Product Quality, Service and Pricing

Abstract

Problem Definition: In this paper we develop a unified framework to investigate firms' joint decisions on product quality, price and ancillary service, when they offer a line of products to consumers in a variety of monopolistic and competitive environments. Academic/Practical Relevance: Product quality, price and its ancillary service, such as product warranty and shipping service, are arguably the most important factors consumers consider when purchasing a product. Meanwhile, they are also among the most commonly-used instruments for firms to differentiate consumers and achieve better market segmentation. However, the literature is void of study on the joint decisions on product quality, price and ancillary service under consumer choice behavior. Methodology: We adopt the widely used multinomial logit choice model to formulate consumer choice behavior among substitutable products in the presence of ancillary service. Optimization and game-theoretical analysis are employed. Furthermore, we show that the multi-product problem can be reduced into one-dimensional analyses for each product as if they were isolated, leading to tractable analytical solutions. Results: Quality of each product should be set at a level such that the marginal utility for consumers is equal to the marginal cost to the firm, independent of the decisions on other products, whereas the pricing decision should take into account all other products. Consumer surplus surprisingly increases when the firm decides on both, product prices and quality levels, compared to when it decides only on prices or quality levels. When an ancillary service is available, we show that the firm should only attach it of charge to high-margin products, only when the utility of the service to the consumers exceeds the cost to the firm. Nevertheless, the free service is not because the firm actually passes its entire cost onto consumers by charging a higher price. Interestingly, consumers are still better off in this case. Managerial Implications: Regardless of product substitution, price competition or the availability of an ancillary service, the quality of each product can be optimally determined in isolation. Ancillary service is an effective strategy for firms to segment markets and improve profit, however, it has pricing implications.