People often use price as a proxy for quality, resulting in a positive correlation between prices and product liking, known as the “price– quality” (P–Q) heuristic. Using data from three experiments conducted at a winery, this article offers a more complex and complete reference-dependent model of the relationship between price and quality. The authors propose that higher prices set higher expectations, which serve as reference points. When expectations are met or exceeded, we observe the familiar P–Q relationship. However, when price is high and quality is relatively low, the product falls short of consumers’ reference point and the P–Q relationship is reversed; thus, people evaluate a low-quality product with a high price more negatively than a low-quality product with a low price. Using the results of a field experiment, the authors discuss implications for pricing considerations and profitability.

W e study a duopoly model where consumers are heterogeneous with respect to their willingness to pay for two product characteristics and marginal costs are increasing with the quality level chosen on each attribute. We show that although firms seek to manage competition through product positioning, their differentiation strategies critically depend on how costly it is to provide higher quality. When the cost of providing quality is not too high, firms use only one attribute to differentiate their products: they maximally differentiate on one dimension and minimally differentiate on the other (a Max-Min equilibrium). Furthermore, they always differentiate along the dimension with the greater attribute range. As for the dimension with the smaller range and along which they agglomerate, firms either choose the highest quality level or the lowest quality level possible, depending on whether the marginal costs of quality provision are low or intermediate, respectively. However, for larger quality provision costs, firms exploit both dimensions to differentiate their products. In particular, we characterize a maximal differentiation equilibrium in which one firm chooses the highest quality level on both attributes while its rival offers the lowest quality level on both attributes (a Max-Max equilibrium). We discuss the managerial implications of our findings and explain how they enrich and qualify previous results reported in the literature on two-dimensional differentiation models.

We model a duopoly in which ex ante identical firms must decide where to direct their innovation efforts. The firms face market uncertainty about consumers' preferences for innovation on two product attributes and technology uncertainty about the success of their research and development (R&D) investments. Firms can conduct costly market research before setting R&D strategy. We find that the value of market information to a firm depends on whether its rival is expected to obtain this information in equilibrium. Consequently, one firm may forgo market research even though its rival conducts such research and learns the true state of demand. We examine both vertical and horizontal demand structures. With vertical preferences, firms are a priori uncertain about which attribute all consumers will value more. In this case, a firm that conducts market research always attempts innovation on the attribute it discovers that consumers prefer and expends more on R&D than a rival that has not conducted market research. With horizontal preferences, distinct segments exist—each caring about innovation on only one attribute—and firms are a priori uncertain how many consumers each segment contains. In this case, a firm that conducts market research may follow a strategy and attempt innovation to serve the smaller segment to avoid intense price competition for the larger segment. A firm that conducts market research may therefore invest less in R&D and earn lower postlaunch profits than a rival that has forgone such research.new product development, market research, innovation, differentiation, segmentation

We study how user-generated content (UGC) about new products impacts a firm's advertising and pricing decisions and the effect on profits and market dynamics. We construct a two-period model where consumers value quality and are heterogeneous in their taste for the new product's positioning and examine three information-transfer structures across generations: no information (benchmark), average rating (AR), and the joint distribution of ratings and taste locations (reviews). First, we show that in the AR case, the firm advertises to a smaller set of consumers and prices higher relative to the other cases. This occurs because the firm has an incentive to use advertising strategically to bump up the first-generation average rating in order to increase second-generation quality perceptions. The firm charges a higher first-period price as consumers who are relatively close to the product's location are advertised to. Second, we find that as more information is transferred across generations, there is a greater likelihood that average ratings will exhibit an increasing pattern over time. This happens because with reviews, second-generation consumers are able to base purchase decisions on the product's positioning in addition to its quality. Interestingly, because of the firm's narrower advertising strategy in the AR case and the richer UGC in the reviews case, average ratings will exhibit a reversal over time: higher in the AR case in the first period but higher in the reviews case in the second period. Third, a firm's expected profits can exhibit a nonmonotonic relationship with respect to the amount of UGC transferred: highest in the AR case if the marginal return on advertising is high (e.g., when advertising is cheap to execute, consumers are insensitive to product fit or consumers greatly value quality) but highest in the reviews case when the return on advertising is low. We then examine a setup whereby second-generation consumers become aware of the product through social interaction with first-generation buyers. We find that advertising and social contagion interact: the firm generally has a greater incentive to advertise as homophily increases, that is, as social interactions occur between consumers who more likely share similar preferences. However, this pattern can reverse with reviews. This paper discusses several robustness checks and model extensions and concludes by highlighting the managerial implications of the results. This paper was accepted by Matthew Shum, marketing.