Abstract

This paper takes a game-theoretic approach to analyze how the availability of e-commerce may change duopolistic firms' incentives of engaging in product differentiation, thereby altering equilibrium product prices and social welfare. The migration of transactions from traditional outlets to Internet markets implies that firms that gained local monopoly power in different geographic areas must now compete in one integrated market, but this does not necessarily imply that e-commerce makes firms worse off. We obtain the following results: (i) The presence of internet markets also allows firms to reach consumers that could not be reached in the past because of prohibitively high transportation costs, and the presence of new potential customers raises the profitability of investments in product differentiation. (ii) With products being more differentiated, the equilibrium product prices may become higher, making firms better off in the presence of Internet markets. (iii) The presence of the Internet channel will intensify price competition between firms with homogeneous products, which in turn strengthens their incentives to conduct product differentiation. Under some conditions, even if the value created to customers cannot cover the associated cost, firms may well differentiate their products. In this case, social welfare is decreased by the overinvestment by firms on product differentiation. (iv) Our results provide implications for practitioners on how to adjust their product and pricing strategies in the presence of the Internet. Furthermore, we provide marketing implications for customization, branding and persuasive advertising on the Internet.