How consumer valuation heterogeneity impacts firms’ profit: Peer influence makes a difference
Introduction
Peer influence plays an important and ubiquitous role in consumers’ purchase decisions. For example, a study found that 81% of consumers were directly influenced in their purchase decisions by posts from their friends on social media (Hussain, 2017). Over 93% of consumers reported that online product reviews impacted their purchase decision (Fullerton, 2017). A study by Bapna and Umyarov (2015) has demonstrated that influence from peers who have purchased and used a product can increase the probability that a consumer also buys the product by 60%. While there is clearly strong inter-influence between consumers, understanding consumers’ purchase behavior has historically been difficult (Williams, 2018). Many company executives still do not possess a solid grasp on how social media and word of mouth have changed sales, profitability, and their customers’ behavior (Divol et al., 2012, Wright, 2014).
To understand consumers’ purchase behavior, a fundamental starting point would be to examine consumers’ valuation for a product, which refers to the worth of a product as perceived by consumers (Hu et al., 2020). This valuation is jointly determined by the quality, functionality, brand, and other features of a product and it directly influences a consumer’s purchase intention (Dodds et al., 1991, Snoj et al., 2004). Consumers are often heterogeneous in their valuation for a product since their different product preferences or demographic characteristics, such as income level (Allenby and Rossi, 1998, Feick and Higie, 1992). Today, with the recognition of such heterogeneity and the significant impact of peer influence on consumers’ product choices, firms are cultivating brand advocates who highly value a product and utilizing them to influence the purchase decisions of other consumers who are intrinsically less willing to adopt the product (Sweeney et al., 2020). One successful example is Xiaomi Inc, a Chinese tech giant. When Xiaomi launches a new product, it often utilizes advocates’ word of mouth to create buzz in the market and evoke desire in potential customers to buy the product (Wong, 2014). This practice has received much praise: “Xiaomi’s success and rapid growth can be attributed to its strong fan base that helps promote its brand via word of mouth” (Wong, 2014).
Although firms widely utilize peer influence to promote products in a market with heterogeneous consumers, still there is no study providing a solid examination on how consumer valuation heterogeneity impacts firms’ profit, especially in the presence of peer influence. This paper fills that gap by exploring how consumer valuation heterogeneity impacts a firm’s pricing policy and profit when consumers’ purchase decisions depend on not only their own valuation for a product but also the purchase decisions of their peers. The findings will provide firms with a better understanding of consumers’ purchase behavior in the presence of peer influence and offer firms guidance on how to better deal with consumer valuation heterogeneity.
In this study, we develop a theoretical model to answer the research question. We consider a monopoly firm that launches a new product to the market. The product is categorized under durable goods and is sold in a long time window. The firm decides the product price over the whole selling season based on its knowledge about the distribution of consumer valuation. A consumer’s willingness to pay for the product is determined by the consumer’s intrinsic valuation for the product and peer influence from prior adopters (Sun et al., 2020). Consumers who highly value the product will buy the product early, while consumers who have low valuations of the product may initially decide not to buy. However, with the later influence from their peers’ adoption decision, consumers who initially did not buy may change their minds and eventually buy the product. The study uses a general approach to characterize peer influence: a potential customer’s willingness to pay for a product increases with the number of prior adopters (Shen et al., 2017, Sun et al., 2020). Consumers’ heterogeneous valuation is modeled through different valuation distributions, including a uniform distribution and a truncated normal distribution (Hu et al., 2020).
The main findings are as follows. First, in a benchmark model in which we assume no peer influence among consumers, consumer valuation heterogeneity always hurts the firm’s profit. Specifically, the firm’s profit always decreases as the heterogeneity level of consumer valuation increases. An increase in the heterogeneity level means wider variation in consumer valuations. When consumers’ product valuations vary more, the firm has to lower the price to maintain the market penetration rate. If the firm does not want to lower the price, it must give up more low-valuation consumers and thus serve a smaller consumer segment. The decrease in the price or market penetration rate caused by increased consumer valuation heterogeneity hurts the firm’s profit.
However, when consumers’ purchase decisions are significantly influenced by their peers’ adoption decisions, the impact of consumer valuation heterogeneity on the firm’s profit is different. More specifically, when the intensity of peer influence is high enough, a certain level of valuation heterogeneity can increase the firm’s profit. This is because in this study, a certain level of valuation heterogeneity means that there exists a base of consumers who highly value the product and are willing to pay a high price for it. In this case, valuation heterogeneity creates an opportunity for the firm to charge a higher product price. Although this higher price results in a lower initial adoption rate, the firm eventually achieves a higher profit with the early adopters’ influence on the potential buyers.
The above findings provide several managerial insights. First, the results offer firms a better understanding about how peer influence changes consumers’ purchase behavior and firms’ profitability. When peer influence significantly influences a consumer’s purchase intention, a certain level of valuation heterogeneity can be beneficial for a firm. Second, the findings explain why it is crucial for firms to increase brand strength or equity and to cultivate brand advocates. A strong brand helps a firm to attract a base of super-fans (Aaker, 1996, Rhoden, 2011). These super-fans are willing to pay a high price for the product, which enables firms to charge a high product price (Arvidsson et al., 2006). They are also brand advocates who passionately recommend the product to their social contacts, which attracts more buyers (Fuggetta, 2010, Sweeney et al., 2020). Intensifying peer influence is also important. For example, firms can invest in and nurture consumer tribes, allowing advocates to connect with potential buyers and spread word of mouth (Cova et al., 2007, Wong, 2014).
The rest of this paper is organized as follows. Section 2 reviews the related literature, while Section 3 presents the research model. Section 4 analyzes the impact of valuation heterogeneity on the firm’s optimal pricing policy and profit. In Section 5, the paper presents an extension that show the robustness of the findings. Finally, Section 6 concludes the paper.
Section snippets
Theoretical background
In this section, we review the literature on the concepts discussed in this study. This research provides the theoretical foundations for the analytical model and research findings of our work. We begin by reviewing studies on peer influence and how peer influence impacts product diffusion. We also investigate the literature on how firms can exploit peer influence, such as by leveraging brand advocates. Second, we dig into the literature on how brand equity influences consumers’ valuation for a
Research model
We consider a monopoly firm that introduces a new product to the market. The product is categorized under durable goods and is sold over periods, with . The firm sets the selling price to maximize the total profit of the whole sales season. To focus on the impact of consumer valuation heterogeneity on the firm’s profit, this study does not consider the price adjustment of the firm. That is, the selling price is always in the periods.
There are a total of consumers in the market.
Benchmark: when there is no peer influence
We first provide a benchmark that assumes no peer influence among consumers: is set to 0. In this case, the firm’s optimal pricing policy and profit are summarized in Proposition 1.
Proposition 1 (i) When , the firm’s optimal pricing policy is the market penetration rate is and the firm’s optimal profit is (ii) The firm’s optimal profit decreases with .
Intuitively, when a firm launches a new product, it
A truncated normal distribution of
To check the robustness of the above findings, we extend the study by considering a truncated normal distribution of consumers’ product valuations (Hu et al., 2020). This normality is consistent with the findings in Rogers’ diffusion theory, which holds that adopter distributions follow a bell-shaped curve over time (Rogers, 2010). Assume follows distribution , where the mean of is and the standard deviation of is . A larger value of indicates a higher level of valuation
Conclusion
Evidence has demonstrated that in a large social network, heterogeneity in consumer product valuation can help consumers to learn a product’s true quality, which could increase a firm’s profit (Zhang et al., 2015). Our study also shines light on the impact of consumer valuation heterogeneity on a firm’s profit in the presence of peer influence. The findings demonstrate that word of mouth and peer influence can significantly change consumers’ purchase behavior and firms’ profitability. When the
CRediT authorship contribution statement
Rui Zheng: Conceptualization, Methodology, Formal analysis, Writing - original draft, Writing - review & editing. Ruibing Wang: Writing - original draft, Writing - review & editing. Chao Yang: Supervision, Funding acquisition.
Acknowledgments
This research was supported by the National Nature Science Foundation of China (No.71931005; No.71672065).
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