Impact of Social Interactions on Duopoly Competition with Quality Considerations

Abstract

We study the impacts of social interactions on competing firms’ quality differentiation, pricing decisions, and profit performance. Two forms of social interactions are identified and analyzed: (1) market-expansion effect (MEE)—the total market expands as a result of both firms’ sales—and (2) value-enhancement effect (VEE)—a consumer gains additional utility of purchasing from one firm based on this firm’s previous and/or current sales volume. We consider a two-stage duopoly competition framework, in which both firms select quality levels in the first stage simultaneously and engage in a two-period price competition in the second stage. In the main model, we assume that each firm sets a single price and commits to it across two selling periods. We find that both forms of social interactions tend to lower prices and intensify price competition for given quality levels. However, MEE weakens the product-quality differentiation and is benign to both high-quality and low-quality firms. It also benefits consumers and improves social welfare. By contrast, VEE enlarges the quality differentiation and only benefits the high-quality firm, but is particularly malignant to the low-quality firm. It further reduces the consumers’ monetary surplus. Such impact is consistent, regardless of whether the VEE interactions involve previous or current consumers. We further discuss several model extensions, including dynamic pricing, combined social effects, and various cost structures, and verify that the aforementioned impacts of MEE and VEE are qualitatively robust to those extensions. Our results provide important managerial insights for firms in competitive markets and suggest that they need to not only be aware of the consumers’ social interactions, but also, more importantly, distinguish the predominant form of the interactions so as to apply proper marketing strategies. This paper was accepted by Matthew Shum, marketing.