Faced with a new competitor in the market, an incumbent company is usually expected to respond by investing more into its products to offer products that will please more customers. However, new research shows that a higher product investment in response to competition is not necessarily the best answer. The reason: new entrants may change the incumbent’s return on investment trade-off.
Using the movie exhibition industry as its central case study, a team of researchers studied how the entry of a new movie theatre impacts an incumbent’s theatre movie choices. From the perspective of movie theatres, the movies that bring in more patrons (for example, the big-budget blockbusters or highly popular, recently released movies) are more expensive to screen because they cost more to acquire.
Movie theatres thus face a trade-off: they must decide whether it’s more profitable to show an expensive newly released blockbuster, or choosing instead a cheaper independent film that might bring in less customers but also cost significantly less.
The more competition a movie theatre faces, the more it should be willing to make an investment in the high demand-generating movies to prevent its customers from going elsewhere. (In economic terms, the product that sells the most at a given price is considered higher “quality.” Thus, high-demand blockbusters are all high quality to economists — an assessment with which most movie critics would vehemently disagree, of course).
The new research shows, however, that because of the cost vs. return tension described above, more competition from other theatres does not always result in more investment into the product by the incumbent. The study revealed that incumbent theatres respond strategically when their markets are invaded: they increase or decrease product “quality” in economic terms (e.g., showing new releases) depending on the different factors that impact the cost/revenue equation.
One of the most significant factors is whether the new theatre in the market is a rival theatre or a sister theatre from the same chain. (For an independent incumbent theatre, any new theatre would be considered a rival theatre.)
If the new competitor is a rival theatre, the incumbent will respond by trying to compete with the new theatre, which means spending more money to offer action blockbusters or new releases with popular stars. If the new competitor is a sister theatre from the same chain, the incumbent does not have the same incentive to compete. After all, the customers (and their money) are all going to the same “pot.” For this reason, if the incumbent is facing competition from a sparkling new sister theatre, the incumbent might respond by showing older movies or less high-impact movies.
In short, the entry of a new competitor will always result in a reduction of sales for the incumbent. But when the sales are migrating to a rival theatre rather than a sister theatre, the incumbent has a greater motivation to fight for its customers (i.e. to increase demand).
The other factor that affects how an incumbent theatre responds to a new entrant in its market is brand. If the incumbent theatre has a very strong brand, it is less likely to lose a significant number of customers to the new theatre; customers will remain loyal to an established brand. If the incumbent has a weaker brand (or none at all), and it is the new theatre that has the stronger national brand, then the incumbent faces a major threat in terms of sales. The incumbent is thus motivated to battle hard for customers, which means — again — increasing demand by increasing the product’s economic quality: showing the major new releases and blockbusters that bring in more customers.
Fighting for customers costs money. Popular new releases and blockbusters are more expensive than slightly older films or independent films — but they also bring in more customers. When a new theatre starts to take away customers, the incumbent will have to decide whether the new competition is worth the expensive fight. The sister vs. rival issue and the brand issue are two factors that will impact the ultimate decision.
The lessons from the research can be generalized to industries beyond movie distribution. When a business has the competitive incentive to protect its customers from a rival, it will increase the provision of demand-generating products to keep customers from switching to the competition. However, the research reveals, somewhat counterintuitively, that a new competitor should not always increase the competitive incentive.
Instead of automatically increasing your investment in (often expensive) demand-generating products in response to new competition, look carefully at the characteristics of the new competition. Is the new entrant a sister competitor? Is there a brand differentiation between you and the new competitor? How loyal are your customers? These and other issues — location or advertising expenditure, for example — must be carefully considered before deciding on the response strategy to a new business in town. You might be surprised at your options.
Impact of Competition on Product Quality Provision: Movie Choices of Exhibitors. A. Yesim Orhun, Pradeep K. Chintagunta & Sriram Venkataraman. Ross School of Business Paper (October 2014).
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