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Should Firms Share Information About Expensive Customers? An Equilibrium Analysis

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3. ModelInformation Sharing under Bertrand CompetitionConsumersInformation StructureConditional Probability Beliefs about Expensive CustomersConditional Probability Beliefs about Inexpensive CustomersBayesian Updating of BeliefsGame4. The Impact of Information Sharing on Equilibrium ProfitsBoth Firms Keep Information Private Both Firms Share Information Only One Firm Shares Information 5. Firm Incentives to Share InformationInsert Figure 1Comparative StaticsInsert Figure 2Insert Figure 3Insert Figure 46. The Impact of Information Sharing on Consumer SurplusConsumer Surplus When Both Firms Keep Information Private Consumer Surplus When Only One Firm Shares Information Comparing the Change in Consumer Surplus of Expensive and Inexpensive Customers Insert Figures 5-8Insert Figures 9-12Change in Profits(Aggregate Consumer Surplus)(Aggregate Consumer Surplus)(Aggregate Consumer Surplus)(Aggregate Consumer Surplus)ReferencesKirby, Alison, J. 1988. Trade associations as information exchange mechanisms. RAND Journal of Economics 99 138-146Appendix AProof of Lemma 1Appendix BProof of Proposition 1When is ?When is ?Appendix CProof of Proposition 2Should Firms Share Information About Expensive Customers? An Equilibrium Analysis Sameer Mathur1Tel: (412)-622-0257 Email: [email protected] Kannan Srinivasan Tel: (412)-268-7357 Fax: (412)-268-7357 Email: [email protected] Baohong Sun Tel: (412)-268-6903 Fax: (412)-268-7357 Email: [email protected] Tepper School of Business, Carnegie Mellon University 5000 Forbes Avenue, Pittsburgh PA 15213 June 14, 2007 1 Sameer Mathur is a doctoral student in Marketing; Kannan Srinivasan is H.J. Heinz II Professor of Management, Marketing and Information Systems; and Baohong Sun is Associate Professor of Marketing at Carnegie Mellon University.Should Firms Share Information About Expensive Customers? An Equilibrium Analysis Abstract Advances in information technology increasingly allow firms to identify expensive, high-cost customers, who are not only individually less profitable for firms but also raise the average marginal cost incurred by firms and thus impose a negative externality on inexpensive customers. Should competing firms share information that identifies such customers? The answer to this question has important implications for firm profitability, consumer welfare, and privacy laws that currently constrain firms’ ability to share information. Considering consumers to be heterogeneous in terms of the cost they impose on firms, this paper presents an analytical model to examine the conditions in which two differentiated Bertrand competitors prefer to share information. The firms’ incentives to share information differ according to the degree of product differentiation, the relative proportion of expensive customers in the market, the relative marginal cost of selling to expensive customers and the level of noise in the information. When firms sell substitutable products a Prisoner’s Dilemma results. The competing firms unilaterally benefit from sharing information, but the benefits from reneging on an information-sharing agreement are even higher; paradoxically, in equilibrium, both firms therefore keep their information private. A third-party agency such as an industry trade association might serve to supervise and coordinate information-sharing agreements between competing firms. In contrast, when the firms sell complementary products, they always have an incentive to share information. Importantly, this paper establishes that information sharing decreases the welfare of expensive customers but increases that of inexpensive customers. Privacy laws thus protect expensive customers more than inexpensive customers. In certain conditions, the aggregate consumer welfare might increase, when firms share information identifying expensive customers. This research recommends relatively weaker, not stronger, privacy laws, which is counterintuitive to the recommendations of the popular press. Keywords: Customer knowledge, Expensive customers, Information sharing, Trade association, Privacy laws, Game theory 21. Introduction With the onset of the information revolution and advances in technology, companies possess increasingly detailed databases of individual-level customer information that enable them to better identify individual-level customer preferences and reveal who bought what, when, and for how much. Consistent with the recent trend of shifting from product management to customer portfolio management (Gupta and Lehmann 2005), companies often use customer information as a strategic asset to individually identify their best customers. However, not every customer is necessarily valuable, and firms can use individual-level databases to identify undesirable customers. As Selden and Colvin (2003) argue, retail markets contain a high-cost market segment, along with a typical low-cost, profitable market segment. This high-cost segment typically spends too little, complains too much, and/or ties up too many firm resources. Firms can cater their marketing-mix tools to avoid doing business with such customers, for example, by not sending them promotional catalogs. In the case of Best Buy, an estimated 100 million of 500 million annual customer visits are undesirable; some customers buy products, apply for rebates, return the purchases, and then buy them back at returned-merchandise discounts. Alternatively, they may load up on loss leaders, then sell the goods at a profit on eBay. Other undesirable customers present rock-bottom price quotes from Web sites and demand that Best Buy make good on its lowest-price pledge. “They can wreck enormous economic havoc,” noted Brad Anderson, CEO of Best Buy, in a Wall Street Journal interview (McWilliams 2004). Along similar lines, Federal Express has kicked off a marketing program to rate customers as the good, the bad, and the ugly, using data mining technology. “We want to keep the good, grow the bad, and have nothing to do with the ugly,” says Sharanjit Singh, managing director for marketing analysis, in Business Week (Judge 1998). Federal Express has recognized that the cost of doing business with the ugly is greater than the revenue it provides. Such an adverse impact of a minority segment of customers is widespread across markets as diverse as clothing retailers and financial services providers, with less than 20% of customers typically responsible for more than


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