Product Differentiation Advantages of Pioneering Brands
`
`By RICHARD SCHMALENSEE*
`
`This essay presents and explores a rela-
`tively simple market model in which rational
`buyer behavior in the face of imperfect infor-
`mation about product quality can give long—
`lived advantages to pioneering brands. The
`analysis has some implications for the varia-
`tion in the strength of such advantages across
`markets with different basic conditions. Twe
`sorts of evidence provide the motivation for
`this research.
`First, Joe Bain’s seminal empirical study
`of conditions of entry led him to conclude
`that “the advantage to established sellers
`accruing from buyer preferences for their
`products as opposed to potential entrant
`products is on average larger and more fre—
`quent in occurrence at large values than any
`other barrier to entry” (p. 216). Treating
`advertising as a proxy for product differenti-
`ation, a large literature has attempted to test
`this assertion by relating advertising to prof~
`itability in cross section.1 It is interesting to
`note, however,
`that Bain concluded that
`advertising was not the main force at work:
`
`seem to
`these things might
`All of
`the existence of fundamental
`suggest
`technical considerations,
`institutional
`developments, and more or less funda-
`mental consumer
`traits which make
`possible or even very probable the de—
`velopment of strong and stable prod-
`uct—preference patterns. They may also
`
`*Professor of applied economics, Sloan School of
`Management, Massachusetts Institute of Technology. I
`am grateful to the US. Federal Trade Commission for
`its support of this research. I am also grateful for helpful
`comments to Steven Salop, a referee,
`the managing
`editor, and seminar audiences at MIT, Chicago, Harvard,
`Princeton, Rochester,
`the Department of Justice,
`the
`Federal Trade Commission, and the Santa Barbara and
`San Diego campuses of the University of California.
`Naturally, only I can be held accountable for this essay’s
`shortcomings and the opinions it expresses.
`1William S. Comanor and Thomas A. Wilson and
`Harold Demsetz provide interesting overviews of this
`literature; see also my forthcoming essay, especially
`Section 3.
`
`suggest that advertising per se is not
`necessarily the main or even the most
`important key to the product differ-
`entiation problem.
`[p. 143]
`
`Bain did not explicitly describe any mecha-
`nism by which product differentiation ad-
`vantages might be created, but a number of
`his remarks pointed toward buyer uncer-
`tainty about product quality as centrally
`involved.2
`Second, conventional wisdom in market—
`ing and scattered recent empirical research
`support the notion that there are important
`advantages to being the first entrant in some
`sorts of markets. Marketers usually predict
`little success for “me too” brands,
`those
`claiming to be identical to established brands
`but selling at a lower price.3 The success of
`generic and private—label brands of some
`consumer products makes it clear that the
`strength of any handicap under which such
`brands operate must vary considerably across
`markets of different sorts. Ronald Bond and
`
`David Lean (1977, 1979) find that important
`and long-lived advantages are enjoyed by
`pioneering brands of prescription drugs,
`advantages that can be overcome by later
`entrants only if
`they offer distinct
`ther-
`apeutic benefits, not just lower prices. Ira
`Whittin’s study of cigarette market segments
`points in this same direction, as do the
`cross-section analysis of marketing costs by
`Robert Buzzell and Paul Farris, and the study
`of order-of—entry effects reported by Glen
`Urban and his associates.
`
`The next section describes the assumptions
`and notation employed and outlines the
`analysis of Sections II—V. Buyer learning
`about quality takes place over time, so that
`buyers and sellers generally face dynamic
`decision problems when quality information
`
`2See pp. 116, 140, and 142, as well as other discus-
`sions in ch. 4.
`3For typical statements, see Kenneth Runyon, p. 214,
`or J. O. Peckharn.
`
`349
`
`
`
`Copyright © 2001 All Rights Reserved
`
`Argentum Pharm. LLC V. Alcon Research, Ltd.
`Case IPR2017-01053
`
`ALCON 2068
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`350
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`THE AMERICAN ECONOMIC REVIEW
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`JUNE 1982
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`is incomplete. In order to render those prob-
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`lems more or less tractable, a number of
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`rather drastic simplifying assumptions are
`made. Like most exercises in economic the-
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`ory, this analysis should thus be thought of
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`as a parable illustrating a general principle,
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`not as a literal description of any particular
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`piece of reality.4 The findings and some of
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`their implications for research and for public
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`policy are summarized in Section VI.
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`1. Assumptions and Notation
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`Consider a narrowly defined product class,
`like freeze-dried instant coffee or stainless
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`steel razor blades, such that individual con-
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`sumers can be sensibly modeled as using at
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`most one brand in the class at any instant. It
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`is assumed for simplicity that brands in this
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`class either “wor ” or “don’t work”;
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`either perform as a brand in this class should,
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`or they fail to perform acceptably. This makes
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`it possible to describe uncertainty about the
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`quality of a new brand by a single parame-
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`ter, the subjective probability that it won’t
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`work. It is assumed that these products are
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`what Phillip Nelson (1970) christened “expe-
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`rience goods,” so that the only way a con-
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`sumer can resolve uncertainty about quality
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`is to purchase a brand and try it. One trial is
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`both necessary and sufficient to determine
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`whether or not any single brand works.
`Consumers differ in their valuation of
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`products in this class. Let the function Q(v),
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`0 < v < V, give the number of consumers
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`willing to pay at least 1) for a brand in this
`class that is certain to work. Each consumer
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`values a unit that doesn’t work at —- qbo, with
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`<1) a nonnegative constant. (One might have
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`<1) > 0 for a bleach that could ruin clothes, for
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`instance.) Consumers are perfectly informed
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`4A number of related works deserve mention here.
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`Christian von Weizsacher, ch. 5, considers a basically
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`competitive model of this sort of situation. The Bond
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`and Lean (1979) model of first-entrant advantages relies
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`heavily on assumptions about buyers’ response to ad-
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`vertising. Cecelia Conrad presents a dynamic model
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`resembling mine in some aspects, but she neglects the
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`first brand’s problems of getting buyers to learn about
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`it. The development here traces its ancestry to the
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`simple model in the Appendix of my 1979 article. Carl
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`Shapiro’s recent work has a number of formal similari-
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`ties to mine.
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`except about product quality, so that neither
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`informative nor persuasive advertising oc-
`curs.
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`The time between purchases is assumed
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`constant and equal to one period, so that
`trial of a new brand consumes the entire
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`normal interpurchase time. This assumption
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`can be altered without changing the basic
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`results, as long as the cost of learning about
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`a new brand’s quality is not made negligible
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`relative to current and expected future unit
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`price. Let the one-period discount rate, as-
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`sumed the same for all consumers, be r. All
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`else equal, more frequent purchase implies a
`smaller value of r. Consumers are assumed
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`to be risk neutral, to have infinite horizons,
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`and to behave rationally in a sense to be
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`made precise shortly.
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`The analysis below considers a two-stage
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`scenario. In the first stage, a pioneering brand
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`enters the market and attains steady-state
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`equilibrium. I have in mind here the first
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`appearance of a distinctly new product, like
`stainless steel razor blades. It is assumed that
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`the first brand actually works for all buyers.
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`If buyers knew enough about the costs of
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`producing working and nonworking brands,
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`they
`and if they were very sophisticated,
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`might attempt to infer the pioneering brand’s
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`quality from its price or simply from its ‘
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`existence. It avoids serious game-theoretic
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`problems and does little violence to reality,
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`especially in the case of new products, to
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`assume that buyers do not have enough in— .
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`formation to behave in this fashion.5 Instead,
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`it is simply assumed that prior to the intro-
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`duction of the first brand, all consumers ‘
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`have subjective probability 7 that it will not
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`work, and all act to maximize the discounted
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`value of expected utility. Trial of a new .
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`brand of unknown quality yields both an
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`immediate utility payoff and information,
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`the value of which depends on future prices
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`of the brand. Section II analyzes the first
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`5My 1978 article defends neglect of such signalling
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`considerations in this general context. This assumption
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`and the assumption that information sources such as
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`word-of—mouth do not exist seem most plausible when
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`quality is subjective, so that consumers can disagree
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`about whether a brand actually works. In the interests
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`of simplicity, I have not attempted to incorporate this
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`sort of preference heterogeneity explicitly.
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`.
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`

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`VOL. 72 N0. 3
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`SCHMALENSEE: PRODUCT DIFFERENTIATION 0F BRANDS
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`351
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`brand’s pricing problem under the extreme
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`assumption that buyers have static expecta-
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`tions about prices. Section IV examines the
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`implications of the polar opposite extreme
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`assumption of perfect foresight. Neither as-
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`sumption is especially attractive, but
`to-
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`gether they should at
`least bound actual
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`buyer expectations.
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`In the second stage of the scenario consid-
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`ered here, a second, objectively identical
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`brand appears on the market. Innovation is
`ruled out in order to focus on the effects of
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`order of entry and on related barriers to
`imitation. The second brand is also assumed
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`to have exactly the same cost structure as the
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`first. Two additional simplifying assump—
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`tions are made. First, it is initially assumed
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`that the second brand is subjectively identi-
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`cal to the first at the introductory stage, so
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`It
`that
`the same value of
`7r applies.
`is
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`straightforward to relax this assumption, and
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`this is done in Section V. Second, it is as—
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`sumed that the first brand does not change
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`prices in response to entry and that the sec-
`ond brand knows this in advance. This is a
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`much more passive response to new competi-
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`tion than is usually considered plausible.6 In
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`an undifferentiated world,
`this behavior
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`would permit the second brand to undercut
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`the first by an arbitrarily small amount, steal
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`all the first brand’s customers, and duplicate
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`its profit performance. Regardless of cost
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`conditions, it would thus make it impossible
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`for the first brand to earn positive profits
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`without attracting new entry. Despite this
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`assumption, it is shown below that the addi-
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`tion of uncertainty about quality can make a
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`profitable pioneering brand immune to sub-
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`sequent entry. This assumption permits us to
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`avoid (at least in this essay) modeling the
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`complicated dynamic game between the first
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`and second brands that would be played
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`after the latter’s entry.7
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`Section III analyzes the second brand’s
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`pricing problem for the case of static expec-
`tations and demonstrates that brand’s order—
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`GSee, for instance, Avinash Dixit and the references
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`he cites.
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`7Conrad’s paper illustrates the seriousness of these
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`complications. It may be necessary to make basic changes
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`in the model presented here in order to obtain a tracta—
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`ble post-entry game.
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`of—entry disadvantage. Section IV shows that
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`our basic conclusions are equally valid in the
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`polar opposite extreme case of perfect buyer
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`foresight. The consequences of relaxing the
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`assumptions that buyers assign the same ini-
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`tial probability of inadequacy to both first
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`and second brands, that they know for cer-
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`tain the value to them of a working brand,
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`and that purchase is necessary to get infor-
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`mation about quality are explored in Sec-
`tion V.
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`In my forthcoming essay, this basic setup
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`is analyzed under the assumption that buyers
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`correctly expect sellers never to change price.
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`This very ad hoc pricing restriction drasti-
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`cally simplifies the model and turns out not
`to alter the basic nature of its conclusions.
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`Since both brands actually work, each sells
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`forever to those consumers who try it when it
`is introduced and to no others. Both brands
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`then have well—defined demand curves, with
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`the second brand’s curve depending on the
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`first brand’s price. It is shown that the sec-
`ond brand’s demand curve has the first
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`brand’s price as its intercept. It coincides
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`with the first brand’s demand curve only for
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`prices distinctly below the first brand’s price.
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`This means that with economies of scale, the
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`(common) long—run average cost schedule can
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`lie everywhere above the second brand’s de-
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`mand schedule even though the first brand is
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`earning positive profits. The analysis below
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`obtains essentially the same results without
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`restricting price changes. Since the second
`brand’s demand curve turns out not to be
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`easily defined in general, however, there does
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`not seem to be a simple graphical description
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`of the second brand’s disadvantage.
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`II. Pricing the Pioneering Brand
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`In this section and the next, buyers have
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`static expectations;
`they expect the most re-
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`cently observed price to hold forever, even if
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`price has changed in the past. Suppose that
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`in order to try a new brand, a consumer
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`ceases for the trial period to use a substitute
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`that yields a nonnegative surplus, s. Assum-
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`ing away income effects and indivisibilities,
`one can take s = 0 for the first brand.
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`If a consumer would be willing to pay 0
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`for a working brand in this class, immediate
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`Copyright © 2001 All Rights Reserved
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`

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`352
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`THEAMERICAN ECONOMIC REVIEW
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`JUNE 1982
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`trial of a new brand selling at price p is
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`rational if and only if the following inequal-
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`ity is satisfied:8
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`(1) 7T[(—<;>v—IJ)+(S/r)l+(1—w)
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`><[(v—p)(l+r)/r] >s(l+r)/r.
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`The first bracketed term on the left gives
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`discounted surplus if the new brand is tried,
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`doesn’t work, and the consumer switches
`back to the substitute. The second term on
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`the left capitalizes the stream of surplus asso-
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`ciated with buying a brand that works at
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`price p forever, and the term on the right
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`gives the capitalized benefit of continuing to
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`purchase the substitute.
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`Inequality (1) can be rewritten simply as
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`(2)
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`p<v(1~r)*s,
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`where the important quantity 1- is defined by
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`r=7rr(l+<j>)/(l+r*w).
`(3)
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`If 1- = 0, condition (2) indicates that the new
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`brand will be purchased if and only if its net
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`surplus, o — p, exceeds s. Larger values of 1-
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`always discourage trial of a new brand. As
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`one would expect, a- is increasing in both 7r
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`and n1), as these contribute to the expected
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`cost of trial. Larger values of r, which corre-
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`spond to lower purchase frequency, also in-
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`crease r. The lower is purchase frequency,
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`the more important is any single purchase
`relative to the entire future stream of
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`purchases. This makes the risk associated
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`with trying a new brand loom larger relative
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`to the alternative of sticking forever with the
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`substitute. If 7?], condition (2) shows that
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`is so subjectively risky that it never
`trial
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`occurs at positive p. To rule this out, let us
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`assume 0 < ‘1‘ <1 in all that follows.
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`If the first brand on the market charges
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`price p, and all buyers with v> p are sure
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`that it works, its sales equal Q( 17). Let 11(1))
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`be the per period profit function correspond-
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`ing to this demand curve. When the first
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`brand initially appears on the market, nobody
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`8One can derive condition (1) with s = 0 more rigor-
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`ously by letting buyer utility be the sum of utility from
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`this product class (either zero, 0, or — 9512) and income
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`left over to spend on other goods. It is then straightfor-
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`ward to show that
`trial of the pioneering brand is
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`optimal if and only if (1) holds with s = 0.
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`is sure that it works, and condition (2), with
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`s=0, implies that a price 12 will produce ‘
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`sales of Q[ p /(1 - 1-)]. Let the profit function
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`corresponding to this less-attractive intro-
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`ductory—period demand curve be II°( p), and
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`assume both profit functions are globally
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`strictly concave.
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`In period 1, let 1_3 = V(l — 1-), and in later
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`periods let 13 equal the lowest price previ-
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`ously charged. The demand curve for the ‘
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`pioneering brand then has the general shape
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`of the solid kinked curve in Figure 1. If
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`p<£, some new buyers are reached, and
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`profits equal H°( p). If ng/(l— ’7'),
`the
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`only buyers are those who have purchased
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`the brand at least once before, and profits
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`are given by II(p). If I: <p < 1_’/(1-— 7),
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`current profits could obviously be increased,
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`and no new customers are being informed, so
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`that prices in this range can never be opti-
`mal.
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`If the pioneering brand adopts a monopoly
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`Q-constant strategy, it maximizes profit sub-
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`ject to the constraint that it sell to the same
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`buyers in all periods. This constraint implies
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`that it charges a first-period price p0 and a
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`price p in all later periods such that p0:
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`p(l - 1'). (See Figure l.) The optimal values
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`of p and p0 can then be obtained by maxi-
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`mizing {H°[p(1—T)1+<1/r)mp1}- This
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`sort of
`low/high pricing sequence corre-
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`sponds roughly to what is called “penetra-
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`tion pricing” in the marketing and managerial
`economics literature.9 One can show that if
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`marginal production cost is positive, a mo-
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`nopoly Q-constant policy yields an output
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`level below that which would be chosen by
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`an ordinary monopolist with profit function
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`H( p) because of the extra marginal cost that
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`the pioneering firm must incur in order to
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`persuade buyers (by means of a low price) to
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`try its ex ante risky product.
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`In Appendix A, it is shown that the mo-
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`nopoly Q-constant strategy just described is
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`the best dynamic pricing policy for the first
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`brand, as long as no thought is given to
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`possible subsequent entry. In order to high-
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`light those aspects of later entrants’ prob-
`9See Joel Dean for a brief discussion and a compari-
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`son with the alternative high/low strategy usually called
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`“cream-skimming” and more commonly associated with
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`durable goods.
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`

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`VOL. 72 N0. 3
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`SCHMA LENSEE: PRODUCT DIFFERENTIA TION 0F BRANDS
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`353
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`oE/u—rfl
`FIGURE 1. SINGLE PERIOD DEMAND FOR THE PIONEERING BRAND
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`lems that arise naturally, I assume away any
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`such thoughts on the part of the first brand.
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`Allowing the pioneering brand to price stra-
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`tegically could only strengthen the results
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`obtained below at a high cost in added com-
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`plexity. On the other hand, little is gained by
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`confining the first brand to the monopoly
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`Q-constant strategy defined above. It is thus
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`assumed below only that the first entrant
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`follows some Q-constant policy, charging
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`price P1(l - 'r) in the first period and P1 in
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`all periods thereafter, and selling Q( P1) in all
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`periods. Under any such policy, the levelized
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`per period equivalent
`to the first brand’s
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`average revenue stream is simply
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`i=[11r][P1(1~7>+P1/r1
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`_
`_ ra-
`—P‘[1
`l+r]‘
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`<4)
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`III. Demand Conditions Facing a Later Entrant
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`Because the first brand has followed a
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`Q-constant policy,
`the second brand faces
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`two and only two distinct
`types of con-
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`sumers. If the first brand’s price is P1, those
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`consumers with v < Pl have never tried the
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`first brand. If the second brand then charges
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`introductory price p, the condition for trial is
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`again given by (2) with s = 0, as for the first
`brand:
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`(5a)
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`v<P1 and p<v(1—r).
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`Consumers with high 12’s are a second type
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`of buyer, as they have already tried brand
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`one and found it to work. Because purchase
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`of brand one yields a surplus of (v - P1), the
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`Copyright © 2001 All Rights Reserved
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`

`

`354
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`THEAMERICAN ECONOMIC REVIEW
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`JUNE 1982
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`P,
`ngu-r)
`(PI —P§)/r
`v
`FIGURE 2. FIRST-PERIOD DEMAND PRICES FACING A LATER ENTRANT
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`V
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`condition for trial is given by (2) with s = v
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`_ P1210
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`(5b)
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`12>P1 and p<P1—'rv.
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`Condition (5b) shows that consumers with
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`large values of v are least likely to try brand
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`two, even though they were most likely to try
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`brand one. Their high valuation of brand
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`one, after they have made the investment of
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`trying it, gives them a high opportunity cost
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`of trying brand two.
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`The demand conditions facing brand two
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`in its first period are depicted in Figure 2.
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`Prior to the second brand’s appearance, the
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`first brand (assumed to have completed the
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`10One can derive condition (5b) more formally using
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`the framework sketched in fn. 8, above. The difference
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`is that the alternative to trying the second brand yields
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`utility of u from this product class for certain at a price
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`of P1.
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`introductory phase of a Q-constant policy)
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`charges P1 and sells Q(P1). If the second
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`brand charges an introductory price of P20,
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`its first-period customers are those with 12’s
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`between the two intersection points of the
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`p = P20 line with the heavy kinked curve. As
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`Figure 2 is drawn, the second brand sells
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`Q[P2°/(1—T)]~Q[(P1—P2°)/T]
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`in its first period. This is less than the first
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`brand would have sold had it charged P20
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`during its introductory period. Only if P20 is
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`less than (P1 —'rV) are the second brand’s
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`introductory sales equal
`to those the first
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`brand would have achieved at the same price.
`If the second brand undercuts the first
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`brand’s price sequence, P,(1—- 1-) for one
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`period and P1 thereafter, by an arbitrarily
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`small amount, it will sell only to those buyers
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`with v’s arbitrarily close to P1. Such a policy
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`would give the second brand a levelized aver—
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`VOL. 72 N0. 3
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`SCI-[MA LENSEE: PRODUCT DIFFERENTIA TION 0F BRANDS
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`355
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`age revenue equal to that of the first brand,
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`E, but it would make essentially zero sales.
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`Under constant returns, entry will occur in
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`spite of this disadvantage (though at arbi-
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`trarily small scale) if P1 exceeds unit cost.11
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`With fixed costs or other economies of scale,
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`however, it should be clear that PI can be
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`above the first firm’s average cost (at output
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`Q(P1)) without provoking entry.
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`If the second brand charges any first-period
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`price between Pl(1 - r) and P1 - 7V, it makes
`fewer sales than the first brand would have
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`made at the same introductory price. Since
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`first-period sales
`translate into informed
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`buyers willing to pay more because they
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`know the brand works, this difference is the
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`heart of the second brand’s disadvantage. If
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`the first seller of fluoride toothpaste can
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`persuade those who care a lot about cavities
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`to try one tube, and if the taste is acceptable
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`to most consumers, the second brand of fluo-
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`ride toothpaste will find it much harder to
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`get a trial. It will be compared to a known,
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`acceptable fluoride toothpaste, while the first
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`brand was compared only to “ordinary”
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`toothpaste.
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`If the second brand charges an introduc-
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`tory price less than Pl"”TV, which is dis—
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`tinctly less than the first brand’s introduc-
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`tory price, it thereby persuades all those who
`would have tried the first brand at that same
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`price to try it. (That is, as Figure 2 should
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`make clear, its first-period demand is given
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`by Q[P2°/(l~r)],
`the same function that
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`held for the first brand at all prices.) It then
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`has essentially the same second-period op-
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`tions the first brand would have had. (The
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`second brand cannot
`sell anything if it
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`charges a price above P], but
`this is not
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`likely to be a relevant alternative.) If the first
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`brand could have earned positive profit with
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`a Q-constant strategy beginning with a very
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`low first-period price, the second brand will
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`find entry of the same sort attractive. Even
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`with constant costs, however, it is obviously
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`possible for the first brand to be highly
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`profitable but entry at drastically lower prices
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`to be unprofitable.
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`The preceding discussion establishes the
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`existence of a barrier to entry. Profitable
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`entry deterrence can occur in this model
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`even though potential entrants have the ex-
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`the
`ceptionally optimistic expectation that
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`first brand’s price will never change, even if
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`they steal all its customers. In order to in-
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`vestigate the importance of this barrier in
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`general, it would be necessary to calculate
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`the second brand’s optimal price policy and
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`the consequences of following it. This turns
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`out to be very difficult. The argument in
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`Appendix A establishing that the first brand’s
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`optimal policy involves only one price change
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`can be applied to the second brand also. The
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`problem is that it is not always optimal for
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`the second brand to follow a Q-constant
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`policy.
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`The nature of the difficulty here can be
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`understood by examining the second brand’s
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`demand curve for periods after the first, as
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`shown by the heavy kinked curve in Figure
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`3. As above, I_’ is the lowest price this brand
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`has ever previously charged, and P1 is the
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`first brand’s price. Figure 3 is drawn assum-
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`ing I_’ > P1_ TV. The flat portion of the de-
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`mand curve at price P1 corresponds to those
`consumers who have tried both brands and
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`know that both work. The segment AB re-
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`flects those who have tried only the second
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`brand because they found the first too ex-
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`pensive. A reduction in 13 increases the length
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`of the flat segment (moves point A to the
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`right) as well as that of the declining seg-
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`ment. If the optimal introductory price is
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`above P1 —- TV, it may be optimal to follow a
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`Q-constant policy and go to a point like B
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`thereafter. On the other hand, since a low
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`introductory price increases the number of
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`brand one’s customers who engage in trial, it
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`may be optimal to set a low introductory
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`price for this purpose and then move to a
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`point like A in Figure 3.12 Finally, since a
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`”Note that if entry occurs at small scale, the pioneer-
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`ing brand loses only a few of its customers, so that the
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`present value of its excess profits may still be positive.
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`Thus even without scale economies, entry may not drive
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`the pioneering brand to a zero (discounted) profit posi-
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`tion. I am indebted to Dennis Carlton for this observa—
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`tion.
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`l2If the first brand has followed a monopoly Q—con-
`stant policy, P1 exceeds the static, perfect information
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`monopoly price, as Appendix A shows. Thus marginal
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`revenue just to the right of point A in Figure 3 exceeds
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`the first brand’s equilibrium marginal cost. If the second
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`brand’s ma