When and How Should Firms Differentiate? Quality and Advertising Decisions in a Duopoly

Abstract

A prominent hallmark of competitive interaction is the desire to differentiate from rivals. In this article, the authors examine under what conditions firms will differentiate through product quality versus advertising intensity. Firms select quality in a first stage, advertising in a second stage, and price in the last stage. The probability that a consumer is informed of a firm’s offering depends on its advertising expenditure. The authors find that when advertising is not cost effective, both firms choose a light ad spending. This allows them to minimally differentiate in quality without concern of intense price competition, as each firm has a segment of “captive” consumers. When advertising is moderately cost effective, one firm spends heavily on advertising. The rival advertises lightly, while choosing the same maximal quality level. This strategy softens price competition by inducing the heavy advertiser to price high more often to capitalize on its large captive segment. When advertising is very cost effective, both firms advertise heavily and differentiate in quality. Three extensions are examined: upfront fixed quality costs, continuous advertising levels, and simultaneous advertising and pricing decisions. This research reveals that letting market awareness be determined endogenously suggests less product differentiation than previously suspected and regions of advertising differentiation.