Differentiate or Imitate?: The Role of Context-Dependent Preferences

Abstract

Conventional wisdom, derived from standard economic theory, is that affirm should differentiate itself from its rivals to mitigate intense price competition. Yet there are many examples of firms positioning themselves to mimic their rivals. In this paper we examine the role of context-dependent preferences in explaining this phenomenon. Behavioral researchers have long argued that consumers consider not only the absolute utility of a product but its utility relative to a reference in the choice set as well. Using this premise we construct a game theoretic model of competition between two firms. We consider two horizontally differentiated firms where some consumers own the product of one firm while the rest own the other firm's product. One firm upgrades its existing product by adding a new feature. In the absence of any cost or capability constraints, to protect its competitive position, the other firm would prefer to update its product by adding a differentiated new feature. We show that if consumers' preferences are context-dependent, then under some conditions the second mover would tend to imitate the first mover by adding the same feature even when with no cost disadvantage it can differentiate itself. This happens because context-dependent preferences cause consumers to dislike brands that are very differentiated from one another and value common features among the brands more than distinct features. As a result of this, when consumers exhibit context-dependent preferences and the proportion of second-mover's consumers who enjoy the first mover's new feature is not too small, if the second mover mimics the first mover both firms can charge higher prices for their upgraded products. This outcome, in turn, leads the first mover to pick a new feature to upgrade its existing product such that it would encourage the second mover to imitate itself. Therefore, unlike the extant literature, our analysis shows that mimicking/co-location does not necessarily require a tradeoff between higher demand and lower prices.