Differentiate or Imitate? The Role of Context-Dependent Preferences

Laboratory and field experiments show that when choosing among a set of objects, consumers could be subjected to context-dependent preferences and evaluate options by considering both the absolute utilities and their relative standing in the choice set. Using this premise we construct a game-theoretic model of competition between two firms and investigate how a firm's decision to differentiate or imitate is affected when consumers' preferences are context-dependent. We consider two horizontally differentiated firms where some consumers own the product of one firm and the rest own the other firm's product. One firm 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 firm would prefer to upgrade its product by adding a differentiated new feature. We show that if consumers' preferences are context-dependent and the new feature is of an incremental type, the second mover prefers to imitate the first mover by adding the same feature even when there is no cost disadvantage to differentiate itself. This happens because context-dependent preferences cause consumers to dislike brands that are very differentiated from one another. Thus, if the second mover mimics the first mover, both firms can charge higher prices for their upgraded products i.e., imitation leads to higher prices. This outcome, in turn, leads the first mover to pick a new feature such that it would induce the second mover to imitate. Therefore, our analysis shows that the need for context management leads not just to imitation but also to accommodating imitation.