Customization with Vertically Differentiated Products

Abstract

We consider a duopoly market with heterogenous consumers. The firms initially produce vertically differentiated standard products located at the end points of the variety interval. Customization provides ideal varieties for consumers but has no effect on quality. The firms first choose whether to customize their products, then engage in price competition. We show that the low quality firm never customizes alone; customization becomes more likely as the difference between the firms' qualities increases; and less likely as the fixed cost of customization increases.

We extend the base model by relaxing two important assumptions - uniform pricing and exogenous quality. The main conclusions with uniform pricing continue to hold when price customization is allowed. In the second extension the firms' qualities are endogenously determined. We show that the firms choose to be either substantially differentiated in quality or non-differentiated.

Keywords: customization, horizontal differentiation, vertical differentiation

JEL Classification: D43, L13, C72