The effect of exogenous product familiarity on endogenous consumer search

Abstract

When a consumer is familiar with one product but not its competitor, she is faced with a decision: either buy what she knows, or engage in search to learn more. When search is costly, competing firms may attempt to encourage or discourage search by adjusting prices. In this paper we consider how competitive dynamics between two quality differentiated firms are affected if one product enjoys a familiarity advantage. Familiarity is defined as a consumer’s ex-ante knowledge of fit for a particular product. An increase in the level of familiarity for one product allows a firm to charge higher prices since there are more consumers with information on that product relative to the competition. We call this the direct effect of familiarity. However, an increase in familiarity also has an indirect effect, since it gives the rival firm a stronger incentive to decrease price in order to encourage searching, in turn increasing overall competition. The effect of familiarity on profits depends on the magnitudes of these effects, and it is moderated by the level of quality differentiation between products. For very high or very low levels of differentiation, the results are relatively straightforward. However, when the level of differentiation is moderate, the results are more nuanced, with the higher-quality firm realizing higher profits from more familiarity, even if it must lower prices due to the indirect effect. We also find that, contrary to conventional wisdom, overall competition may be higher when firms are more quality differentiated. This is driven by the fact that higher quality differences bolster the indirect effect, with a lower quality firm providing deeper price cuts to counter increased familiarity of a high quality rival. We conclude by examining how changes in the cost of searching impact equilibrium outcomes.