Do Firms Endowed with Greater Strategic Capability Earn Higher Profits?by Bo Zhou, Carl F. Mela, Wilfred Amaldoss

Journal of Marketing Research

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Year
2015
DOI
10.1509/jmr.13.0616
Subject
Economics and Econometrics / Business and International Management / Marketing

Text

Do Firms Endowed With Greater Strategic Capability

Earn Higher Profits?

Bo Zhou

Robert H. Smith School of Business, University of Maryland

Carl F. Mela and Wilfred Amaldoss

Fuqua School of Business, Duke University

Abstract

Different firms with different management teams evidence different strategic capabilities. Some are able to reason through the reactions of their competitors, while others are less sophisticated in their thinking. In such cases, conventional wisdom suggests that the strategic firms will undercut their less sophisticated competitors’ prices and earn greater profits. We show that, under some conditions, the strategic firms charge higher prices and accrue smaller equilibrium profits than their non-strategic counterparts. Strategic firms’ efforts to capitalize on their loyal customers’ higher willingness to pay increases non-strategic firms’ share of the price-sensitive consumers. Furthermore, by raising prices, strategic firms help their non-strategic counterparts more than themselves. This outcome arises when the proportion of consumers loyal to each firm is sufficiently large. A laboratory test for the main proposition’s predictive accuracy provides empirical support.

Bo Zhou is Assistant Professor in Marketing, Robert H. Smith School of Business, University of Maryland; e-mail: bzhou@rhsmith.umd.edu. Carl F. Mela is T. Austin Finch Foundation Professor, Fuqua School of

Business, Duke University; email: mela@duke.edu. Wilfred Amaldoss is Thomas A. Finch Jr. Endowment

Professor, Fuqua School of Business, Duke University; email: wilfred.amaldoss@duke.edu. Authors are listed in reverse alphabetical order. The authors would like to thank Yu-Hung Chen, Yuxin Chen, Mushegh

Harutyunyan, Baojun Jiang, Yi Lu, Yue Qin and the review team for their constructive comments. © 2015, American Marketing Association

Journal of Marketing Research

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Do Firms Endowed With Greater Strategic Capability

Earn Higher Profits?

Abstract

Different firms with different management teams evidence different strategic capabilities. Some are able to reason through the reactions of their competitors, while others are less sophisticated in their thinking. In such cases, conventional wisdom suggests that the strategic firms will undercut their less sophisticated competitors’ prices and earn greater profits. We show that, under some conditions, the strategic firms charge higher prices and accrue smaller equilibrium profits than their non-strategic counterparts. Strategic firms’ efforts to capitalize on their loyal customers’ higher willingness to pay increases non-strategic firms’ share of the price-sensitive consumers. Furthermore, by raising prices, strategic firms help their non-strategic counterparts more than themselves. This outcome arises when the proportion of consumers loyal to each firm is sufficiently large. A laboratory test for the main proposition’s predictive accuracy provides empirical support.

Keywords. Behavioral Economics, Bounded Rationality, Experimental Economics, Game theory,

Pricing 1 1 Introduction

Field research documents differences in firms’ strategic capabilities and a profound link between capability and performance. For example, Goldfarb and Yang (2009) analyze the decisions of

Internet service providers to offer their customers new services, finding considerable heterogeneity in the degree to which firms behave strategically; more strategic firms have higher profitability and an enhanced survival rate. Similarly, Goldfarb and Xiao (2011) find sizable variation in managers’ strategic capabilities in the U.S. local telephone market. Managers with degrees in economics or business, and managers who attended selective undergraduate institutions, display higher estimated levels of strategic ability. More strategic firms also achieved better results: They were more likely to survive and obtain higher revenues. Similarly, Che, Sudhir and Seetharaman (2007) systematically evaluate whether boundedly rational firms indeed look ahead when they set prices and, if so, to what extent. The authors find that the observed retail prices are consistent with a pricing model in which both manufacturers and retailers are forward looking, but some firms have short time horizons when setting prices. Specifically, they look ahead by only one period, suggesting that firms are boundedly rational in their dynamic pricing behavior.

Heterogeneity in capabilities is also evidenced in the experimental economics literature. McKelvey and Palfrey (1995) and McKelvey, Palfrey and Weber (2000) show that differences in bounded rationality across players can better account for behavior in a collection of games. Camerer, Ho and Chong (2004) propose a Cognitive Hierarchy (CH) model where each boundedly rational player assumes her own strategy is the most sophisticated. They show that cognitively superior players exploit the poor decisions of their rivals and earn more profits in a variety of games.

Taken together, field and experimental research on bounded rationality consistently find that players with greater strategic capability perform better in competition. In contrast, we seek to assess whether and when the opposite can be true: Is it theoretically possible for the less strategic players to achieve superior performance in a competition? If so, under what conditions will this happen? Answers to these questions can help to generalize insights regarding the nature of strategic interactions in the context of limited capabilities (Ho, Lim and Camerer 2006, Meyer et al. 2010). 2

Building on the work of Varian (1980) and Narasimhan (1988), this paper considers price competition in the context of an oligopoly where the market consists of some consumers who are loyal to a specific firm and others who are price sensitive and thus switching between brands based on prices. We extend this research to incorporate asymmetric strategic capabilities among competing firms. Conventional wisdom suggests that firms with higher strategic capability will undercut their competitors’ prices and earn more profits than their less sophisticated rivals. This conjecture is true when the size of the loyal consumers is small and firms compete aggressively for the price-sensitive consumers. However, firms with higher strategic capability can actually be less profitable than their less sophisticated rivals when the size of the price-sensitive segment is small. In this instance, strategic firms raise prices to capitalize on their loyal customers’ higher willingness to pay; thereby directing a larger share of the price-sensitive consumers to the nonstrategic firms. This finding is robust to alternative formulations that allow for i) different levels of strategic thinking (as opposed to only two levels), ii) asymmetric strategies (as opposed to symmetric strategy among strategic players), and iii) private knowledge about players’ types (as opposed to common knowledge). Notably, regardless of information about firm types, strategic firms in equilibrium will not mimic their less strategic counterparts, even though the non-strategic firms earn higher profits. Empirical support for our theoretical findings is evidenced in a laboratory setting that reflects the structure of the model. In this experiment, strategic firms charge higher prices and earn lower profits than their non-strategic counterparts.