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Personalized Pricing and Quality Differentiation

Paul Merage School of Business, University of California, Irvine, California 92697
IOMS/IS Group, Leonard N. Stern School of Business, New York University, Henry Kaufman Management Center, 44 West 4th Street, New York, New York 10012
Tepper School of Business, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213
Stephen Ross School of Business, University of Michigan, 701 Tappan Street, Ann Arbor, Michigan 48109
veecee{at}uci.edu
aghose{at}stern.nyu.edu
tridas{at}andrew.cmu.edu
urajan{at}bus.umich.edu

We develop an analytical framework to investigate the competitive implications of personalized pricing (PP), whereby firms charge different prices to different consumers based on their willingness to pay. We embed PP in a model of vertical product differentiation and show how it affects firms’ choices over quality. We show that firms’ optimal pricing strategies with PP may be nonmonotonic in consumer valuations. When the PP firm has high quality, both firms raise their qualities relative to the uniform pricing case. Conversely, when the PP firm has low quality, both firms lower their qualities. Although many firms are trying to implement such pricing policies, we find that a higher-quality firm can actually be worse off with PP. While it is optimal for the firm adopting PP to increase product differentiation, the non-PP firm seeks to reduce differentiation by moving in closer in the quality space. While PP results in a wider market coverage, it also leads to aggravated price competition between firms. Because this entails a change in equilibrium qualities, the nature of the cost function determines whether firms gain or lose by implementing such PP policies. Despite the threat of first-degree price discrimination, we find that PP with competing firms can lead to an overall increase in consumer welfare.

Key Words: personalized pricing; quality differentiation; price competition
History: Received: February 3, 2003;

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