Which is better for competing firms with quality increasing: behavior-based price discrimination or uniform pricing?

Abstract

With the prevalence of subscription service model (i.e. Software-as-a-service, SaaS), firms are able to continuously improve their service quality online. Besides, subscribers need to renew their services after each subscription period, which provides more convenience for firms to implement behavior-based price discrimination (BBPD), namely, charging different prices for the repeat customers and for the rival's customers. Firms can respond to the rival's BBPD by adopting BBPD or by adopting uniform pricing (UP) and with a higher service quality. In this paper, we study the choices of competing firms’ pricing strategies in a two-period duopoly market when both firms can improve their quality in the second period. We consider firms’ asymmetric capability to improve their service quality and find that this asymmetry plays a critical role in determining firms’ pricing strategies. With exogenous quality improvement levels, we find that when two firms’ quality improvement difference is small, multiple equilibria prevail, namely, both adopt BBPD or both adopt UP in equilibrium. When the quality improvement difference is moderate, the asymmetric case where the disadvantaged firm adopts BBPD while the advantaged one adopts UP prevails in equilibrium, which is a unique finding absent in the previous literature. When the quality improvement difference is large, both firms will adopt UP in equilibrium, but both firms can be better off by adopting BBPD when the quality improvement difference exceeds a threshold, which is a win-win situation but a prisoner's dilemma game different from the previous studies. By examining industry profit, consumer surplus and social welfare, we find that firms’ interests are usually not aligned with the social planner's interests, and the social planner's interests are not always aligned with consumers’ interests. With endogenous quality improvement choices, the firm with R&D cost advantage tends to make a greater quality improvement, and the asymmetric case where firms adopt different pricing strategies disappears due to the impact of endogeneity of quality improvement. More specifically, when the R&D efficiency difference is small or moderate, both firms will adopt either BBPD or UP in equilibrium; but when two firms’ R&D efficiency difference is large, both firms will tend to adopt only UP in equilibrium. Comparing with the case under exogenous quality improvement levels, the social planner's interests are better aligned with the overall industry's interests but are worse aligned with consumers’ interests.