Information Personalization in a Two-Dimensional Product Differentiation Model

We use a game-theoretic model to examine how information personalization by firms interacts with different dimensions of product differentiation (namely, horizontal and vertical differentiation). We consider the possibility that consumers attach different importance to various types of product differentiation, and report the equilibrium in terms of the “quality–fit” ratio, which measures the relative strength of preference for quality compared to preference for product fit and is a function of the cost of quality and the cost of product misfit. We also consider how different market structures (whether firms are similar or differentiated on the horizontal dimension 70 Wattal, tElaNg, aND MukhOpaDhyay ex ante) lead to different equilibriums when firms adopt personalization. We show that personalization by one firm leads to higher profits for both firms if product quality and misfit costs are high and the firms offer similar products ex ante. On the other hand, if firms offer differentiated products, personalization is profitable only if the effectiveness of the personalization technology is high or if both product quality and misfit costs are low. We also highlight conditions under which investments in personalization and product quality can be complements or substitutes to each other. Finally, we show that a firm can respond to a competitor’s personalization by either increasing (aggressive response) or decreasing (defensive response) investments in its own quality. Our results provide insights to managers on when to invest in personalization technologies and how to adjust their investments in product quality after the firm (or its competitor) adopts personalization. key WoRdS and phRaSeS: game theory, horizontal and vertical differentiation, market structure, personalization, quality–fit ratio. peRSonalization, alSo knoWn aS “one-to-one MaRketing” [20], refers to the practice of using information technology to treat customers on an individual basis by tailoring products, customer service, and other interactions uniquely for each customer. In other words, customers have unique tastes and preferences that may not always match the products available in the market. Firms are using technology to collect information about consumers’ preferences and tailor products or customer service uniquely for each consumer. For example, the Washington Post (www.washingtonpost.com) allows its readers to create their own personal online newspaper that displays only the news topics that the readers are interested in, rather than displaying the newspaper’s generic front page. Other examples of personalization where firms treat customers on an individual basis and offer different products to different consumers include Signature Supplements (vitamins; www.signaturesupplements.com) and Dell (computers; www.dell.com). While recent research [11, 23] examines the personalization of physical products, there is little work on personalization of information. We address this shortcoming by modeling the economics of information personalization in this research. Firms personalize information in various ways: (1) firms tailor information goods such as news, music, and online content such that each customer receives only his or her preferred information (in this case, the core product, which is a digital good, is personalized), and (2) firms personalize information-related attributes of goods or services (in this case, information is auxiliary to the product; for example, amazon.com sells books but also uses consumer information to create a personalized experience for shoppers by giving online recommendations). thus, information personalization extends beyond information goods. Even firms that sell noncustomizable physical goods (e.g., books, apparel) or services (e.g., credit cards, financial services, online movie rentals) can create a personalized experience for their customers by tailoring the information-related attributes of the customer buying experience. pERSONalIzatION aND pRODuCt DIFFERENtIatION 71 Information personalization is important because information age and ubiquity of the Internet have ushered an information overload. On the Internet, information overload manifests in the proliferation of numerous Web sites, and an increase in links and sublinks within each Web site. Firms offer personalized products to their customers to reduce information overload and increase user satisfaction [15]. For example, the online DVD rental firm Netflix has 90,000 DVD titles in over 200 genres. Consumers have a wide variety of preferences and it can be difficult and time-consuming for customers to search through and evaluate all of these options to locate a DVD they may enjoy. to resolve this issue, Netflix uses personalization technologies to make recommendations to consumers based on information about movies they or their friends watched or rated through Netflix’s Web site. there are numerous other examples of firms using information personalization. One such example is credit cards, which have many attributes, such as annual fees, membership points, and apR (annual percentage rate); and different customers may value these attributes differently. For example, some customers may value a low apR more than a low annual fee. Firms may differentiate horizontally by positioning themselves on select attributes (such as Capital One for rewards and Discover for cash back), or vertically (such as the Citi Simplicity card, which offers a higher quality level in terms of faster access to live representatives). Firms use information about consumer preferences to target the right credit card to the right consumer. Similarly, the Wall Street Journal (a business news Web site; www.wsj.com) and Washington Post (a general news Web site; www.washingtonpost.com) offer personalized content based on users’ stated preferences. prior research on personalization [10, 23] focuses on horizontal differentiation where personalization reduces a user’s misfit costs when a firm’s product differs from the user’s preferred product. In reality, firms simultaneously differ on other dimensions of product differentiation as well, such as vertical differentiation. For example, amazon.com offers personalization and at the same time also offers higher quality levels (one-stop shopping, guaranteed delivery) than its competitors such as Bestprices.com. the impact of vertical differentiation on firms’ decision to invest in personalization has not been studied, mainly because there is little prior research on multidimensional product differentiation models. Both personalization and product quality increase the utility that consumers derive from a product. given that firms usually have finite resources at their disposal at any point in time, an interesting question that arises is whether firms should invest in personalization or in quality improvements, or both. prior analytical work on personalization [11, 23] assumes that personalization technology is always perfect and can help a firm in predicting consumers’ preferences with complete accuracy. In reality, personalization technologies are not perfect and firms routinely invest in improving the accuracy of their recommendations. For example, in October 2006, Netflix announced a prize of $1 million to anyone who could improve the efficiency of its movie recommendation software by 10 percent (www.netflixprize.com). We investigate firms’ incentives to invest in new technologies that can improve the accuracy of prediction. In summary, prior research has 72 Wattal, tElaNg, aND MukhOpaDhyay characterized personalization as simplistic and static. In this paper, we enhance prior work by considering a firm’s decision to invest in quality as well as in personalization. We examine a duopolistic market structure to study the role of competition in firms’ decisions regarding personalization. Finally, we also let the personalization technology be imperfect and examine firms’ decisions to improve prediction by investing in technology. More precisely, we consider the following research questions: RQ1: Are personalization and quality substitutes or complements in equilibrium? RQ2: How does personalization by one firm in a duopoly affect the competitor’s investments in quality? RQ3: Under what conditions does a firm find it profitable to personalize? RQ4: How does the equilibrium change with improvements in firms’ ability to personalize? Our main results are as follows: we show that when firms are horizontally differentiated and the cost of product quality and misfit costs are high, personalization and quality are complements. however, when firms are locationally undifferentiated, personalization and quality are substitutes. Moreover, while our study reiterates results from prior literature that personalization by one firm can lead to lower profits for both firms when firms are horizontally differentiated, we show that this result holds only under certain conditions. By endogenizing firms’ decision to invest in quality in our model, we are able to show that a firm can earn a higher payoff from personalization under horizontal differentiation if either the cost of quality and misfit costs are low or the effectiveness of the personalization technology is higher than a certain threshold. Further, if firms are locationally undifferentiated and the cost of quality and misfit are high, then personalization by one firm can increase profits for both firms. Our results also suggest that personalization by one firm can force a competitor to increase its product quality (“aggressive” response) if firms are locationally undifferentiated and the costs of quality and product misfit are high; otherwise, personalization by one firm can lead a competitor to reduce its investments in product quality (“defensive” response). Finally, we contribute to the literature on two-dimensional product differentiation models by showing that in such models, given exogenous location choice and personalization adoption, firms choose to differentiate on either one (MaxMin differentiation) or both (MaxMax) or neither (MinMin) dimension, depending on the market structure and the costs of quality and product misfit.