Overcoming Product Cannibalization in the Online

Channel using Personalization Technology, Community

Access, and Intertemporal Price Discrimination

Frederick J. Riggins
Carlson School of Management
University of Minnesota, Minneapolis, MN
friggins@csom.umn.edu
Phone: 612-624-5760
Fax: 612-626-1316

Sridhar Narasimhan
DuPree College of Management
Georgia Tech, Atlanta, GA
sri.narasimhan@mgt.gatech.edu
Phone: 404-894-4378
Fax: 404-894-6030

November 2001

1
 Overcoming Product Cannibalization in the Online
Channel using Personalization Technology, Community
Access, and Intertemporal Price Discrimination

Abstract

We develop a model of separating equilibrium where a monopolist

markets a physical product to two types of consumers in the online
channel. We show how the seller may use personalization technology to
limit or even eliminate the distortion caused by the cannibalization
problem. This results in higher product quality levels and earlier product
introductions for goods aimed at low type consumers. We find that
personalization technology also lessens the adverse effects caused when
the seller cannot credibly commit to future actions. We show that the
seller should focus all of its personalization efforts on high type
consumers, and must concern itself with the level of patience of high type
consumers and not low types. We also examine three different seller
strategies for bundling the sale of the physical good with customer access
to a seller-sponsored online community. When personalization
capabilities are relatively low, the seller should segment consumers into
two communities by allowing consumers to have access to the community
associated with the type of physical good that was actually purchased.
When personalization capabilities are sufficiently high, the seller should
switch from the segmented communities strategy and merge all consumers
into one community to take advantage of externality effects.

2
1. Introduction
Conducting business over the Internet allows firms to employ new online
technologies and marketing strategies to serve customers in new ways. In particular, the
online channel enables new interactive communications capabilities that can add value to
buyers and sellers. For example, online sellers can make use of both active and passive
customer feedback mechanisms to better understand their customers’ preferences and
thereby provide highly customized product offerings. In addition, customers may interact
with one another within a seller-sponsored online community to learn about new products
and share opinions on the value of the firm’s offerings. Effective utilization of these
types of online technologies is an essential component of the overall value proposition
that e-business offers relative to traditional forms of commerce.
One of the problems that plague sellers in any marketplace is the cannibalization
problem that occurs when a seller attempts to market to different types of consumers
within a given channel, but is not able to identify a particular consumer’s type. For
example, with two types of consumers the seller will attempt to sell two versions of a
good where a high quality, high priced good is targeted at high type consumers and a low
quality, low priced good is aimed at low type consumers. However, the cannibalization
problem is based on the fact that if the seller sets the price of the low quality good at the
low type consumer’s willingness to pay, high type consumers may view that version as a
bargain and be attracted to it rather than the high quality good. This is because high type
consumers typically place a greater value on a given level of quality than low types. This
distortion caused by the cannibalization of sales of high-end goods will result in lower
profits for the seller. To ensure that consumers purchase the appropriate product, sellers
may practice second-degree price discrimination by setting their price and quality levels
to create a separating equilibrium where consumers self-select into their appropriate
consumer segments. This separating equilibrium may result in the seller lowering the
quality of goods normally targeted at low type consumers to make them less attractive to
high type consumers (Moorthy and Png 1992). If the potential for cannibalization is
particularly high, sellers may focus entirely on high type consumers such that low types
may not be served at all.

3
 In an effort to avoid the cannibalization problem, sellers often attempt to segment
the market by employing intertemporal price discrimination by offering high-end goods
early and low-end goods at a later time (Bensanko and Winston 1990). Rather than
lowering the actual quality of the low good, the seller degrades the product by using
delay to force low type consumers to wait for the introduction of products suitable to
their needs. However, certain unique features of the online channel may provide the
seller with additional ways to combat the cannibalization problem. For example, because
personalization technology allows the seller to better identify a prospective customer’s
preferences, the seller may be able to use personalization to mitigate the cannibalization
problem and move toward first-degree price discrimination in the online channel. In
addition, the seller may be able to provide an additional incentive to entice customers to
reveal their preferences by bundling the purchase of the physical good with access to a
value-added online community. If the seller is able to restrict community access based
on specific consumer purchasing behavior, the seller may be able to entice consumers to
reveal their true purchase preferences.
In this paper, we develop a model of separating equilibrium where a monopolist
seller markets a physical product to two types of consumers in the online channel. We
show how the seller may be able to use personalization technology to move from second-
degree price discrimination toward first-degree price discrimination and thereby limit or
even eliminate the market distortion caused by the cannibalization problem. In particular,
we show that when the seller employs personalization technology, low type consumers
may experience higher product quality levels and earlier product introductions. In
addition, we will show that increased personalization capabilities can result in less
restrictive access to online community interaction for all customers. The results of this
analysis are pertinent for information technology budget managers and Internet marketing
strategists.
The organization of the paper is as follows. We begin in the next section by
reviewing the relevant literature upon which we construct our model. The single period
model is developed in §3 where we show the impact of personalization technology on the
seller’s strategy in terms of the price and quality selection, and the resulting profits to the
seller. In §4, we analyze the seller’s strategy when the seller can bundle the purchase of

4
the physical good with access to an online community. We show that the optimal
strategy for community segmentation and customer access is dependent upon the extent
to which the seller engages in personalization. We investigate the timing of product
introductions in §5 where we develop a two period model when the seller is able to
commit to future product introductions and when the seller is not able to credibly commit
to future actions. We show how the seller is able to substitute personalization technology
for intertemportal price discrimination. In other words, when the seller is able to practice
personalization in the online channel, low type consumers need not be forced to wait for
the introduction of products appropriate for their level of spending. We conclude with a
discussion of our results in §6 and directions for future research.

2. Previous Modeling of the Cannibalization Problem

Several researchers have examined pricing strategies of sellers that practice
intertemporal price discrimination. Conner (1988) illustrates how a firm may spend
aggressively on research and development to create a new version of an old product, only
to set the new product aside until the old one is challenged by a competitor. Besanko and
Winston (1990) model the monopolist’s optimal timing and pricing strategy in the
introduction of a new product when consumers are intertemporal utility maximizers
versus being myopic. They show that prices are always lower when consumers act
rationally as opposed to myopic, allowing the seller to practice intertemporal price
discrimination. Similarly, Levinthal and Purohit (1989) show how expectation of a future
product improvement cannibalizes sales of the current version of the product. They show
conditions under which the seller should phase out the old product versus instituting a
buy-back policy when the new product is introduced.
Purohit (1997) develops a two-period model of a manufacturer that markets its
goods in two channels – a rental agency and a dealership. He determines the profitability
of the manufacturer under three different channel structures that are used to explain how
automotive manufacturers coordinate their rental and dealership relationships.
Zettelmeyer (2000) examines how the size of the Internet affects the firm’s pricing and
communications strategies. He shows that when the Internet is relatively small in size,
firms will provide more information online and prices will be lower than in conventional

5
channels. As the number of users on the Internet increases, the amount of information
the firm provides through the Internet channel and the firm’s online pricing policy will be
similar to that in the conventional channel.
Balasubramanian (1998) adapts Salop’s (1977) circular city model to compare the
direct mail efforts of a physically unconstrained catalog retailer versus the efforts of
traditional retailers who cater to neighboring customers. While he indicates the model
can be used to illustrate the efforts of an online Internet retailer he doesn’t examine the
use of online features such as personalization or community. In another model, Roy
(2000) examines how targeted direct marketing can result in complete market
segmentation between two competing firms.
Mason and Milne (1994) conduct an empirical study of the cigarette industry to
show how the proliferation of brands results in cannibalization of other product lines,
leading firms to reduce the number of brands they sell. They develop a method of
identifying the degree of cannibalization in mature retail markets.
The current analysis is most closely related to Moorthy and Png (1992) who
develop a model of separating equilibrium where a monopolist produces a durable good
that can be differentiated along some dimension of quality. The monopolist sells to a
market that is made up of high and low type consumers, where high types have a greater
value for a given level of quality than low types. Given this scenario, the seller will
produce two versions of the product – a high quality product targeted at high type
consumers, and a low quality, low priced product targeted at low types. The authors
show that the optimal solution to the cannibalization problem is to give high type
consumers a price discount and lower the quality (and corresponding price) of the low
quality good to the point that the high type consumer is not interested in that version of
the product. Indeed, the cannibalization distortion may be so strong that the seller may
lower the quality of the low good to the point that it essentially doesn’t exist, i.e. the low
type consumer is not served in the marketplace. This distortion has two important effects
on the market. First, low type consumer choice is reduced since they receive a lower
quality product. Second, this distortion lowers the profits of the seller who must contend
with the moral hazard associated with second-degree price discrimination. They extend
their model to consider the impact of sequential product introductions. By offering the

6
high quality product in the first period and the low quality product in the second period,
the seller is able to mitigate the cannibalization problem when buyers are relatively more
impatient than the seller. In the remainder of this paper, we extend their model to
incorporate the impact of the seller’s employment of personalization technology and
community features in the online channel.

3. Single Period Separating Equilibrium with Personalization

We begin with the basic single-period model with personalization where a
monopolist produces a durable good and markets it in the online channel. The
cannibalization problem arises because the seller is not able to distinguish a prospective
customer’s type and therefore must practice second-degree price discrimination. As the
seller is able to collect user information and thereby personalize the online offering, the
seller is able to move away from second-degree price discrimination and move closer to
first-degree price discrimination. Indeed, in an environment where the seller is able to
gather perfect information about the user, he would be in a position to extract all
consumer surplus by setting the price at each consumer’s willingness-to-pay. For
example, once enough information is collected, an online high type user would only have
access to pages promoting high quality goods and may never see low quality goods in the
online channel. It is easy to see how in the extreme this would eliminate the
cannibalization distortion.
We consider a market for a durable good that can be differentiated according to
some dimension of quality, q. There are two types of consumer segments in the market,
h and l, where nh is the number of high types and nl is the number of low types. Further,
high type consumers value a given level of quality q at vhq, while low types value the
same item at vlq. Let vh > vl > 0 such that high types value a given level of quality more
than low type consumers. Let vlh =vh/vl, nlh =nh/nl and R= nlh ( vlh –1) where R is a measure

of the degree of cannibalization as shown in Moorthy and Png (1992). The seller’s
marginal cost of supplying one unit with quality q is cq2, where c > 0. Finally, assume
that a consumer buys at most one unit of the durable good and then exits the marketplace.
To model the seller’s use of personalization technology we introduce a
personalization parameter, ω ∈ (0, 1), which measures the extent to which the online

7
seller is able to know the user’s likes and dislikes, and correspondingly personalize the
online channel offerings. When ω is close to 0, the seller is not able to personalize at all.
When ω is close to 1 the seller knows everything about the user and is able to practice
first-degree price discrimination. When this occurs the seller would be able extract all
consumer surplus.
With two consumer segments in a single channel, there can be at most two
“products” or levels of qualities – a high quality good targeted to the high type consumers
and a low quality good offered to the low type consumers. We can calculate the efficient
qualities of the two products as the qualities that maximize the difference between the
targeted customer’s valuation and the firm’s marginal cost of quality. Specifically, the
efficient qualities for the two products are
vh
qh * = (1)
2c
and
vl
ql * = . (2)
2c
Given that vh > vl > 0, we know that q h * > q l * .
With this scenario, our goal is to understand when and how the seller will offer
products to the two market segments. With two segments, there are at most two products
and at most two possible product introduction dates. The seller can execute one of the
following strategies:
1) offer both products simultaneously in the first period;
2) offer the high quality product in period one and the low quality product in
period two;
3) offer the high quality product in period one and not serve the low type
consumers; or
4) offer neither product at any time.
The fourth scenario is trivial and occurs when the cost, c, is too high to encourage entry
into this market, i.e. qh = ql = 0. Also, it should be noted that if the seller enters the
market it will never delay offering the high quality product and the low quality product
will never be offered before the high quality good. While the seller may degrade the low
quality product to avoid the cannibalization problem, he will never delay offering the

8
high quality good, since delay is a form of product degradation. This is so because, while
the high type consumers may be tempted to buy the low quality good, the low type
consumers will never consider purchasing the high quality good.
We now turn our attention to the first situation noted above where the seller
introduces all products in the same period and commits to no further product
introductions. Clearly, there is no reason to delay both introductions, so this case
considers simultaneous first period introductions. When the seller targets the appropriate
good to the appropriate consumer segment, the seller’s problem is to select the quality
levels, qh and ql, and prices, ph and pl, according to the following problem

( ) (
max nh p h − cq h 2 + nl pl − cql 2
qh , ql , p h , pl
) (3)

subject to:
vl ql − pl ≥ (1 − ω )[
vl q h − p h ] (4)

v h q h − p h ≥ (1 − ω )[
v h ql − pl ] (5)

vl ql ≥ pl (6)

vh qh ≥ ph . (7)
The constraints (4) and (5) are the self-selection constraints for the two consumer
segments. Since the seller must practice second-degree price discrimination, he must set
the quality and price levels so that each segment chooses the appropriate quality and price
offering. Constraints (6) and (7) are the participation constraints that ensure that each
consumer type will participate in the market.
As pointed out by Moorthy and Png (1992), because high type consumers value a
particular level of quality more than low type consumers, the seller cannot extract all of
the consumer surplus from both types by binding constraints (6) and (7) simultaneously.
If the seller attempted this, the high type consumers would forgo purchasing the high
quality good and instead purchase the low quality good, thereby gaining some positive
surplus. In fact, if the seller sets the price of the low quality good within the low type
consumer’s price range, the high type consumers are sure to participate in the market.
The seller’s problem is to make sure low type consumers participate and that high type
consumers buy the appropriate good. Therefore, the seller will bind constraint (6) such
that

9
 pl = vl ql . (8)

Also, the seller should set the price for the high quality good such that high type
consumers are indifferent between the high quality good and the low quality good. This
is accomplished by making constraint (5) bind, such that
ph = ω vh qh + (1 − ω )[
vh qh − (vh − vl )ql ]. (9)

Substituting these prices into the objective function and maximizing with respect to the
two levels of quality, we see that

ql =
vl
[1 − R(1 − ω )] (10)
2c
and
vh
qh = (11)
2c
The seller’s profits are

nl v l 2 nh vh 2
Π= [
1 − R(1 − ω )] +
2
. (12)
4c 4c
The two terms in equation (12) represent the profit from selling to low type consumers
and high type consumers, respectively. This two-product solution is feasible, if and only
if ql > 0 , i.e., when R(1 − ω )< 1 . When R(1 − ω )≥ 1 , the seller is able to increase profits
by lowering the quality of the low quality product, and does so until the point that it
essentially doesn’t exist – the low type consumer is not served in the online market. As
Moorthy and Png (1992) show, the seller should supply the high type consumers their
efficient qualities from (1) and price them according to (9). Low type consumers receive
a product that has a quality level lower than the efficient amount provided that
R(1 − ω )> 0 . As R(1 − ω )→ 1 , profits are increased as ql goes down. In the limit, no
two-product solution can have profits greater than nhvh2/4c. Therefore, the profits with
two distinct products for the single period introduction case where the seller can commit
to no further product introductions are
 nl vl 2 nh vh 2


= [1 − R(1 − ω )]+ if R(1 − ω )< 1
Π12c  4c 4c (13)
2
p nh vh
if R(1 − ω )≥ 1.

 4c

10
As expected, this result is the same as Moorthy and Png (1992) when ω → 0 . Moorthy
and Png (1992) also show that if the seller attempts to sell only one product, q, at price, p,
it will serve only the high type segment with a price p = vhq at the efficient quality level,

nh vh 2
such that Π11c = . This is better than (12) when R(1 − ω )≥ 1 . For the case where
4c
the seller employs personalization technology, we can now state Proposition 1 as

PROPOSITION 1. If the seller is able to personalize according to the personalization

parameter, ω ∈ (0, 1), and chooses to introduce products in one period only, then he will
1 1
do so in the first period, and offer two qualities if R < ; if R ≥ , then he will
(1 − ω ) (1 − ω )
offer only one quality and commit not to introduce any more products.

We see then that personalization technology increases the likelihood that low type
consumers will be served by negating the cannibalization problem. In fact, in the limit as
ω → 1 we see that the seller will never offer only one product, but will serve both high
and low consumer types, or neither if c is too high. Also, we see from (13) that in the
∂Π
region R(1 − ω )< 1 , ≥ 0 such that increasing the use of personalization technology
∂ω
increases the seller’s profits. Of course, we have not taken into account the cost of
personalization. It would be straightforward to calculate an optimal level of
personalization, ω*, based on an assumed personalization cost function.
Realizing that personalization is not a costless venture brings us to another
important point in our model. Specifically, what is the nature of the seller’s
personalization efforts? Recall again the seller’s maximization problem and constraints
in equations (4) to (7). Because we are concerned with keeping the high type consumers
from buying the low quality good we bind constraint (5) and not (4). Therefore,
including the personalization parameter in constraint (4) has no effect on the seller’s
problem. We could have included two personalization parameters: ωl for personalization
to low type consumers in (4), and ωh for personalization to high type consumers in (5).
The reader can readily see that ωl would not enter into the seller’s quality and pricing

11
strategy. In other words, the seller’s efforts to engage in personalization are targeted at
high type consumers only. We now state Proposition 2.

PROPOSITION 2. Because the nature of the cannibalization problem is to cannibalize

sales of the high quality good via inappropriate purchases of the low quality good, and
not vice versa, the seller should direct all of its personalization efforts toward the high
type consumers.

As the seller increases its personalization capabilities toward the high type consumers,
the potential for cannibalization is lessened as high type consumers get more focused,
personalized service. This allows the seller to raise the price for the high quality good
and increase the quality and price of the low good, both of which contribute to increased
seller profits.

4. Bundling the Physical Good with Access to an Online Community

Another interesting characteristic of the online shopping channel is the potential
existence of user externalities in the online marketplace. In particular, online storefronts
often include certain community features that are valued by many online shoppers.
Opportunities to interact with other shoppers in online chat rooms or bulletin boards
allow users to find out what products are available for purchase, receive opinions on the
overall value of the goods offered, and learn how other like-minded individuals have used
the product. Rogers (1995) emphasizes that the influence of near-peers may be
particularly strong in terms of innovation adoption. Therefore, interaction with
individuals of the same type may be particularly attractive to online consumers,
suggesting that the seller should segment the online community by consumer type. On
the other hand, if consumers value interaction with all types of consumers, the seller may
want to provide access to one large online community to take advantage of potential
network externalities. In this section, we consider the impact of bundling the physical
good with access to an online community. In particular, we examine the impact on price,
quality, and the seller’s profits when the seller can choose to segment the online

12
community by type and employ different strategies for granting access to the different
community segments based on the consumer’s purchase choice of the physical good.
We include an externality factor in the user’s valuation of the shopping
experience that captures the number of individuals in the online community. Let κij > 0
be the relative value to consumer of type i of having a consumer of type j in the online
community.
We consider three ways that the seller can segment the online community and
provide community access to consumers1:
1) offer one community that is open to all consumers who purchase either physical
good;

2) segment the community into two separate communities where one is promoted as
being for low type consumers and the other is promoted as meeting the needs of
high type consumers. When a consumer makes a purchase of a physical good, the
consumer may choose to have access to one community or the other; and

3) segment the community into two separate communities based on the purchase of a
physical good. When a consumer makes a purchase of a physical good, the
consumer is given access to the community associated with the particular good
that was purchased.

4.1 Strategy 1: Single Online Community for All Customers

The first strategy is where a consumer receives access to the single community
made up of all of the seller’s customers. The seller’s problem is

(
max nh p h − cq h 2 + nl pl − cql 2
qh , ql , p h , pl
) ( ) (14)

subject to:
v l q l + κll nl + κlh n h − p l ≥ (1 − ω )[
v l q h + κll nl + κlh n h − p h ] (15)

v h q h + κhl n l + κhh n h − p h ≥ (1 − ω )[
v h q l + κhl nl + κhh n h − p l ] (16)

v l q l + κll nl + κlh n h ≥ p l (17)

v h q h + κhl n l + κhh n h ≥ p h . (18)

1
There are many other ways to offer access to communities not considered here. Future research should
examine the role of communities provided for free to build brand or communities that require a periodic
subscription fee.

13
Proceeding in the same manner as before, the seller would bind (16) and (17), such that
the two prices would be
p l = v l q l + κll nl + κlh n h (19)

and
p h = ω (v h q h + κhl nl + κhh n h )+ (1 − ω )[
v h q h − (v h − v l )q l + κll n l + κlh n h ]. (20)

As in the previous case the seller is able to extract all consumer surplus from the low type
consumers such that if they value community interaction, the seller is able to charge them
their willingness to pay for that service. This is not the case for high type consumers,
except when ω is near 1. When ω is near 0, the seller charges high type consumers what
the low type consumers are willing to pay. This is because this is the markup for the low
quality good in (19), so the seller is able to charge that to the high types regardless of
which product they choose. As ω increases towards 1, the seller is able to increase this
mark-up to reflect the extent to which high type consumers value community access.
Again, using (19) and (20) to solve the objective function, we see that

ql =
vl
[1 − R(1 − ω )] (21)
2c
and
vh
qh = (22)
2c
just as in the previous section. We can calculate the seller’s profits for Strategy 1 as

Π (1) = Π (0) + κlh [n l n h + (1 − ω )n h 2 ] + κhl [ω nl n h ] + κhh [ω n h 2 ] (23)

nl v l 2
[ ] and
2
2 nh v h
where Π (0) = [
1 − R(1 − ω )] + + κll nl 2 + (1 − ω )nl n h represents a
4c 4c
portion of the seller’s profits that is common to all three strategies under consideration.

4.2 Strategy 2: Segmented Communities by Consumer Type

The second strategy is where a consumer must choose to receive access to either
the high type consumer community or the low type consumer community. In this portion
of the analysis, we will assume that when given the choice of choosing between one
community segment or the other, the consumer will choose to receive access to the
community with consumers of the same type as themselves. We could investigate other

14
scenarios, but the basic results given below would not be altered.2 In this case, the
seller’s problem is

(
max nh p h − cq h 2 + nl pl − cql 2
qh , ql , p h , pl
) ( ) (24)

subject to:
vl ql + κll nl − p l ≥ (1 − ω )[
v l q h + κll nl − p h ] (25)

v h q h + κhh n h − p h ≥ (1 − ω )[
v h ql + κhh n h − p l ] (26)

vl ql + κll nl ≥ p l (27)

v h q h + κhh n h ≥ p h (28)

whereby
p l = v l q l + κll nl (29)

and
p h = ω (v h q h + κhh n h )+ (1 − ω )[
v h q h − (v h − v l )ql + κll nl ] (30)

leading again to

ql =
vl
[1 − R(1 − ω )] (31)
2c
and
vh
qh = . (32)
2c
Here, the seller’s profits for Strategy 2 are

Π (2) = Π (0) + κhh [ω n h 2 ] . (33)

We can now state Proposition 3 as

PROPOSITION 3. In terms of the seller’s profits, Strategy 1 weakly dominates Strategy

2. The two strategies are equal when consumers do not value interaction with types other
than their own.

2
If we allow consumers to select a community other than the one targeted for their type, the quality levels
would be unaltered and the seller’s profits would be between that found in (23) and (33) with no change to
the propositions given below.

15
This should not be surprising since a consumer will believe that “more is better”. If the
consumers do not value interaction with other types of consumers, then the profits from
the two strategies are identical. However, if consumers value interaction with other types
at all, then consumers receive more value in Strategy 1 and can be charged accordingly,
thereby raising the seller’s profits. In particular, note that the seller’s selection of
Strategy 1 versus Strategy 2 does not affect the consumer’s physical product selection –
Strategy 1 simply results in more value to the consumers. This is not the case with the
third strategy.

4.3 Strategy 3: Segmented Communities Based on Physical Product Purchased

In the third strategy, the seller segments the consumers into two community
segments and provides the consumer with online access to the segment associated with
the particular physical product that was purchased. Unlike the first two strategies, the
seller is essentially providing added incentive to entice the consumer to select the
“appropriate” physical good, provided that consumers value interaction with their own
type. The seller’s problem is

( ) (
max nh p h − cq h 2 + nl pl − cql 2
qh , ql , p h , pl
) (34)

subject to:
vl ql + κll nl − pl ≥ (1 − ω )[
vl q h + κlh nl − p h ] (35)

v h q h + κhh n h − p h ≥ (1 − ω )[
v h ql + κhl n h − pl ] (36)

vl ql + κll nl ≥ p l (37)

v h q h + κhh nh ≥ p h (38)

whereby
pl = vl ql + κll nl (39)

and
p h = ω (v h q h + κhh n h )+ (1 − ω )[
v h q h − (v h − vl )ql + κll nl − κhl nl + κhh nh ] (40)

leading again to

ql =
vl
[1 − R(1 − ω )] (41)
2c
and

16
 vh
qh = . (42)
2c
Here, the seller’s profits for Strategy 3 are

Π (3) = Π (0) − κhl [(1 − ω )nl n h ] + κhh [n h 2 ] . (43)

Since Strategy 1 weakly dominates Strategy 2, we want to compare the seller’s profits for
Strategy 3 with Strategy 1. First, we can state Proposition 4 as

PROPOSITION 4. In terms of the seller’s profits, if consumers do not value interaction

with types other than their own, then Strategy 3 weakly dominates Strategy 1, and
therefore Strategy 2, where the three strategies are equal when ω is near 1.

What about when consumers do value interaction with other types? Comparing
(23) and (43) we see that Π(3) > Π(1) when

 n (κ + κlh )
ω < 1 − l hl . (44)
 nh (κhh − κlh )
When κlh = κhl = 0, then Π(3) > Π(1) when ω < 1 as we stated in Proposition 4.
However, when κlh > 0 or κhl > 0, then Π(1) > Π(3) for high levels of ω, provided that
κhh > κlh. In other words, if consumers value interaction with other types and the seller is
not able to employ sophisticated personalization technology, then the seller can fight the
cannibalization distortion by segmenting the community into two separate groups and
allowing consumers to have access only to the community associated with the physical
product purchased. However, when the seller is able to employ high levels of
personalization technology, then personalization eases the cannibalization distortion, such
that the seller is able to increase profits by merging the community segments into one
large community and charging consumers accordingly for the added value. When
consumers do not value interaction with other consumer types, then the seller should
segment the community into two groups and allow access only to the community
associated with the good purchased. The exception occurs when κlh > κhh where

17
 nl (κhl + κlh )
1 −  > 1 so that (44) is always satisfied and therefore Π(3) > Π(1). We can
 nh (κhh − κlh )
state the key result in Proposition 5 as follows

 n (κ + κlh )
PROPOSITION 5. For low levels of personalization, i.e. when ω < 1 − l hl ,
 n h (κhh − κlh )
the seller’s profits are greater with Strategy 3 than Strategy 1 or 2. For high levels of
 n (κ + κlh )
personalization, i.e. when ω > 1 − l hl  , the seller’s profits are greater with
 n h (κhh − κlh )
Strategy 1 than Strategy 3 or 2.

Essentially, bundling the purchase of the physical good with access to the associated
online community segment provides an additional incentive to entice the consumers to
select the appropriate physical good. This bundling provides an additional weapon
against the cannibalization problem that should be used when personalization capabilities
are relatively low. On the other hand, relatively high personalization capabilities allow
the seller to move toward first-degree price discrimination such that the seller should
provide full access to online community members and charge consumers accordingly in
order to take advantage of potential network externality effects.

5. Sequential Product Introductions with Personalization

We now extend our model to two periods to consider the second case outlined
earlier where the seller can employ sequential product introductions. In an effort to
circumvent the cannibalization problem, sellers often use delay, or intertemporal price
discrimination, as a way of segmenting the marketplace by offering high-end goods early
and low-end goods at a later time. Examples of this tactic are visible in many markets.
For example, hard copy books are released several months before paperback versions,
movie goers enjoy the superior visual and audio experience of the movie theater nearly a
year before the same movie is released on home video cassette, and season tickets with
priority seating go on sale long before single-game tickets are sold. While the model

18
becomes intractable if we include community features in the two period setting, we will
continue to include the personalization parameter in our model.

5.1 Sequential Product Introductions with Commitment

We continue to look at the case where the seller can credibly commit to future
price and quality levels. When considering the option of delay, the seller would consider
delaying the introduction of the low quality good and not the high quality good, since
delay is a form of product degradation. Therefore, for the two-period scenario, we
introduce the high type consumer’s discount factor, δh ∈ (0, 1), which is the cost of
waiting until the second period to purchase the low quality good, the low type
consumer’s discount factor, δl ∈ (0, 1), and the seller’s discount factor, δs ∈ (0, 1), which
is the cost of waiting until the second period for profits from those sales. The
interpretation is that the discount factor is a measure of the particular party’s patience.
For example, when δh is close to 0, the high type consumer has no patience and would
gain no value from a second period purchase. When δh is close to 1, the consumer is
perfectly patient and derives the same value from a first or second period purchase. The
seller’s problem is now

(
max nh ph − cqh 2 + δs nl pl − cql 2
qh , ql , p h , pl
) ( ) (45)

subject to:
δl (vl ql − pl )≥ (1 − ω )[
vl qh − ph ] (46)

(v h q h − p h )≥ δh (1 − ω )[
v h q l − pl ] (47)

vl ql ≥ p l (48)

vh qh ≥ ph . (49)

Proceeding as before, we have

pl = vl ql (50)

and
ph = [
1 − δh (1 − ω )]vh qh + (1 − ω )δh [
vh qh − (vh − vl )ql ] (51)

where the quality levels are

19
 vh
qh = (52)
2c
and

ql =
vl
2c
[ ]
1 − δsh R(1 − ω ) (53)

where qh is offered in the first period, ql is offered in the second period when

δsh R(1 − ω )< 1 , and δsh = δh/δs.3 The seller’s profit for two products offered over two

periods with commitment is



=
4c
[
 δs nl v l 2
] 2 n v 2
1 − δsh R(1 − ω ) + h h
4c
if δsh R(1 − ω )< 1
Π 22c  2
(54)
 p h h
n v
if (
δsh R 1 − ω )≥ 1.

 4c
We can follow the methodology of Moorthy and Png (1992) to derive the seller’s
optimal product introduction strategy for four different cases:

 1 1 δs 
Case 1: R ≥ max  ,  . By Proposition 1, the seller should offer one product
1 − ω 1 − ω δh 
and commit not to offer any future products. By (54), offering two products does not
increase profits, so the seller’s appropriate strategy is to introduce one product only (the
high quality good) in the first period and commit not to introduce any more products in
future periods. In this case, the cannibalization distortion is go great that the seller will
not offer a product to low type consumers. Notice that in the limit, as ω → 1 ,
personalization technology will make Case 1 infeasible. Therefore, just as we saw after
Proposition 1, if ω → 1 the seller will never offer only one product, but will serve both
high and low type consumers, or neither if c is too high.

1 1 δs
Case 2: ≤R < . Again, the optimal one period solution is to offer one
1− ω 1 − ω δh
product only and commit to no future offerings. However, we see from (54) that the two-

3
Similarly, let δhs = δs/δh.

20
period solution has a higher profit, so the seller’s optimal strategy is to introduce two
products sequentially over two periods.

1 δs 1
Case 3: ≤R < . In this case, we see from (14) that introducing two
1 − ω δh 1− ω
products in the first period maximizes the seller’s profits, and this profit is greater than
the two-period solution in (54). Therefore, simultaneous first period product
introductions are best.

 1 1 δs 
Case 4: R < min  ,  . In this case, from (14) and (54), we see that the two
1 − ω 1 − ω δh 
product solution is optimal in both one and two-period solutions. Using (14) and (54),

we can show that Π 22c > Π12c if and only if

1 δs − [
1 − R(1 − ω )] δs 1 δs
R< and δh < or R ≥ and δh ≤ (55)
1− ω R(1 − ω ) 1− ω R(1 − ω )
in which case the seller should introduce two products sequentially over two periods. We
can now state Proposition 6 as

PROPOSITION 6. When the seller can commit to future product introductions and
pricing levels, the seller will
(a) sell two qualities simultaneously in the first period if

1 δs − [
1 − R(1 − ω )] δs
R< and δh ≥ ; (56)
1− ω R(1 − ω )
(b) sell a high quality product in the first period and a lower quality product in the
second period if

1 δs − [
1 − R(1 − ω )] δs
R< and δh <
1− ω R(1 − ω )

1 δs
or R ≥ and δh ≤ ; and (57)
1− ω R(1 − ω )
(c) sell a high quality product in the first period and nothing in the second period if

21
 1 δs
R≥ and δh > . (58)
1− ω R(1 − ω )

The seller’s strategy is summarized in Figure 1 for the cases of ω → 0 and ω = .5.
Notice that the case of ω → 0 corresponds to the Moorthy and Png (1992) example (see
Figure 2 in that paper). The upper right corner is Case 1. The upper left corner is Case 4.
The bottom middle portion of the figure represents Cases 2 and 3. Our purpose here is to
show the impact of personalization. As ω increases, all three segments of the figure shift
to the right. In particular, as ω increases, selling two products simultaneously in the first
period becomes a much more attractive strategy. In other words, implementation of
personalization technology minimizes the cannibalization distortion allowing the seller to
forgo delay of the low quality product. Therefore, personalization of service to the high
type consumers benefits the low type consumers because they are less likely to be forced
to wait for service in their market place. As ω increases, selling two products
simultaneously dominates the seller’s strategy except for the bottom right corner of the
figure where sequential introduction may still be optimal. This occurs when the potential
for cannibalization if particularly high and where consumers are very impatient relative
to the seller.
But which consumers are we referring to? Notice that the discount factor of the
low type consumers does not appear in the seller’s solution. Just as was the case when
we considered the personalization parameter in Section 3, we see that because the seller
binds constraint (47) and not (46), the seller must be concerned with the level of patience
of high type consumers only, and not low type consumers. We state this result in
Proposition 7 as

PROPOSITION 7. Because the nature of the cannibalization problem is to cannibalize

sales of the high quality good via inappropriate purchases of the low quality good, and
not vice versa, the seller should concern itself with the level of patience (discount factor)
of the high type consumers and not the low type consumers.

22
This is an important finding since high and low type consumers probably have different
levels of patience. Because high type consumers have a high valuation for a given level

23
of quality, they probably have a higher valuation of their time. In other words, high types
are likely to be more impatient than low type consumers.

5.2 Sequential Product Introductions without Commitment

Thus far in the analysis we have assumed that the seller is able to credibly commit
to future actions regarding product introductions. However, in the online channel,
credibility may be hard to come by. In particular, with the collapse of the dot-com
economy and the ensuing fluctuations of entry and exit from the online market, online
storefronts may find it difficult to convince prospective customers of their long-term
online commitments. Without the seller’s commitment to future actions, potential
customers will look ahead to the second period and take this into consideration when
making their first-period choice. As Moorthy and Png (1992) point out, if the seller sells
to both types in the first period, then there will be no one to sell to in the second period,
and therefore there is nothing to commit to in advance. Therefore, Π 12nc = Π 12c which is
found in (13).
Now suppose the seller serves high type consumers in the first period and low
types in the second period. Then, in the second period the seller will extract all of the
low type consumer’s surplus by setting
pl = vl ql (59)

such that second period profits will be π2 = nl(vl - cql)ql which is maximized when
vl
ql = . (60)
2c
Working backwards, the seller’s first period problem is

max
q ,p
h h
( )
nh ph − cqh 2 + δsπ1 (61)

subject to:
δl (vl ql − pl )≥ (1 − ω )[
vl qh − ph ] (62)

(v h q h − p h )≥ δh (1 − ω )[
v h q l − pl ] (63)

vh qh ≥ ph . (64)

Proceeding in the usual fashion yields

24
  v 
ph = [
1 − δh (1 − ω )]vh qh + (1 − ω )δh vh qh − (vh − vl ) l  (65)
 2c 
such that we again obtain
vh
qh = . (66)
2c
It can be seen that (62) is satisfied and the seller’s profits for the no-commitment case are
 δs nl vl 2


=
4c
[
1 − 2δs R(1 − ω ) +
h
]nh v h 2
4c
if δsh 2 R(1 − ω )< 1
Π 22nc  2
(67)
p nh v h if (
δsh 2 R 1 − ω )≥ 1.

 4c

Now compare Π 22 nc with Π12nc from (13). We see that Π 22 nc > Π12nc if and only if

1 δ− [
1 − R(1 − ω )]2 1 δs
R< and δh < s or R ≥ and δh ≤ (68)
1− ω 2 R(1 − ω ) 1− ω 2R(1 − ω )
This result is shown in Figure 2 and is summarized in Proposition 8 as

PROPOSITION 8. When the seller cannot commit to future product introductions and
pricing levels, the seller will
(a) sell two qualities simultaneously in the first period if

1 δs − [
1 − R(1 − ω )]2
R< and δh ≥
1− ω 2 R(1 − ω )

1 δs
or R ≥ and δh > ; (69)
1− ω 2R(1 − ω )
(b) sell a high quality product in the first period and a lower quality product in the
second period if

1 δs − [
1 − R(1 − ω )]2
R< and δh <
1− ω 2 R(1 − ω )

1 δs
or R ≥ and δh ≤ . (70)
1− ω R(1 − ω )
Again, we see that increased personalization makes it more likely that the seller will sell
to both types in the first period. Higher values of ω essentially stretch the function in
Figure 2 to the right while causing the δh intercept point to occur at greater values of R.

25
26
For very large values of ω, selling two products simultaneously dominates the figure.
We should point out that the peak point of the function in the figure does not change for
different values of ω; it simply shifts to the right as ω increases.
Comparing Figures 1 and 2 we see that the no-commitment case is beneficial to
low type consumers in two important ways. First, there is much more likelihood they
will be served in the market since selling to high types in the first period and on one in
the second period will not happen when the seller cannot commit to such a strategy in
advance. Second, we saw from (60) that low types will be served at the efficient level of
quality. Practically speaking, the volatility in the dot-com economy is beneficial to the
low type consumers because sellers are less able to make credible commitments to future
actions, which means sellers are less able to fight the cannibalization problem at the
expense of low type consumers.
Of course, this has negative implications for the seller’s profits. In the volatile
dot-com economy, high type consumers know that an online seller has more difficulty
making a credible threat that they will not offer a low quality product at a later time.
Therefore, the seller knows that some high types will want to wait for the low quality
good. For this reason, in the low-commitment dot-com environment, the seller is less
able to fight the cannibalization problem and therefore suffers less profit due to the

[ ]
distortion. In (67), the bracket term 1 − 2δsh R(1 − ω ) ∈ [0,1] represents the ability of the
seller to extract profits from serving the low type consumers in the no commitment case.

[ ]
Similarly, 1 − δsh R(1 − ω ) ∈ [0,1] from (54) represents the ability of the seller to receive
2

profits from serving low types in the commitment case. The reader can easily see that

[1 − δ R(1 − ω )] > [1− 2δ R(1 − ω )]

h
s
2 h
s (71)

such that profits are always higher in the commitment case than the no commitment case.
When the seller can credibly commit to future actions, he is more able to use the threat of
delay, or a commitment to not offer a low quality good later, to fight the cannibalization
problem. This may help explain why new start-ups have had a difficult time surviving in
the volatile dot-com economy. However, inspection of (71) shows that for high values of
ω, the difference between the terms decreases such that (71) holds as an equality when
ω → 1 . We can state this result as Proposition 9 as follows

27
 PROPOSITION 9. The seller’s profits are higher in the two-period commitment case
than the two-period no-commitment case, but the appeal of commitment over no
commitment diminishes as ω increases, whereby the profits are equal when ω → 1 .

Therefore, in an environment where online storefronts have difficulty making credible

future commitments, these online sellers should employ personalization technology to
lessen the impact on their online profits caused by the volatile low-commitment dot-com
environment.

6. Conclusion
In this analysis, we have extended the Moorthy and Png (1992) model to examine
some ways a monopolist selling a durable good in the online market can make use of the
unique features of the online channel to fight the distortion caused by the cannibalization
problem. We have shown how the seller can employ personalization technology to move
away from second-degree price discrimination toward first-degree price discrimination.
By better understanding the wants, needs, and willingness-to-pay of potential customers,
the seller can mitigate the cannibalization problem, which results in higher product
quality levels and earlier product introductions for goods aimed at low type consumers.
We also have shown that personalization technology lessens the adverse effects caused
when the seller cannot credibly commit to future actions. In the volatile dot-com
economy this becomes particularly important for new start-ups fighting to compete
against established companies that have a stronger brand image and therefore better
ability to make credible commitments.
We have shown that the seller should focus all of its personalization efforts on
high type consumers. Essentially, the seller’s strategy should provide highly focused,
personalized service to high type consumers and let low type consumers interact with
each other within a seller-sponsored online community. While this might seem unfair to
low type consumers, they actually are the ones who benefit from the seller’s
personalization to high type consumers in terms of higher product quality. We have also
shown that the seller need not concern itself with the level of patience of low type
consumers, but must take into account the patience of high type consumers when

28
considering delayed introduction of the low quality good. This is actually good news to
the seller since high type consumers are more likely to be more impatient than low types
and therefore would encourage the seller to use delay as a differentiation tactic.
We also examined three different seller strategies for bundling the sale of the
physical good with customer access to a seller-sponsored online community. We found
that when personalization capabilities are relatively low, the seller should segment
consumers into two communities by allowing consumers to have access to the
community associated with the type of physical good that was actually purchased. When
the seller is able to increase personalization capabilities to sufficiently high levels, the
seller should switch from the segmented communities strategy and merge all consumers
into one community to take advantage of positive externality effects. This would be the
case if consumers value interaction with types other than their own. Otherwise, the
segmented community strategy makes more sense, even with high personalization.
Future research in this area should include modeling the implications of selling in
multiple channels at the same time. For example, by catering to two types of consumers
in both online and offline channels simultaneously, the seller should consider marketing
four different levels of quality, requiring additional segmenting mechanisms. This
situation becomes even more interesting if one considers that the cost of providing goods
in the two channels should have considerably different cost structures. We also noted
earlier that there are many other ways to provide access to seller-sponsored online
communities including periodic fee-based access and free advertising supported sites.
How should these be incorporated into the current analysis?
The analysis presented in this paper results in several directions for possible
empirical research. For example, do sellers have a tendency to focus their efforts on high
type consumers more than low types? If so, are the reasons presented here validated by
real managerial motivations? Also, does personalization capability actually impact the
seller’s method of segmenting online communities? Why or why not? How prevalent
are the community access strategies presented in this paper? What other mechanisms are
used and under what circumstances are they used, particularly in light of personalization
ability?

29
 The online channel provides many technologies that can be used to redefine how
commerce is conducted in the online channel relative to more traditional forms of
commerce. Personalization tools and community features are two of the most interesting
technologies available to online storefronts. Future research should consider other online
technologies as well.

30
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