Three essays on operational and strategic decisions in a competitive auto component replacement market

Abstract

With constantly evolving markets and changing dynamics among firms, the competition has taken new dimensions. Competition on price alone is no longer sustainable. Increasingly, firms are competing on multiple dimensions such as service quality, performance quality, process technology,and product variety. In this research we study how should firms make some of these decisions in a competitive auto component replacement market. Depending on the type of domestic customers firms in the replacement market are of two types. The first type of suppliers is manufacturers for OEM and replacement market, i.e., original equipment suppliers (OES). Second type of suppliers is manufacturers for only replacement market (non-OES).OES firms service the replacement market through OEM run service stations and also as an independent supplier. They are characterized by a wider distribution network and higher prices. Non- OES firms operate only in the replacement market. Two types of non-OES firms can be found in the Indian market- regional or national non-OES firms depending on their market coverage. Besides price (p), process technology (t) and performance quality (q) of the product are the prime elements of competition in the auto component replacement market. Process technology has an influence on two dimensions of product quality- conformance and performance quality. Conformance quality, besides being a function of process technology is also influenced by the skill of labors and shop floor practices. But for modeling purposes we assume that conformance quality and technology has one-toone correspondence. The two dimensions of quality effects different components of cost and also has an implication on demand. Performance quality primarily influences the raw material cost such that the higher performance quality component requires superior type of raw material which increases the marginal cost. The investment in more capable technology decreases waste, rejects and labor cost, thus decreasing the marginal cost but increasing the fixed cost. On the demand side, customers have higher preference for more capable technology and better performing products. We incorporate these effects of technology and quality while formulating the firm level demand and cost functions. This thesis constitutes three essays as discussed below. The first essay analyzes the replacement market when the non-OES makes decisions in presence of an OES. Along with this, we analyze the market when the OES and non-OES enter simultaneously and make decisions in a competitive setting. The second essay analyzes the market when the two firms, i.e., non-OES and OES, enter sequentially and make decisions in a competitive setting. In the first two essays, we assume linear demand function (Dixit 1979) but in the third essay we relax this assumption and model various competitive situations of entry by the OES and non-OES firms. In the first essay we model two situations of decision making. First, we consider the entry decision of the non-OES firm with the OES already present and not influenced by the new entrant’s decision. Non-OES firm makes decisions on product features (i.e., technology and performance quality) and price. This situation arises in the replacement market because the OES decisions are governed by their prime customers- OEM. Our results indicate that the investment in a more capable technology can either increase or decrease the optimal price. More capable technology decreases the marginal cost which allows the firm to decrease the price but more capable technology also increases the market demand which allows the firm to price higher. In addition, we consider the entry decisions of the OES and non-OES firms who enter simultaneously and make decisions competitively. OES incorporates competitive threats into decision making when the capabilities of the firms in the replacement market are almost identical and none of the firms can ignore each other. Also, the non-OES enters the market along with the OES firm if it can correctly anticipate the timing of entry of the OES, and size of the market for a replacement component is large. We model this situation as an incomplete information game. We show that the price equilibrium exists for simultaneous game. We find that if the non-OES firm has a dominant cost, then the best strategy for the OES could be to produce inferior quality product and invest in comparatively lesser capable technology. Under such conditions, the optimal price could be higher for components produced by the OES firm. In the second essay, we model the entry decision by sequential entering firms, i.e., the OES followed by the non-OES. The OES is expected to be the first entrant in the replacement market because the entry of the OES is triggered by the launch of a new vehicle from its OEM customer. Once the OES enters, then the other firms decide to enter the market. We show that the price equilibrium exists for the sequential game. We then analyze the market under various competitive strengths and environments. The competitive strengths of the firms are defined by their relative sizes and their marginal cost. The competitive environment is defined by the growth of the market when a non-OES enters. Our findings reveal that even when the market at the time of entry of the non-OES is stagnant, the marginal cost of the non-OES is dominated by the OES and the non-OES firm has a smaller size, then the non-OES can invest in more capable technology. The high price of the product doesn’t necessarily signify usage of a more capable technology and a better performing product. We also find that market structure is affected less by firm size than the state of the market, i.e., whether it is growing or is stagnant at the time of entry of non-OES. In the third essay, we model the choices of firms in the replacement market using a standard market share model- multinomial logit, instead of a linear demand model as used in earlier two essays. We collect data on consumers’ willingness to pay for the existing brands of a specific auto component automobile battery and estimate the parameters of a multinomial logit market share model for the products of OES and non-OES firms. As discussed in the second essay, OES is usually the first entrant in the market and therefore we model for the entry decision by non-OES firms and the reaction of the OES to the new entrants. Because of the complicated demand functional form we assume product features as exogenous to our model and only determine prices. We start with a basic model where a non-OES considers the entry when both an OES and another non-OES (either regional or national) are already present in the market. The entering non-OES firm makes the decision on price. Our results show that though the optimal price increase at an increasing rate with increase in marginal cost, the margin for a non-OES decrease at an increasing rate. Next, we also model for two variants of this situation. The two variants are distinguished in terms of the timing of launch of two products by OES, as this could be a crucial strategy by the OES to counter the competition. The results indicate that the passive behavior of the OES to competition helps the survival of non-OES firms. If OES reacts to competition with price changes, it leads to a worse off situation for all the firms, with low profits for the OES and low market share for the non-OES. The sensitivity of these results to marginal cost indicates the robustness of our conclusions. In conclusion, our research has strong implications for all the entities that we study: OES, non-OES and customers. The optimum product strategy for OES is to launch variety of products and to adopt a passive response strategy to the threat by non-OES. Firms with national and regional focus need to competitively price their products by being cost efficient. Technological investments by all the firms increase their demands at the optimal price and better quality increase their optimal prices. Customers definitely benefit from the intense competition with low prices in the market. However, they need to be more cautious in making inferences about the quality of non-OES products. Non-OES firms can have better product features despite being cheaper as compared to OES products.