Costs on Prots We now illustrate how the comparative statics derived in Proposition 1 may lead to one rm beneting from another rms equilibrium decision on price reduction due to a decrease in its marginal costs. The rst order conditions on prices of the two rms are derived from the demand equations (5) and (6). To make sure that the solution of the rst order conditions constitutes a unique equilibrium, we must also check that a) a deviation by either rm j to set 19

price at or below p3j t/2 to possibly capture the demand from both high subtypes leads to a lower prot then the price determined by the rst order conditions, and b) it is not optimal to set price as to sell to the low type consumers. If condition a) is not satised, the equilibrium will be in mixed strategies since a pure strategy equilibrium would have to satisfy the rst order conditions. The solution to the rst-order conditions is algebraically complex. However, one can easily see that the pure strategy equilibrium has to exist when costs are suciently high, so that the rst order conditions would lead to prices that exceed costs by no more than t/2. Therefore, we have the following proposition. Proposition 2. If the equilibrium is in pure-price strategies (which holds when it is not optimal for either rm to set its price t/2 below the other price even if it then captures all demand)6 with both rms having positive sales, then a cost reduction of one rm strictly benets both rms if the rst rm did not fully penetrate either high-type subsegment. Proof. See Appendix. To illustrate the equilibrium price and prot changes due to one rms cost change, consider 20% decrease of Firm 2s cost starting from t = 1, vL = 1, vh [2, 4], c1 = c2 = 2. Given these parameters, if = 1/4 we have the following equilibrium prices and prots: c2 = 2 c2 = 1.6 Prices Prots (2.171, 2.171) (.0205, .0205) (2.247, 1.993) (.0354, .0781)

On the other hand, if = 1/10, we have the following equilibrium prices and prots: c2 = 2 c2 = 1.6 Prices Prots (2.723, 2.723) (.0361, .0361) (2.741, 2.535) (.0373, .0584)

The above example illustrates a curious possibility that prots may increase when the size of the high-type segment decreases. This is possible because while the potential demand for a status product increases with the high-type segment size, the value of the product decreases in 20

that size (the payo of not owning the product increases in the high-type segment size while the payo of ownership does not change). Proposition 2 is a fairly straightforward consequence of Proposition 1: as far as v2 > v h , a cost reduction of Firm 2 makes it optimal for it to lower its price to increase its penetration of H2 consumer segment, and this increased penetration increases the value of both products to both H1 and H2 -type consumers. Here we considered the case when Firm 2 increases sales without nding it optimal to take away sales from Firm 1. In the next section, we show that a stronger result may also hold: in the case the optimal monopoly price of Firm 1 is such that it equally penetrates both high-type segments, a competitor entry may still increase prots of Firm 1 even as the entrant takes away all the demand from one of the high-type segments. We also show another implication of Proposition 1 on equilibrium prices: the prices are lower when the two rms are horizontally integrated. Note that since the benecial eect of one rms price reduction on the other rm relies on changing the distribution of non buyers, the eect is weaker when is smaller. However, it never disappears. Note also that in reality, should not be necessarily interpreted as a proportion of Hj segment in the total consumer population, but rather as a proportion only in the population of consumers that are not distinguishable from Hj -type consumers by other consumers except through the use of products under consideration. On the other hand, because one rm penetration reduces the contribution of image valued at vh t by the other subsegment, the eect is stronger when t is smaller. The prot implications of smaller are not clear-cut: although prots must tend to zero as tends to zero, as we have noted on the example above, a smaller may lead to higher prots. Comparison of Duopoly to Single- and Two-Product Monopoly In this subsection, we complete the model analysis by considering two other market structures: the one-product monopoly case and the case of horizontal integration of the two rms.

21

The rst case is theoretically equivalent to one of the rms having cost above value of all consumers. In this section, we also analyze the case when the price of the existing rm is low enough so that both H1 - and H2 -type consumers buy the product, which adds the possibility that the entrant takes away half of the incumbents consumers. As we show below, it is possible that the incumbent rm benets from the competitors entry even in this case. Let us start with the analysis of one-product monopoly and the possibility that the product sells to both Hj subsegments. In this case, equating the payo of the marginal consumer of each high-type segment when buying the product and not buying it, we have the following equilibrium conditions on the demands D1 and D2 from each of the two high-type segments:

(8)

D1 v1 +D2 (v1 t) D1 +D2 D2 v2 +D1 (v2 t) D1 +D2

p= p=

(D1 )v1 +(D2 )(v1 t) , 1D1 D2 (D2 )v2 +(D1 )(v2 t) , 1D1 D2

where p is the products price and vj is still related to Dj according to Equation (6). It turns out that the solution to the above system is always unique and symmetric: (9) v1 = v2 = 2p (2v h t) (v h v h ) + 2p(v h v h ) , and D1 + D2 = (v h v h ) 2p (v h v h ) 2p

When this solution implies positive demand and satises vj > vL + t/2, it represents the unique consumer choice equilibrium with demand coming from both high-type consumer segments. The latter condition is necessary and sucient to make it optimal for the L-type consumers not to buy the product. Note that the highest price that results in positive sales in this equilibrium is just below (v h t/2) and is lower than the maximal symmetric price that achieves positive demand in the competitive case. There may also be a consumer choice equilibrium where the demand is coming from one Hj segment only. That potential equilibrium would not have to satisfy Equation (8), because no consumers in the segment with zero demand are indierent between buying and not buying. The following are the equilibrium conditions for such asymmetric equilibrium with demand D 22

coming from H1 -type consumers only.7 (10) v1 p = vh t p

(D)v1 +(v1 t) , 1 D (D)(v h t)+v h , 1 D

and v1 vL ,

where D = max{0, (v h max{v1 , v h })/(v h v h )}. The rst inequality in the above system is needed to make it optimal for H2 -type consumers not to buy the product even when they have the highest valuation of pairing, and it means that this asymmetric consumer choice equilibrium will not exist for p < v h t. The unique solution of Equation (10) leads to (11) D= p v h t (v h t + t)(v h v h ) and p . p (v h v h ) (v h v h ) + t

Note that this equilibrium does not exist if the price is low enough. Comparing the optimal monopoly choice to the competitive equilibrium outcome, we obtain the following proposition. Proposition 3. A monopoly seller of a status good may be better o due to competitor entry even though the optimal monopoly choice is to equally serve both high-type consumer subsegments and entrant would take away sales from one of the subsegments. Proof. See Appendix. When half of the consumers who would buy from the incumbent in the absence of entry switch to the entrants product, the two products are clearly substitutes. Nevertheless, the proposition states that the competitor entry may still benet the incumbent. This nding is consistent with Qians (2011) empirical nding that the high-fashion shoes are the ones that may benet from entry of counterfeits in the Chinese market. The above monopoly vs. duopoly comparison assumes that monopoly can only sell a single product. Another interesting comparison is between the cases of monopoly selling both products and two competitors selling one product each. This can be a relevant comparison for the consideration of horizontal merger decisions or for the internal pricing policy guidelines governing how semi-independent brand managers would tend to behave within the organization when they 23

are rewarded not according to the total prot impact of their pricing decisions but according to the individual prot contributions of their respective products. To see how a monopoly selling two products should modify its pricing relative to that of a duopoly, consider the following. If monopoly increases one of the prices without decreasing another, the monopoly prot would decrease because increasing price was not optimal for competitors and cross-eect is also negative. Therefore, the monopoly should nd it optimal to either decrease one of the prices relative to a duopoly or keep them the same. Furthermore, if one of the products did not fully penetrate its high-type segment, the prots would increase if its price decreases because the eect on the prot from its sales is second order, but the eect on the prot from the sales of the other product is rst order. Also, since equal costs result in equal equilibrium prices, the above implies that in the symmetric-cost case, both prices will be optimally reduced in the case of horizontal integration, and thus, the total demand will increase. We summarize these results in the following proposition. Proposition 4. When the competitive equilibrium is in pure price strategies, a horizontal integration will result in the following: (1) both prices remain the same or the price of at least one product decreases; (2) when c1 = c2 , the total category demand increases if not all high type consumers purchase one of the products, and stays constant otherwise.8 While the above result could be counter-intuitive without the background of the prior analysis, it does not come as a surprise after Propositions 1 and 2 are understood. The intuition is that the joint prot-maximization takes into account the positive externality of a price reduction which increases the demand for both products. In addition to the managerial implications of the proposition we described above, one should also note its public policy implication: while competition may be promoting lower prices and higher consumption in most product categories, competition may be promoting higher prices and lower consumption in the categories of status goods. 24

The analysis above also shows that as opposed to a product cannibalization concerns in utilitarian markets, in status goods markets, a rm has an extra incentive to increase product line. This could be a force towards increasing product line length in status goods.9 At the same time, given that the dierentiation is through image, product line extensions may run a risk that consumers will confuse two products if they are coming from the same manufacturer (or at least, if they have the same brand name). This raises another interesting question: how imperfect observability of status good possession could change the dynamics of a status goods market. This issue becomes especially relevant when brand counterfeits exist for status goods. Applying the same line of reasoning about benets of penetration, one could imagine that if multiple consumer types are vertically heterogeneous, a counterfeit product might even help the brand name one as it could separate medium-type subsegment from the low-type one. Product Dierentiation in Physical Attributes Although we have modeled dierentiated product competition through high-type consumers horizontal preference heterogeneity for the image to project, one could have alternatively assumed that high-type consumers have heterogenous value for the functional product attributes. For example, one could assume that a Hj -type consumer has value vh of projecting both the image of H1 type and that of H2 type (i.e., t does not enter the image value), but in addition derives functional value t from product j but zero from product 3 j . Our main results are robust to this model modication. In fact, the benet of one products price reduction on the demand for the other product would be even stronger, because penetration of a product would be taking out equally desirable consumers rather than less desirable ones from the population of consumers who do not own a product. However, the model we developed shows that one does not need status products to be functionally dierentiated to obtain this and other results. It also shows how in markets where self-expression is an important consideration, rms may become

25

dierentiated not due to rms actions but due to consumer choices. In similar vein, Kuksov, Shachar, and Wang (2012) also show that the rm may in fact prefer to abstain from actively creating image through advertising to facilitate the endogenous formation of image through consumer communication. At the same time, interaction of functional and image dierentiation is also an interesting phenomenon to explore further. For example, in this regard, Muller and Shachar (2006) argue that lack of functional dierentiation could be a result of rms ability to dierentiate on a self-expressive attribute. EXPERIMENTAL VALIDATION This section describes several experiments supporting our theoretical model. First, we experimentally validate the key assumption of our model that the value of the product depends on the type of consumers who own it and those who do not own it. Second, we experimentally validate the result of Proposition 1 that as the price of one product declines, the demand for both products increases. Conrming Assumptions: Product Ownership Distribution and Perceived Product Value One of the key assumptions in our theoretical model is that the value of a product used by consumers to signal their type is endogenous and determined by the pattern of product ownership: the proportion of product owners who are of the desirable type and the proportion of non-owners who are of the desirable type. Specically, the assumption of endogenous signal value implied that the value should increase in the rst proportion and decease in the second. As we have discussed, this assumption is consistent with consistency of beliefs and outcomes imbedded in the notion of Nash Equilibrium as well as reected in some consumer behavior and theoretical literature. To provide additional support for this assumption, we conducted a consumer preference survey to examine the eect of proportion of dierent type of owners on the perceived product value. Eighty participants from a national Internet panel were randomly assigned to one of two

26

conditions and completed a consumer preference survey in exchange for a $5 gift certicate. Participants were asked to imagine that they are considering whether to purchase a luxury wrist watch to wear at the nal round interview for a high-paid management job at a company. They were then informed about the percentage of managers and other employees at that company who wear a luxury watch at work. Specically, the following information was provided to participants in the high-percentage of high-type owners (low-percentage of high-type owners) condition, henceforth referred to as Condition 1 (Condition 2): You consulted a friend of yours, who works at the company that you will interview with. The friend told you that although almost never a choice by other employees, luxury watches are popular (somewhat popular) among managers at the company with roughly four (one) out of ten of them seen wearing one at work. Participants were then asked to indicate how much they desire to wear a luxury watch at the interview on a 10-point Likert scale (1 = not at all desire; 10 = very much desire). Note that although in either of these two conditions product ownership identies the employee as a manager, the absence of product ownership implies higher probability that the employee is a manager under Condition 2 than it does under Condition 1. Therefore, our prediction was that the desirability of product ownership would be higher under Condition 1. The analysis of variance with the mean desirability evaluation as the dependent measure indeed yielded a signicant main eect such that participants in Condition 1 rated the luxury watch as more desirable than the participants in Condition 2 did (MCond 1 = 5.88 vs. MCond 2 = 4.50; F (1, 78) = 4.72, p < .05). This nding is consistent with our assumption that the perceived value of the product increases when the proportion of the desirable consumers among non-owners decreases. To test whether the value of the product increases when the proportion of the undesirable consumers in the total customer base of the product decreases (i.e., when owning a product is stronger signal of being a high-type), we conducted the following manipulation: keeping

27

constant the proportion of high-type employees (managers) wearing a luxury watch at one out of ten, we varied the proportion of other employees wearing luxury watches from almost never (henceforth, Condition I) to one out of ten (henceforth, Condition II). If our assumption holds, the perceived value of product should be higher in Condition I when other employees almost never wear a luxury watch. A separate set of 40 participants, randomly drawn from the same Internet panel, went through the same procedure as participants in the rst study with the modication described above. The analysis of variance again yielded a signicant main eect: the participants in Condition I rated the luxury watch as more desirable than the participants in Condition II (MCond I = 4.50 vs. MCond II = 3.19; F (1, 78) = 4.53, p < .05). In summary, the data from the consumer survey is consistent with the assumptions of our theoretical model. Note that one explanation for the increased value in the rst manipulation is the herding eect: a products valuation may increase just because more people desire it (Becker 1991, Zhang 2010). However, the second manipulation show that this is not exactly the full story: when the product use increases due to the less desirable type of consumers, the valuation actually decreases. Testing Predictions: Experimental Validation of Proposition 1 The model implications derived in the previous section are crucially based on the consumer choice predictions of Proposition 1 that as the price of one product declines, the demand for the competing product increases. As this prediction might seem counter-intuitive, one may ask: would consumers follow the optimal strategy, or would they tend to lower their choice probability of a product if the price of the competing product declines as they would behave in a regular goods market? In this section, we describe an experiment that lends support to the consumer choice prediction of Proposition 1. Model modication for an experiment. In the model, we assumed an innite number of

28

consumers of each type and a uniform distribution of payos for the high type consumers. Since an experiment has to consist of nitely many consumers, we have to modify these assumptions and re-derive the equilibrium. To adapt the uniform distribution of payos on [v h , v h ] to a nite consumer number, we use a discrete set of payos rounding them to an integer for simplicity: vi = v h + i(v h v h )/N (i = 1, ..., N ) where N is the number of Hj -type consumers. Specically, we used = 1/4, N = 7 (i.e., seven consumers per Hj segment and 14 low-type consumers) and payos of pairing with high-type consumers dened as presented in the following table: Consumer index Payo when pairing with the same subtype Payo when pairing with the other subtype 1 2 3 4 5 6 7 34 38 42 47 51 56 60 14 18 22 27 31 36 40

This distribution of payos across consumers approximates the uniform distribution from v h = 30 to v h = 60 and t = 20. We numerically checked that for prices (p1 , p2 ) = (33, 28) and (33, 35.5), the unique consumer choice equilibrium demands are (D1 , D2 ) = (6, 7) and (3, 2), respectively. In other words, similarly to the main model setup, our theoretical prediction in this model adaptation to nite consumer number is that when the price of one of the products reduces from 35.5 to 28 and the price of the other product is held constant at 33, the demand for both products increases. Experiment setup. The objective of the experiment was to trace the change in the demand for one product in response to the price change of the other product. Therefore, we kept the price of one product constant at 33 francs, while we changed the price of the other product between 28 and 35.5 francs. The prices were manipulated within participants. In the experiment, we dene three types of consumers, Type 0, Type I and Type II, which corresponded to L, H1 and H2 type consumers, respectively, in our theoretical model. In each experimental session, seven Type I buyers and seven Type II buyers are played by the experiment participants. The purchase decision of the Type 0 buyers was straightforward because their values of matching is dened to be so low that buying neither product is always optimal for them regardless of what

29

they thought about the decisions of the other buyers. Therefore, we automated the 14 type 0 buyers to reduce the number of subjects needed. We recruited 56 undergraduate students from a subject pool of a mid-western US university to participate in four such experimental sessions and paid them a monetary award contingent on individual performance. On average, the participants ended up earning approximately $15. During the experiment, we used a hypothetical currency unit called franc convertible to the dollar payo at the rate of 100 francs per US $1 at the end of the experiment. When participants arrived at the lab, they were given an information sheet describing the purpose of the study. They were told that the study aims to explore how prices aect consumer purchase decisions in a competitive status goods market where consumers use products to signal their type to other consumers. They were then informed that during study they will be given the payo matrix in which their payo from purchasing a status good depends on their and other consumers purchase decisions, and their objective is to make a series of purchase decisions to maximize their payos in the computerized study given the price information presented. After that, participants were told that at the beginning of the study, they have 100 francs each which they can use to purchase one of the two products or neither. Before they started the rst trial of the session, they were informed about the number of buyers of each type in the experiment, their own type (randomized between Type I and Type II), and that the formula for their payos is derived from the inference one can make of their type from their purchase decision given the realized distribution of choices across participant types. Further, the subjects were given written instructions, which included the following: There are three types of buyers: Type 0, Type I and Type II. You are a Type I (II) buyer. There are 14 Type 0 buyers, 7 Type I buyers (including you [if applicable]), and 7 Type II buyers (including you [if applicable]). The type-0 buyers are computerized and never buy either product, while the type I and type II buyers are played by actual people like you. You will be repeatedly presented

30

with prices of two products, and your task is to decide whether to purchase a product, and if so, which one to purchase. In each period, after all buyers make their choice, you will be told the choice of other buyers (the number of Type I and Type II buyers who purchased product 1 and product 2) and you will receive your payo which will be calculated based on the following formula (for this purpose, the computers of all experiment participants communicated with one central computer with the master program): (12) Payo = w1 M1 + w2 M2 P, M0 + M1 + M2

where w1 is your value of matching with Type I buyer, w2 is your value of matching with Type II buyer, M0 , M1 and M2 are the numbers of Type 0, I and II buyers who have made the same purchase decision as you, and P is the price of the product chosen. If you choose not to purchase, P = 0. Type 0 buyers are computerized and always choose not to purchase either product. Type I and Type II buyers are all actual players in this lab. We provided a software calculator to each participant for calculating the payo of Equation (12) conditional on their predictions of purchase decisions of other consumers. After that, they were informed (on the computer screen) about their individual values for w1 and w2 , which were dierent across participants as reported above. They were then told that these values would remain the same until a change was announced. To allow participants to become familiar with the structure of the game, they were required to play ve practice trials. They were told that the purpose of the practice trials are to familiarize themselves with the buttons and the visual presentation of the software and that the results of these trials would not aect anything else. Then the game was restarted for the actual trials that would be counted towards their payos. We kept the prices constant for 20 trials, before we changed one of the prices. After another 20 trials, we restarted the game again switching the type of each participant from type I to type II, and vice versa, and switching the participants values of w1 and w2 from high to low, and vice versa. The participants were told 31

that their weights and types will be re-assigned, but were not told the exact rules of how we switched these values. We then ran another 40 trials under the new setup, again changing one of the prices right in the middle of these 40 trials. The purpose of restarting the game was to allow for more independence between trials: as one can see from the equilibrium predictions, it is the consumers with the lower valuation who are supposed to switch their behavior. For the exact price sequence manipulation in each experimental session, please refer to Table 1. Insert Table 1 about here. As Table 1 shows, the product which price was changed and the price trend whether it was increasing, i.e., when the price of one product increased from 28 to 35.5 francs, or decreasing, i.e., when the price of one product decreased from 35.5 to 28 francs were counterbalanced across the four experimental sessions so that we could test whether our prediction holds regardless of these two factors. At the end of each session, the cumulative payo was calculated in francs and then converted to U.S. dollars, to be mailed to the participants in checks later. Then, the participants were debriefed and dismissed. Data analysis and results. Table 2 reports the average realized demand in each of the four experimental sessions. Insert Table 2 about here. When the price changed from 35.5 to 28 francs for one product, its own demand increased on average from 1.25 to 5.69 units. In other words, the own-price elasticity is negative, which is intuitive and expected. The average demand for the other product with price held constant throughout the experiment also increased from 2.51 to 3.61 units, as predicted by the model. This change is also statistically signicant (F(1,318) = 50.35, p < 0.0001) and consistent with the prediction of Proposition 1. Moreover, as reported in Table 2, when examining the average

32

demand within each experimental session for the product with constant price, we obtained similar results. The signicance level of the demand changes for the product with unchanged price when the price of the other product changes is p < 0.0001, p < 0.001, p < 0.05, and p < 0.01, in the four sessions, respectively. In addition, we ran a regression of the demand for the product with unchanged price as a function of the price level of the other product, while controlling for the price trend (whether it was an increasing trend or not) as well as whether it was product 1 of which the price was changed or not. We nd that the price level of the other product is signicant (t = 7.11, p < 0.0001), with the low price of the other product leading to an average increase of 1.10 units in the demand for the product. Neither of the two control variables, the price trend (t = 1.30, p > 0.1941) and whether it was product 1 of which the price was changed (t = 0.84, p > 0.3993), is signicant. To further understand which consumer type the increased demand is coming from, in each of the 20-trial experiment segment with constant prices, we dene each products consumer type to be the type of consumers predominently associated with this product, i.e., the consumer type which results in the majority of demand for this product. We then split the demand for each product into that coming from its consumer type and that coming from the other consumer type and obtain the following. With a reduction of price from 35.5 to 28 francs, the average demand for the product from its consumer type increased from 1.12 to 5.38 units, and from 0.13 to 0.31 from the other consumer type. At the same time, the average demand for the product with constant price increased from 2.33 to 3.45 unit from its consumer type, while the demand for it from the other consumer type decreased from 0.18 to 0.16 units. In other words, we nd that which consumer type generated extra (or less) demand for each product when one of the products price changed is also consistent with our model prediction. Although the equilibrium of the empirical model makes point prediction about consumer demand, we observed that actual demand varies quite a bit across trials in the experiment.

33

Figure 1 plots the frequency distribution of demand for the product with constant price over 320 trials across the four experimental sessions. Insert Figure 1 about here. In equilibrium, the demand for this product should be three units when the price of the other product is high (i.e., at 35.5 francs). We observe that under this condition, the actual demand for the product ranges from 0 to 7 units, with mean = 2.51 and median = 3. If the price of the other product is low (i.e., at 28 francs), the demand for the product should be six units, based on the prediction of our empirical model. The observed demand ranges from 0 to 6 units, with mean = 3.6 and median = 4. Thus, the actual demand is lower than theoretically predicted. One possible explanation is that not buying may be considered as a safer choice because buying a product could generate negative payo under the structure of the game. Another potential reason for this is related to the question which consumer type should correspond to buying which product. Due to symmetry, there are two equilibria (leading to the same demand predictions): one in which Product 1 is bought only by Type I consumers and one in which Product 1 is only bought by Type II consumers. Thus, in the rst few trials of each experimental session, we normally observed the demand for the lower priced product coming from both Type I and Type II consumers. Such mixed demand decreases the value of the product and therefore the demand for it. Remind that in each experimental session, we ran four sequences of 20 identical back-to-back repeated trials for a given price combination. In the sequences where one of the prices was low (28 francs), the perfect Type/Product correspondence always emerged by the end of 20 repetitions with Product 1 receiving only demand from Type I participants in 5 out of 8 sequences. In the sequences where one of the prices was high (35.5 francs), the perfect Type/Product correspondence emerged in 7 out of 8 sequences with Product 1 receiving demand from Type I in 5 out of these 7 sequences. In two

34

of the experimental sessions, the correspondence, after having been established, actually ipped when price was changed. However, despite the variance in the demand across trials and in the Type/Product correspondence across sequences, we nd that the change in the average demand of the product is qualitatively consistent with the equilibrium prediction of the model. Note that the fact that only slightly more than half of the emerging correspondences (ve-eights to be precise) between consumer type and product number were of the intuitive form (i.e., when product 1 corresponds to Type I), further validates the prediction that asymmetric equilibrium outcome does empirically emerge in an a-priori symmetric setup, and is not necessarily driven by the priming through the way choices are phrased. Also note that the potential dynamics (learning and coordination over time) in our repeated-trial experiment could be seen as reecting a realistic market environment and thus validate the applicability of the static theoretical model to a dynamic marketplace. DISCUSSION AND CONCLUSION While most marketing research is related to utilitarian product categories where consumers derive value from physical product characteristics, consumer spending for socially consumed goods is arguably higher than consumer spending on the utilitarian needs. For example, cost of functional clothing can be a small fraction of what consumers usually spend on clothing. While consumers may have intrinsic preference for style, as Pesendorfer (1995) points out, an indirect evidence that consumers value style as means of aecting other consumers perception of them rather than for its internal value is that people like fashionable clothes when in fashion but dislike them when out of the current style, which means tastes are formed from the perception of use by the desirable segment. This paper shows through a formal game-theoretic model that when value is driven by projecting a certain upscale image as opposed to intrinsic (functional) value, a number of competitive eects are reversed. First, we derive an interesting yet counter-intuitive comparative

35

statics that one products price reduction could lead to increased demand for the competing product. A lab experiment where participants act as consumers and make a sequence of purchase decisions under a game structure similar to our model setup, empirically validates this prediction. Second, based on this comparative statics, we show that in a status goods market, a rm may benet from the entry of a competitor. This result provides an additional justication for co-location of dierent specialty stores. Furthermore, we show that a rm may benet from a competitors cost reduction, and the optimal price response to a price reduction by the competitor is often to increase own price. One of the uncertainties in a status goods market with multiple potential status products available is whether consumers would choose a given product as means of signaling their status to other consumers. Bagwell and Bernheim (1996) show that when the price of a product is reduced below a certain limit, this product may result in consumers dropping it from being considered as a status good. In this case, a price reduction by one manufacturer could benet the other manufacturer by essentially making it the monopolist in the status goods market. However, in this case, the positive correlation between one products price and another products demand would not be observed in equilibrium where rms choose prices because a rm would not choose to reduce the price if doing so would lead to lower demand for its product. On the other hand, in our model, a lower cost makes it optimal for the rm to reduce the price and increase its penetration of the market, and this increased penetration increases consumer valuation for both products, which in turn, helps both rms. In other words, in our model, an equilibrium price reduction of one of the products increases value of each of the products rather than destroys the value of the product with the lower price.

36

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FOOTNOTES
1

See www.slideshare.net/razzy/luxury-car-brand-positionings-by-dan-pankraz?from=share email.

Not surprisingly given this BMW brand image, BMW topped the 2010 ranking of the most desirable brands in China ahead of Apple and Rolex (see http://performancecarpartz.com/?p=222953).
2

Micro-modeling the dependence of the value of a status good possession as coming from its

social function allows us to endognenize the functional form of this value. In particular, such value then exhibits both snob and bandwagon eects (Bagwell and Bernheim, 1996). We also show that this value of other consumers beliefs can be endogenized through a matching game where consumers decide whom to pair up with based on the information they have and receive payos depending on the the type of consumer they have paired up with.
3

Kuksov (2007) also adopts the same denition to analyze the consumer value of brand image

in a horizontally heterogeneous consumer population, i.e., in the market of self-expressive/image products that do not necessarily convey the message of status.
4

Burdett and Cole (1997) demonstrate how a similar argument works with a continuum of

types when potential partners arrive through a Poison process and consumers have a disutility of waiting. In that case, consumers pair up not with exactly the same type but rather the population splits into classes within which consumers end up randomly pairing. Alternatively, Pesendorfer (1995) immediately starts with the assumption that after the consumer purchase decisions, consumers who made the same purchase decision are randomly paired up.
5

The only other (not asymptotically stable) equilibria are: 1) when p1 = p2 , both products

receive demands in equal proportion from both Hj segments and 2) one of the products (the one with the higher price if the prices are not equal) receives zero demand while the other one receives demand from Hj subsegments in equal proportions.
6

For example, this condition trivially holds when the solution of the rst order conditions for

prices leads to prices at most t/2 above the lower of the two rms costs.

42

It is possible to show that the symmetric consumer choice equilibrium above is stable if and

only if this asymmetric one does not exist. The two asymmetric equilibria (mirror of each other), whenever exist, are always stable. However, we will not need to use the asymptotic stability renement for the propositions that follow.
8

Numerical simulation shows that this result holds for asymmetric costs as well. However, we

are unable to prove this analytically.

9

There are many other issues aecting product line decisions, such as the expense the rms have

to incur to communicate product line with the consumer (Villas-Boas 2004), and distribution channel issues (Villas-Boas 1998; Liu and Cui 2010).

43

Table 1: The Sequence of Price Changes in the Experiment (p1, p2) Trial 1-20 Session 1 Session 2 Session 3 Session 4 (33, 35.5) (28, 33) (35.5, 33) (33, 28) Trial 21-40 (33, 28) (35.5, 33) (28, 33) (33, 35.5) Trial 41-60 (33, 28) (35.5, 33) (28, 33) (33, 35.5) Trial 61-80 (33, 35.5) (28, 33) (35.5, 33) (33, 28)

44

Table 2: Average Demand in the Experimental Sessions Product with price change Sessions Price 28 35.5 1 5.75 1.25 2 5.33 1.10 3 5.68 0.90 4 6.00 1.73 All 5.69 1.25 1 3.98 2.25 Product with constant price Sessions 2 3.78 2.43 3 3.13 2.63 4 3.53 2.73 All 3.61 2.51

Notes: the price listed here is the price of the product (in francs) which the price was changed in the experiment. The price of the other product was kept constant at 33 francs.

45

Figure 1: Distribution of Demand for Product with Unchanged Price

70 60 50 Freqency 40 30 20 10 0 0 1 2 3 4 5 6 7 Demand LOWPricefortheOther Product HIGHPricefortheOther Product

46

APPENDIX Proof of Proposition 1. The main text already establishes that when Equations (5) and (6) result in |p1 p2 | < t and vj < vL for j = 1, 2, the solution to the equations denes an equilibrium E0 with demand for product j only coming from Hj segment. Furthermore, since the solution is unique, when vj (v h , v h ), the solution is a unique equilibrium with some but not all consumers of each Hj segment buying product j . To prove the comparative statics part of the proposition, we need to show that the derivative of demand of one of the products, say product 1, with respect to the other price is negative given Equation (2). The derivative of D1 with respect to p1 simplies to (13) 2 (p1 t)[v h + t v h ] D1 m, = p2 [ (v h v h ) (p1 t) p2 ]2 [ (v h v h ) t]

which is negative because: p1 < t would result in v1 < v h ; Equation (1) states v h + t > v h ; the rst term in the denominator is squared, and the second term (14) (v h v h ) t = (v h + t v h ) + 2(v h t) > 0,

since both of the terms in the parentheses above are positive when Equation (2) is satised. To prove that there are no other equilibria with demand for product j coming only from Hj subsegment (i.e., no corner solutions), it suces to prove that as vj changes and v3j is kept to satisfy the solution of the (3 j )-th equation of system (5), the left hand side of the j -th equation changes faster than the right-hand side. Let Gap be the dierence between the left-hand side and the right-hand side of equation on vj . Then we need to show that Gap/vj > 0 for any vj , where the derivative is taken after the solution of the (3 j )-th equation for v3j are substituted for v3j . This would mean in particular that starting from the equilibrium vj , increasing or decreasing vj to the corner solution would not result in the equilibrium inequality conditions hold. Since equations are symmetric, it suces to check this condition for the equation on v1 .

47

Denoting v h v h by , we can express the solution of the equation on v2 as (15) v2part sol = (v h v l + v1 )p2 t(v1 vL ) . p2

Note that this solution is internal (i.e., within (v h , v h )) when p2 < (the solution of Equation (5) implies that given Equation (2), the highest p2 leading to a positive demand is v h /(1 ) < /; for a higher price, one should use v2 = v h instead of v2part sol and then Gap/v1 > 0 as well). Substituting this solution for v2 in Gap and dierentiating the resulting expression with respect to v1 , we obtain (16) (v h v l + t)( t)( p2 ) Gap = , vj [ (v h v l + v1 ) 2 (v1 vL )t]2

which is positive because t > v l = v h v h + v h > v h v h + t > 0, where Equation (2) was used in the rst and last inequality. Proof of Proposition 2. If some but not all H2 -type consumers buy product 2 for some (p1 , p2 ), a marginal change in p2 results in a continuous change in D2 in the opposite direction. Therefore, if c2 decreases and rm 2 did not yet fully penetrate H2 -type consumer segment, rm 2 will nd it optimal to decrease price. As a result, D2 increases, which decreases the value H1 consumers have from not buying either product, and hence, the value they have of either product increases. Since p2 > p1 t/2, the H1 -type consumers still prefer product 1 to product 2. Thus, if the price of product 1 is unchanged, the demand for it increases, which benets rm 1. Note that rm 1 may also nd it optimal to change (increase) its price, but only if doing so further increases its prots. To complete the proof, it remains to note that if all H2 -type consumers already bought product 2, a price decrease is not optimal for rm 2 since it would bring no extra demand. Therefore in this case, 2 increases, but 1 stays the same. Proof of Proposition 3. When no L-type consumers buy the product, possible demand equilibria are already derived in the main text. To show the possibility claimed, consider = 1/4, vL = 1, v h = 2, t = 1, v h = 6, and c1 = 2. In this case, due to c1 > vL , it can not 48

be optimal to attract L-type consumers. Furthermore, when p1 = p2 = p, the consumer choice equilibrium is unique (and with the demand split equally between H1 and H2 -type consumers) when p < 18/7 2.571. One can then compute that the optimal price is pm = 4 m = 13/4 10 0.0877. resulting in the prot of 1 5/2 2.419

The rst-order conditions of the competitive equilibrium with c2 = 2 in this case result in prices p1 = p2 = 89/22 5 267/66 2.807, prots 1 = 2 = (4035 235 267)/1848 0.1055, and demands D1 = D2 = (2 267 19)/7 0.1307. This constitutes an equilibrium, because undercutting this price by t/2 = 1/2 to gain demand from all high-type consumers who buy would result (using the monopoly equilibrium equation) in the prot of 1125/308 101 267/462 0.0804, which is lower than without deviation (and since the optimal monopoly price is higher, further decrease of price would lead to even smaller prots). Thus, given the above parameter values, competitor entry takes away half of the existing consumers, results in overall demand reduction of
Dm D1 Dm

0.20940.1307 0.2094

38%, but benets the

existing rm as it allows the existing rm to take advantage of the higher consumer valuations by raising price.

49