Differentiate or Imitate? The Role of Context-Dependent Preferences

Conventional wisdom, derived from standard economic theory, is that a …rm should di¤erentiate itself from its rivals to mitigate intense price competition. Yet there are many examples of …rms positioning themselves to mimic their rivals. In this paper we examine the role of contextdependent preferences in explaining this phenomenon. Behavioral researchers have long argued that consumers consider not only the absolute utility of a product but its utility relative to a reference in the choice set as well. Using this premise we construct a game theoretic model of competition between two …rms. We consider two horizontally di¤erentiated …rms where some consumers own the product of one …rm while the rest own the other …rm’s product. One …rm upgrades its existing product by adding a new feature. In the absence of any cost or capability constraints, to protect its competitive position the other …rm would prefer to update its own product by adding a di¤erentiated new feature. We show that if consumers’ preferences are context-dependent, then under some conditions the second mover would tend to imitate the …rst mover by adding the same feature even when with no cost disadvantage it can di¤erentiate itself. This happens because context-dependent preferences cause consumers dislike brands being much di¤erentiated from each other and value common features among the brands more than distinct features. As a result of this, when consumers exhibit context-dependent preferences and the proportion of second-mover’s consumers who enjoy the …rst mover’s new feature is not too small, if the second mover mimics the …rst mover both …rms can charge higher prices for their upgraded products. This outcome, in turn, leads the …rst mover to pick a new feature to upgrade its existing product such that it would encourage the second mover to imitate itself. Therefore,