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Selling service innovations in differentiated markets (RV of 99/77/MKT)

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Service industries such as banking, retailing and automobile servicing are characterized by cost- saving innovations developed by vendors that specialize in data processing, computing, information systems and communications. This paper examines an innovation developed by an upstream innovator that reduces the cost for downstream firms to provide a given level of service quality. The authors examine the strategies that an innovator/vendor can use to sell a cost-saving service innovation to two firms in a horizontally differentiated market. One strategy for the innovator is to act as a technology seller and to make an outright sale of the innovation to the downstream firms. An alternate strategy is for the innovator to act as a third-party service-provider and to assume control of the service function for downstream firms using the superior technology. The analysis highlights the difference between the sale of a cost-reducing service innovation and other innovations examined in RandD literature. In a horizontallly differentaited market with constant total demand, cost-saving innovations lead to lower equilibrium firm profits compared to a world without the innovation. Equilibrium firm profits are determined by the combination of a direct effect of the innovation ( a positive affect on demand and profits due to higher levels of own service) and a strategic effect (a negative effect on demand and profits due to an increase in the competito's service level). For service innovations in markets with constant total demand, the strategic effect of the innovation is stronger than the direct effect leading to strictly lower requilibrium profits. Since equilibrium profits go down, it is not obvious why firms would pay a positive price for such innovations. The authors show that the value of an innovation to each firm is a function of the firm's profitability after purchasing the innovation and also of its profitability were it to face, utilizing the original (higher cost) technology, a competitor with the innovation. The threat of being left to compete with older inferior technology drives firms to pay positive prices for an innovation that can ultimately make them worse off. Iyer and Soberman call the profit disadvantage that an innovation imposes on a non-purchasing firm as its "threat potential". When an innovator sells an innovation outright to downstream firms, the dominance of the strategic effect leads to higher service levels being chosen and lower equilibrium profits than prior to introduction of the innovation. When th einnovator acts as a third-party service provider, she takes control of the service decision and chooses a lower service level: thisleads to greater equilibrium profits than in the case of an outright sale. However, the selling price that the innovator can extract is also a function of the threat potential that the innovation provides. While the outright sale leads to higher service levels (that are competed away) and lower profitability, the authors show that also provides the innovator with greater threat potential. The equilibrium selling approach for the innovator is to sell the innovation through an outright sale when the impact of theinnovation is low in relation to the level of differentiation. IN this situation, threat potential is more salient in driving the selling approach than th eimpact of the innovation on firm profitability. The reverse is true when the impact of innovation is high in relation to the level of diferentiation.

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