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Optimal strategies to introduce quality improvements

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Significant effort is dedicated to finding processes, tools, and systems that allow firms to affordably increase the quality of the goods and services that they offer to end consumers. These include innovations that allow firms to cost effectively implement higher levels of quality control, build better quality products or provide higher levels of service. This paper examines the strategies that an innovator can use to market an innovation that reduces the cost incurred by downstream firms to provide a given level of quality. The authors consider a monopolistic innovation seller who markets to firms that compete in a downstream market. One strategy for the innovator is to make an outright sale of the innovation to the downstream firms. An alternative strategy is for the innovator to act as a third-party service provider, i.e., to manage the quality improvement capability on behalf of the downstream firm. Their objective is to evaluate the attractiveness of these two strategies for the innovator as a function of market conditions and the magnitude of "quality improvement" capability provided by the innovation. In a differentiated market with constant total demand, the introduction of a capability that allows both firms to implement vertical quality improvements (in their offering) at lower cost leads to a reduction in profits for downstream firms. From the perspective of a downstream firm, the reduction in profits is driven by two effects. The first is a positive direct effect on demand (and profits), as a result of being able to offer higher quality. The second is a negative indirect effect on demand (and profits) due to the competitor's product being of higher quality. When "quality improvement" capabilities increase in a market with fixed total demand, the indirect effect is stronger than the direct effect, leading to lower downstream profits. Since equilibrium profits go down, it is not clear why firms pay positive prices to obtain such capabilities. The authors show that the value of an innovation is a function of both a firm's profitability after purchasing the capability and also of its profitability were it to face, with its current capability, a competitor that acquires the superior capability. It is the threat of being left to compete with inferior capability that drives firms to pay positive prices for a capability that ultimately makes them worse off. The price that an innovator can charge for the "quality improvement" capability is driven by these effects. The outright sale leads to higher quality levels (a downstream benefit that is competed away), but it also means that a non-buying firm is put at greater disadvantage. This is beneficial when the impact of the innovation is low in relation to the level of differentiation. In contrast, when the impact of an innovation is high relative to the level of differentiation, the innovator realizes higher profits by managing the quality improvement capability on behalf of the downstream firms.

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