Entering New Markets in the Presence of Competition: Price Discrimination versus Cannibalization

• Published date: 01 June 2015
• Author: Ralph Siebert
• DOI: http://doi.org/10.1111/jems.12091
• Date: 01 June 2015

Entering New Markets in the Presence of

Competition: Price Discrimination versus

Cannibalization

RALPH SIEBERT

Department of Economics

Krannert School of Management,

Purdue University and CESifo

403 West State Street,

West Lafayette, IN 47906-2056

rsiebert@purdue.edu

This study focuses on firms’ optimal entry strategies in new markets when products are differ-

entiated in quality. We are interested in investigating how many products of different qualities

firms should introduce into an empty market. One profitable strategy is that firms introduce

multiple products to proliferate the product space such that entry by competitors is deterred.

Our results show that firms’ optimal strategy to enter new markets is described by introducing a

single product only. Firms differentiate their products not only toward their rivals’ products to

soften price competition, but also toward their own goods in order to avoid cannibalizing their

own (high quality) product demand.

1. Introduction

The introduction of products into new markets is an important topic and has received

considerable attention in the management and economics literature. One profitable

strategy to enter an empty market is to proliferate the product space in order to discrim-

inate among consumers and to prevent entry by competitors. However, we frequently

observe that firms adopt a common strategy to enter new markets in which products

substantially differ in quality. Many times, firms enter new markets with a single

product, instead of introducing multiple products of different qualities. Beyond the

fact, that firms introduce only one product, they also differentiate their product quality

rather than competing head to head. This phenomenon is extensive in electronics and

telecommunications markets, where technological progress stimulates the introduction

of new products. For instance, Sony frequently enters a new high-tech market with a

high-quality product, whereas Magnavox often introduces a good with lower quality

for a lower price. Other prominent examples that are characterized by a similar entry

pattern are cell phones, cameras, laptops, HDTVs, and tablets. A similar entry behavior

applies to hotel and restaurant chains, which frequently enter local markets with a single

branch, opposed to introducing multiple branches. Hence, they prefer to locally disperse

between different local markets rather than to concentrate within markets. Ron Shaich,

the CEO of the Panera Bread restaurant chain, remarked: “Rather than succumbing to

I am grateful to Yeon-Koo Che, Heidrun Hoppe, Dan Kovenock, Massimo Motta, William Novshek,

Lars-Hendrik Roeller, Armin Schmutzler, Daniel Spulber, Christian Wey, two anonymous referees and the

associate editor for helpful comments and suggestions. All remaining errors are my own.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 369–389

370 Journal of Economics & Management Strategy

product proliferation.....think about how to best use your menu to drive competitive

advantage” (see Nations Restaurant News, 2010; Barroso and Giarratana, 2013).

To summarize, we rarely observe that a firm simultaneously introduces multiple

products of high quality, or multiple products of low quality, or a mixture of low quality

and high-quality products when entering new markets. The question arises, why do

firms introduce only a single product of a certain quality into a new market instead of

introducing multiple products of different qualities?1

This study examines firms’ incentives to introduce new products of different qual-

ities into new markets. Up to date, little is known about multiple firms having the

opportunity to introduce multiple products of different qualities into a new market. We

are not aware of any study that focuses on firms’ optimal product line decisions when

entering new markets characterized by vertical product differentiation.

Previous studies mostly focused on multiproduct monopolists or multi-

ple single-product firms when analyzing firms’ product line decisions (see also

the literature review in Section 2). Two relevant incentives have been highlighted which

determine firms’ optimal product lines. First, the incentive to increase demand and to

charge higher prices for specific products by proliferating the market in order to better

price discriminate among consumers with different characteristics. On the contrary,

more products introduced into the market increase price competition and lower profit

margins. Hence, in order to soften price competition in the market, firms have an

incentive to differentiate their products from their competitors’ products.

We establish a simple game-theoretic model in which two firms face an empty

market and have the choice to simultaneously introduce multiple products of different

quality into a new market. Firms compete in prices in the product market. Hence,

strategic decisions on product qualities and prices play an important role in our study. At

first glance, we may think that introducing multiple products to proliferate the product

space is a profitable strategy as it allows to discriminate among consumers and deters

entry by competitors. On the contrary, introducing multiple products cannibalizes own

demand (see Aron and Lazear,1990; Moorthy and Png, 1992; and Hui, 2004). Some of the

high-end consumers who first considered buying the high-quality product will switch

and buy the product with lower quality. Hence, the low-quality product cannibalizes

the own high-quality product demand. Moving the two product qualities further apart

from each other alleviates cannibalization. Because this study focuses on an oligopolistic

market, it is not obvious whether the cannibalization effect is restricted toward adjacent

product qualities, or if it also applies to nonneighboring products, that is, the opponent

offers a product in-between both neighboring products. Finally, introducing multiple

products intensifies price competition in the market as it adversely effects the prices of

other products. Therefore, price competition is not limitedtoward own products but also

has an impact across firms’ product lines. To summarize, a firm’s decision on optimal

product offerings becomes more complicated once we account for strategic interactions

1. It should be emphasized at this point that the aim of this paper is to explain firms’ strategies to enter

new markets, rather than introducing new products in existing markets. This objective does not necessarily

conflict with the observation that firms eventually introduce further products into the market as time elapses

and as markets mature. The introduction of further products into a matured market is often explained by

multiproduction effects on the demand side and the supply side. Examples for multiproduction effects onthe

demand side are reputation effectsthat spill over between brands within a firm and increase product demand.

Multiproduction effects on the supply side describe benefits in production such as economies of scope. For

the purpose of isolating different demand and price competition effects in this study, and to keep this analysis

analytically tractable, we abstract from those arguments. Wereturn to this point at the concluding remarks of

this study.