PRODUCT LINE EXPANSION CAN INCREASE ALL FIRMS' PROFITS
Raphael Thomadsen finds that competition may not be as bad as you think
If a McDonald’s and a Burger King compete in the center of a small town, and a Burger King opens in the suburbs, can it boost profits for the McDonald’s store? Yes it can, according to new research by UCLA Anderson assistant professor Raphael Thomadsen. Thomadsen presents this result in a paper entitled, “Seeking an Aggressive Competitor: How Product Line Expansion Can Increase All Firms’ Profits.”
In previous research, Thomadsen demonstrated that prices at fast food outlets located near other outlets belonging to the same chain often charge high prices to avoid cannibalizing sales between the two outlets. These price differences can be large, with prices at many restaurants 20 percent or more higher than they would be if the restaurant owners did not worry about cannibalization. Now he finds that a firm may also charge higher prices when faced with a new competitor or product.
Thomadsen started thinking about how geographic or product-line expansion would affect profits when he heard a visiting scholar make an assumption during a research presentation. “He said that when a firm adds products to its line, the profits of the incumbent firms in the market must go down. This actually seemed very innocent and no one commented about it. But it bothered me and it’s something I’ve been thinking about for awhile,” he says.
Thomadsen used a standard economic model in this study. “Consumers have different utility preferences,” he explains. “Some people like one type of food while other people like a different type. There are also variations in location. I may love McDonald’s, but if the nearest McDonald’s is five miles away, I’m not going to drive that far. So we model consumers based on preferences, location and other factors likely to affect their behavior.”
Firms are modeled based on their products, pricing and other factors likely to influence sales – such as whether a firm has multiple outlets. Pricing can be estimated through mathematical calculations or simulations. “We simulate the market to find prices that would maximize profits for each of the firms,” says Thomadsen. “Once the model is created, you can adjust the competitive landscape to see how specific changes might affect prices and profits.”
Thomadsen explains that his findings can be generalized to a variety of markets. “Say Tide releases a new product,” he says. “This does not necessarily mean that competitors will lose profits and market share. There are conditions in which a new Tide might increase everyone’s profits. Kellogg’s can profit when a new type of Wheaties hits the shelves. And the opening of an Albertson’s in the right location could mean higher profits for a nearby Ralph’s. In fact, retail competition is one of the places where one firm’s expansion is most-likely to increase a competitor’s profits.”
Thomadsen notes that when Yoplait introduced the first light yogurt, industry leader Dannon lost market share. But, because Yoplait’s prices increased to avoid cannibalization, Dannon could also raise prices. Ultimately, Dannon’s revenues increased, despite the lost sales. “The preference and location factors that theoretically can cause profits to increase when competitors open up new retail locations actually do exist in the real –world – so I expect this kind of phenomena to be fairly common,” he says.
The current paper complements earlier research by Thomadsen and Amit Pazgal, of Rice University, showing that a firm’s profits can increase when a new competitor enters into a market. The idea behind this paper is based on growing literature demonstrating that competitive entry can lead to increased prices.
“Say you have a McDonald’s and a Burger King -- and a Carl’s Jr. opens nearby,” says Thomadsen. “The entry of the third firm can prompt the others to raise their prices because previously, the two firms aggressively competed to serve a broad set of consumer segments. The opening of a new firm changes the competitive balance, and provides an opportunity for firms to raise prices as the firms switch from a strategy of competing over a broad consumer base to a strategy of niche pricing. This can mean greater profits for all incumbent firms.”
“There’s a pretty large literature on strategies of trying to preempt competitors or scare them off,” says Thomadsen. “These papers say that there could be both costs and benefits when a new competitor enters or an existing competitor expands. People might think about those tradeoffs a little more carefully than they have in the past.”
“What’s surprising about this paper,” he adds, “is that these new results were produced using standard models that people have looked at for at least 30 years. These results run counter to what has been found previously. When I tell other academics the results, they say it must have been done before. But as far as I know – it hasn’t.”