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Three Essays on Strategic Considerations for Product Development

  • Author(s): Sawhill, James Winslow
  • Advisor(s): Villas-Boas, J. Miguel
  • et al.
Abstract

This dissertation is composed of three essays focused on strategic considerations for product development. In chapter I, I address the question of whether consumers equally weigh capital and operating costs when purchasing durable goods. This trade off is important to manufacturers as they determine how much of their product design and production costs should be dedicated to keeping operating costs low. I test this empirically using data from the automobile industry. Chapter II is also an empirical study which explores whether consumers are willing to pay for socially responsible products. The answer to this question is important for firms to address in their product development process as they decide whether they will gain more market share by producing a socially responsible product with somewhat higher costs or a low cost product which does not incorporate socially responsible practices. In this case, I use data on retail sales in coffee industry using fair trade practices as an exemplar of social responsibility. Chapter III addresses the question of how durable or reliable manufacturers of durable goods should make their products. Consumers will likely want to pay more for a more durable product, yet increased durability depresses replacement demand. I attempt to gain insight into this trade off by developing an analytical model of the interplay between consumers and a monopolist manufacturer of durable goods. The remainder of the abstract provides a more detailed summary of each of these chapters in turn.

Chapter I explores whether consumers behave as if they are optimally trading off capital and operating costs when purchasing a durable good. I study this question using data on gas prices and automobile sales over the 20 year period, 1971-1990. This question is important for three reasons. First, it is interesting from a theoretical basis if consumers make this trade off optimally. Many theoretical models in marketing and economics make the fundamental assumption that consumers equally weigh current and future events when making decisions today. Yet there is some evidence, mostly from laboratory experiments, that consumers underweight future events. I attempt to explore this question in a market setting where the stakes are considerably higher. This research adds evidence to the debate about how much weight consumers place on future events when making choices today. Second, it is interesting to firms making product design decisions. If consumers underweight future events, then when making purchase decisions, consumers will view operating costs as less important than the upfront capital cost of the product. Finally, the answer to this question informs public policy. Many have argued that there is a need for the US to reduce gasoline demand per capita. Lower gasoline consumption would reduce environmental pressures, potentially dampen inflation, and allow more foreign policy flexibility in dealing with antagonistic regimes in oil-exporting states. While these rationale for reducing gasoline consumption have a normative flavor, and reasonable people may disagree as to the validity and motivations of this goal, it will nonetheless be useful to know the relative effectiveness of different policy levers in curbing gasoline consumption. For example, if consumers underweight fuel costs during the vehicle purchase decision, then a gas tax will be relatively less effective than a tax on gas guzzling vehicles.

To study this question I develop a choice model of the automobile industry. I identify the weight the consumer places on capital v. operating costs by determining how much of the variation in automobile market share can be explained by variation in each of these two factors holding other product attributes constant. We use data from the period 1971-1990, a period over which gas prices and thereby operating costs experienced considerable variation. In order to model operating costs which are not known at the time of purchase, I account for the expectations of consumers about car usage and gas prices. I assume that consumers are aware that they will respond to changes in the gasoline prices with changes in their driving patterns. Consumers also know that gasoline prices are not stable, and need to form expectations about future gasoline prices at the time of the automobile purchase. To take account of this effect, I estimate an ARIMA model of US gasoline prices from 1960-1995, that is used as the by consumers in their expectations formation process. Taking car usage and gas price expectations together enables an estimate of future gasoline costs of operating the car in the future. I also account for consumer heterogeneity in miles driven, sensitivity to automobile price, and sensitivity to operating costs. Finally, I recognize that prices are not exogenously determined and attempt to model prices as market outcomes.

Based on the results of the model developed, I find no evidence to support behavioral theories that consumers systematically underweight the cost of future events in real market settings. However, I find significant evidence that large portions of the population are not making the trade-off optimally. Some consumers underweight future operating costs (SUV drivers) while others appear to overweight them (hybrid drivers). Conservatively, at least 30% of the population is either drastically underweighting or overweighting operating costs when purchasing a new car.

Chapter II addresses the question of whether consumers are willing to pay for corporate social responsibility(CSR). This question is important in an environment where CSR is ubiquitous, yet it is unclear that these programs actually pay off for the firms that sponsor them. For example, consider Target's program to donate 1% of all retail sales to United Way local charities. Do consumers really want their money spent this way? Are consumers happily paying 1% higher prices or are they switching to a competitor which does not donate a portion of revenues to charity? Who is making the donation in the end, Target's shareholders or customers? From a social planner's perspective, the point is largely moot, yet to the shareholders of Target and many other firms practicing CSR, the question is crucially important.

I endeavor to study this question within the context of the coffee industry, an important and sizeable commodity market. In particular, I explore the impact of Fair-Trade (FT) certification on the retail coffee market. FT is a social and ethical movement that supports the ethical production of coffee and other products largely in third world countries. Coffee can be FT certified by adhering to FT standards. Once certified, FT coffee is distinguished from non-FT by distinctive labeling visible to the consumer who is deciding which coffee product to select from the supermarket shelf.

The analytical strategy for this paper is to first estimate the price premium commanded by FT coffee over non-FT coffees through ordinary least squares (OLS) and Fixed Effects hedonic price regressions. However, these tools do not allow us to disentangle the portion of the price premium which is due to supply considerations (i.e., FT certification costs) from the portion which is due to consumers' willingness to pay for FT coffee because they want to support socially responsible coffee production. To parse out willingness to pay from the overall price premium, I specify a brand choice model similar to the model used in chapter I.

Using hedonic price regressions I establish that FT coffee carries a price premium of $1.74 per 12-16 oz. It seems likely that at least a portion of this premium is due to increased consumer willingness to pay for FT coffee. However, I cannot rule out the possibility that the price premium is a result of the added costs associated with that FT practices. The choice model specified in this paper should enable the allocation of the cause of the price premium we have now established for FT coffee to demand v. supply considerations. I hope to estimate this model in future research.

Chapter III addresses the problem of how durable or long lasting manufacturers should they make their products. On the one hand a more durable product will be more desirable to consumers, since it will provide benefits over a longer period. Thus, a longer-lived product will command a higher price. However, it seems likely that unit production costs will increase as a product is made more durable due to the increased cost of more reliable materials and more exacting quality standards. In addition, a product which is more durable will be replaced less frequently. Ceteris paribus, less frequent replacement is less desirable to manufacturers, as the periodicity of the revenue stream increases. Manufacturers can trade off the benefits of durability with the costs to determine the optimal reliability or life for the goods they produce.

In some sense, this problem is a classic trade-off between quality and cost. What distinguishes the durable goods reliability problem is that increasing quality depresses replacement demand. A common anecdote is that light bulbs could easily be manufactured to last longer, but are not in order to increase replacement sales.

This question is important for manufacturers to understand from several perspectives. First, a manufacturer of a product with technology that is fairly static (e.g., light bulbs), needs to consider replacement demand in developing product designs. When technology is not static (e.g., computers), it is important to understand how the rate of technology advance will stimulate replacement demand. Should the products be designed to be more or less durable in the face of technological advance? An additional complication arises when the rate of technological advance may only be partially observable to the consumer (e.g. golf clubs). Finally, manufacturers need to consider "buying back" used durable goods from their customers in order to stimulate replacement demand. Even if the manufacturer does not take physical possession of the old product, it may be optimal to offer price concessions on newer products in order to induce the consumer to replace her existing technology.

I study this question by developing a partial equilibrium model for durable goods where both manufacturers and consumers are forward looking over an infinite horizon. I make the simplifying assumptions that there is a single monopolist manufacturer and that consumers have homogeneous preferences.

I find that in all cases, it is optimal for manufacturers to incent consumers (buy back) to replace their existing durable goods before the end of the useful life of the product. I also find that under extremely rapid rates of technological advance, it is optimal for manufacturers to extend the life of the product and increase durability. This result runs somewhat counter to intuition in that one might think that rapid advances in technology would promote more frequent product replacement. However, if technology advances rapidly then patient consumers will want to be able to enjoy their new product (e.g., HDTV) and are willing to pay a high price for durability. This increased willingness to pay for an advanced long-lived product will more than offset the loss of replacement sales in the future. Finally, I show that when technology advances are uncertain and not directly observable by consumers, they are willing to pay more than when technology advances at a known and constant rate. The intuition for this result is that consumers are risk averse and do not want to miss out on a new breakthrough product. We believe this may be the reason that certain durable goods manufacturers (e.g. golf club manufacturers) appear to introduce new products at a far greater rate than technology is actually advancing.

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