Entry decisions for vertically differentiated markets with brand spillovers

Abstract

When a branded firm offers a new product at a quality level different from that of its existing product(s), some bias is often present as consumers are affected by the quality of the existing product(s) when evaluating the quality of the new one(s). Consequently, this product offering creates a forward spillover effect and, in turn, might even impact consumers’ utility from the existing product, referred to as the reciprocal spillover effect. Given the potential for such brand spillovers, how should a branded firm enter a new market with a vertically differentiated product? We analytically investigate a branded firm’s choice of quality and the profitability of entering a new market.The results indicate that bilateral spillovers cause the entrant to fail to adjust the quality of its new product, meaning that a new firm providing a high-end existing product entering the market will not be profitable, even in the absence of any fixed entry costs and potential competitors. Nevertheless, we also show that when the new market has a rival firm, the potential presence of severe spillovers works as a commitment device for the entrant’s quality positioning, which can reverse the entrant’s incentive to enter; in contrast, the entrant’s resulting profits can be greater in this case than in the absence of spillovers.