Vertical differentiation, product innovation, and dynamic competition

• Date: 01 July 2020
• DOI: http://doi.org/10.1111/jems.12348
• Author: David P. Baron
• Published date: 01 July 2020

J Econ Manage Strat. 2020;29:635–662. wileyonlinelibrary.com/journal/jems © 2020 Wiley Periodicals, Inc.

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635

Received: 14 January 2019

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Revised: 22 March 2020

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Accepted: 24 March 2020

DOI: 10.1111/jems.12348

ORIGINAL ARTICLE

Vertical differentiation, product innovation, and dynamic

competition

David P. Baron

Graduate School of Business, Stanford

University, Stanford, California

Correspondence

David P. Baron, Graduate School of

Business, Stanford University, 655 Knight

Way, Stanford 94305, CA.

Email: dbaron@stanford.edu

Abstract

This paper presents an infinite horizon dynamic model in which two firms

compete in a market vertically differentiated by the qualities of their products

and consumers have heterogeneous preferences for quality. Given the product

qualities offered, the firms engage in price competition that segments the

market. In each period each firm can spend on product innovation that if

successful increases the quality of its product. Three types of Markov perfect

equilibria are identified. A running–coasting equilibrium exhibits increasing

quality dominance with one firm undertaking innovation and the other

coasting to free ride on the innovation by the first firm. The firm that coasts

can have the larger dynamic payoff, so quality dominance does not imply

payoff dominance. A second is a leap‐frog equilibrium in which the trailing

firm undertakes innovation to leap into the lead. The trailing firm never in-

novates solely to narrow the gap with the leader, so catch up strategies are

never used. In the third both firms undertake innovation, but if both have

innovation successes, product differentiation remains the same and profits are

reduced by the cost of innovation. The rivalry between Intel and AMD in

microprocessors for personal computers provides a motivating example.

KEYWORDS

coasting, dynamic equilibria, leap frogging, product innovation, running, vertical differentiation

1|INTRODUCTION

Vertical product differentiation allows firms to segment a market and reduce the intensity of price competition. Over

time firms can innovate to improve their products and affect the extent of product differentiation, where innovation

success is uncertain and realized in the future. This paper considers firms that choose dynamic innovation strategies

that determine their positions in a vertically differentiated market. Using a textbook model (Tirole, 1988) in which all

consumers prefer higher to lower quality but to different degrees, innovation competition is generally not a race to be

the quality leader. Instead, one firm can innovate and the other coast and free ride on the increased product differ-

entiation provided by the innovator. Moreover, the firm that coasts can have higher profit than the leader both because

of a higher market share and because it avoids the cost of innovation. The leader thus has increasing dominance in

quality but not necessarily in profit. This paper characterizes the equilibria for a duopoly in a vertically differentiated

market with opportunities for innovation and examines the implications for management strategy.

Vertical product differentiation is a feature of many if not most markets where consumers prefer more to less of a

product attribute such as quality but differ on their willingness to pay for that attribute. In contrast to process

innovation where all firms have an incentive to innovate to lower their own cost, product innovation is directed at the

demand side of the market with innovation by one firm directly affecting the performance of the other firms through

product differentiation. Examples of vertically differentiated products include Tesla and Bolt, Uber and taxis, In‐N‐Out

Burgers and McDonald's, Keurig and preground coffee, Whole Foods and Safeway, hardwood and laminate flooring,

Laser Jet and ink jet printers, custom and modular homes, paver stone and asphalt driveways, and so on. Vertical

product differentiation need not be tangible. Baron (2009) provides a positive theory of moral management in which

two firms produce an identical product with one firm maximizing profit and the other exercising social responsibility in

the sense of voluntarily mitigating a negative externality. Consumers value or have warm glow preferences for the

mitigation, allowing the socially responsible firm to charge a higher price for its product.

Vertical differentiation often has multiple dimensions as with cell phones that differ in size, internet connectivity,

battery life, cameras, apps, and so on, and vertical differentiation can be accompanied by horizontal differentiation.

Vandenbosch and Weinberg (1995) cite the example of Signode, which was the leader in the metal strapping industry in

terms of both product quality and service quality. Even with multiple product attributes, there may be a principal

dimension on which competition takes place. Vandenbosch and Weinberg (1995) characterize equilibria for a single

period, two‐attribute model, and for the case in which costs do not depend on product qualities, they find that the firms

choose the same quality on one dimension and maximally differentiate on the other. Lauga and Olie (2011) provide a

full characterization of the two‐attribute case with positive marginal quality costs and identify additional equilibria.

When marginal quality costs are not too high, the firms maximally differentiate on one dimension and minimally

differentiate on the other. To focus on product competition through innovation, this paper considers a market with a

single product attribute, which can be thought of as the dimension on which firms have an incentive to maximally

differentiate their products.

In the model consumers sort based on their preferences for product quality and the prices charged by the firms.

Firms can undertake product innovation that if successful increases quality and the willingness to pay of consumers.

Innovation strategies include a catch up strategy where a firm that trails in quality attempts to close the gap between it

and the market leader, a leap frog strategy where the trailer innovates to become the market leader, and running and

coasting strategies where one firm undertakes product innovation and the other coasts. If both firms undertake

innovation, the competition can take the form of a race.

A leap frog equilibrium is possible if a successful innovation allows the trailing firm to increase product differ-

entiation. The trailing firm may attempt a breakthrough innovation, which if successful allows it to leap into the lead.

Examples include Apple leaping past Motorola, Nokia, and Research in Motion in cellular telephones, Sony leaping

ahead of other TV manufacturers such as RCA and Westinghouse, and Toyota leaping past U.S. auto makers in quality.

The incentive for the trailer to innovate is strongest when the current quality difference is small and the increment to

quality from a successful innovation is large. If the trailer successfully innovates, the former leader has no incentive to

innovate if a successful innovation would reduce product differentiation and intensify price competition. If both firms

innovate, they may gain nothing if both succeed, because product differentiation remains unchanged and each firm has

incurred the cost of innovation. This risk provides a disincentive to engage in a quality race. Racing occurs in the model

considered here only when the available innovation opportunities are very attractive.

The duopoly in the market for microprocessors for personal computers (PCs) is representative of the situation

considered here with AMD and Intel having 95% of the market with little threat of entry. Intel has held over two‐thirds

of the market and been the quality leader with AMD occasionally taking the lead. Quality is measured by micro-

processor speed, and innovation is measured by the increase in speed. As Moore's law suggests innovation opportunities

have been continuously available.

Throughout the period studied, AMD was led by the flamboyant Jerry Sanders, who was committed to an in-

novation race with Intel and its CEO Andy Grove. Sanders said, “You just can't let the bad guys win. I believe in our

business, for all of the achievements and contributions Intel has made, they're the bad guys. They don't want com-

petition …I think justice should triumph.”

1

AMD's profit was flat during most of this period and its stock price was little

changed for a decade until it struck success with its Athlon microprocessor (and the dotcom bubble arrived). Intel's

profits grew but were suppressed by competition from AMD.

A central question is whether AMD was in a racing equilibrium or whether its strategy was driven by Sanders,

where coasting in the lower end of the market would have been more profitable not only for AMD but also for Intel.

Goettler and Gordon (p. 1149) report that AMD's innovation spending as a percent of sales was more than twice that of

Intel, although Intel spent over four times as much as did AMD. Goettler and Gordon estimate that AMD's presence in

the market reduced Intel's rate of innovation by 4.2%. The model considered here allows a characterization of the effect

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