The Impact of Boundedly Rational Consumers on the Strategic Decision of Two Competing Firms

The Impact of Boundedly Rational Consumers on the Strategic Decision of Two Competing Firms

YuHang Zhang (Nanjing University of Aeronautics and Astronautics, College of Economics and Management, Nanjing, China) and Ying Wang (Nanjing University of Aeronautics and Astronautics, College of Economics and Management, Nanjing, China)
DOI: 10.4018/IJISSCM.2017100104
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Abstract

Consider two production competing firms offering vertically differentiated products to strategic consumers who are the boundedly rational consumer surplus maximizers. Distinguishing three settings of production capacity commitment, pricing optimization and dynamic production capacity management, we show how consumer behavior resulting from bounded rationality impact pricing and production capacity decisions of firm. In this study, we follow the and model to analyze that consumers strategize over which product to purchase under two scenarios where two firms enter the same market simultaneously or successively. In either model, consumers have to rely on anecdote reasoning or word-of-mouth to infer the product information of both firms. Due to this bounded rationality, firms dynamically adjust their strategic decisions to maximize profits. In this study, we prove that it is not always optimal to the production capacity decisions no matter under one anecdote or multiple anecdotes in either scenario, and the fill rate of regular product increases as the level of product environmental protection increases, then the profit of corresponding firm might increase. We show that the result of production capacity decisions of both firms being not always optimal is robust to the heterogeneous sample size, price optimization and discounted valuation.
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Introduction

Consumer rationality, consumer social responsibility and dynamic pricing have gained an increasing popularity and have engendered a body of academic research (e.g. Mark & Bettina, 2015; Bitran & Caldentey, 2003). Inter alia, much attention has been concentrated on how consumers make response to the company strategies. Historically, consumers are considered as the entirely rational buyers who can perfectly know the product characteristic and anticipate the company’s strategies. Given the boundedly rational consumers, strategic decisions of companies should be focused on the profit maximization based on the optimal capacity size. Due to the information asymmetry between consumers and firms, consumer cannot obtain complete knowledge about the firm’s product, thus consumer learns about the fill rate of company via anecdotal reasoning (Huang & Liu, 2015). Actually, there exist plenty of homogeneous firms and alternative products in the market, based on this situation, companies face the question about how to price the product and decide fill rate to achieve the goal of profit maximization when consumers have boundedly rational expectations. This study scratches the surface of this question from the specific perspective of consumer bounded rationality resulting from anecdote reasoning.

Vertical product differentiation leads to different procedure cost for firms and then the competing firms vary prices in order to manage demand and increase profits. Consumers with high expected value and environmental consciousness purchase green products at higher prices, low expected value consumers without environmental protection preference purchase regular products at low prices. Faced with dynamic pricing and vertical product differentiation, strategic consumers (who choose the best purchasing time to maximize their utilities when facing the general price reduction) carefully consider which products to purchase through anecdote reasoning. When making strategic decision, a firm needs to consider both consumer behavior and competitor’s decision, capturing their joint effects on competing firms’ production capacity and pricing strategies. This is the focal point of our study. Particularly, this paper makes an attempt to unravel the impact of consumers bounded rationality on the production capacity and dynamic pricing of two competing firms offering green and regular products respectively. Consumers have private and heterogeneous expected value on product characteristic. Firms determine prices simultaneously or successively in each season to maximize their respective profits. Consumers have boundedly rational expectation of firms’ product characteristic, production capacity and prices.

Consumers who act as the user and feedback-rater of the products cannot decide which type of products provided by different firms they should purchase and don’t know the product characteristic through repeat purchasing behavior, especially for products with long life cycle, such as purchasing cars, a focus on the repeat purchasing behavior rooting in long-run learning maybe not always assured (Camerer & Lowenstein, 2003). While consumers can choose which company they purchase goods from through the consumer-generated quality information which is transmitted via Internet, Twitter, word-of-mouth and so on, considering price, the impact of products on environment and consumer surplus. In this analysis, we show the interplay between the strategic decision of firms and consumer’s level of bounded rationality, and indicate how the enterprises achieve profit maximization in the competitive market. In this paper, two key factors that determine the firms’ strategic decisions are consumer bounded rationality measured by anecdote reasoning and the level of environmental protection measured by consumer environmental preference.

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