Preference Evolution in the South Korean Cigarette Market Preliminary and incomplete

In the South Korean cigarette market, consumers have shown dramatic changes in their cigarette preferences. While most consumers smoked high-tar cigarettes ten years ago, now most consumers prefer low-tar cigarettes. Another interesting trend in this market is the growing popularity of super-slim cigarettes. Given the strong dynamics in preferences, I raise two critical questions – 1) what are the sources of preference change, and 2) how does the firm (KT&G Corporation, a de-facto monopolist in the market) react to these preference changes. I answer these questions using a unique structural model of consumer demand and firm behavior. In the proposed demand model, evolution of consumers' preferences is driven by an exogenous effect and a new product introduction effect. On the one hand, the increasing preference for low-tar cigarettes can be explained by consumers' growing heath consciousness, an exogenous effect. Due to stringent government restrictions on promotion and advertising of tobacco products, new product introduction is an important marketing instrument for KT&G. I hypothesize that a new product carries critical information that subsequently influences consumer preferences. This is the introduction effect. I propose an aggregate random coefficient logit model wherein the parameters evolve as a function of the introduction and exogenous effects. This model allows me to separate the two effects and examine their relative significance. Another key research question I study is how the firm reacts to the preference changes. To answer this question, I build two supply side models. First, I specify the firm's pricing model which elucidates the influence of the time-varying preferences on the firm's pricing decisions. Second, I model the firm's decisions regarding new product design and introduction. The firm makes these decisions considering both current consumer preferences as well as the future preferences that will be influenced by the current decision via the introduction effect. Consequently, the firm's decision problem is a dynamic discrete choice problem. The main contributions of this study are the following: 1. It provides valuable insights into the sources of preference changes, and how firms' decisions shape the fundamentals of the market. 2. It sheds light on the role and the value of new products design and introduction. 3. The proposed model can help a firm develop a new product strategy that will move consumer preferences in a preferred direction. 4. This study identifies new endogeneity problems due to time-varying consumer preferences. Also, it extends the aggregate random coefficient logit model …