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Product differentiation, store differentiation, and assortment depth.

Article Excerpt
1. Introduction

Retail product assortments have expanded substantially over the past quarter century. Among supermarkets, for example, the median number of stock-keeping units increased from 16,500 to 25,153 over the 1990-2004 period (Progressive Grocer 2005). An essential element of this trend is an increase in the depth of product assortments, as measured by the number of variants within existing product categories. (1) What are the market forces that drive retailers to increase the depth of their product assortments? To what extent do product-specific attributes that differentiate variants in a category determine which assortments become "deep" and which assortments remain "shallow"? And how does the degree of store differentiation in the market influence assortment depth? The aim of this paper is to characterize how the equilibrium depth of the product assortment is determined across categories that vary in the degree of product differentiation and across retail environments that vary in the degree of store differentiation.

There is little research to date on the nature of the incentives that underlie product assortment decisions (Draganska and Jain 2005, 2006). Messinger and Narasimhan (1997) examine a number of seemingly plausible alternatives for why retailers stock more products in their stores (economies of scale, technological improvement, monopoly power, higher margins, and lower inventory cost) and rule out each of these factors in favor of a theory based on consumers' desire to minimize shopping costs. We frame our analysis around a similar effect by considering transaction costs between consumers and retailers that generate economies of "one-stop shopping." This feature alone is capable of explaining why retailers expand their product assortments; however, it falls short of providing insight to explain why the equilibrium assortment is deeper in some categories and shallower in others.

A large and growing literature on efficient assortment seeks to identify the relationship between assortment depth and sales in a product category. This literature finds a positive relationship between assortment depth and category sales in some cases (Van Ryzin and Mahajan 1999, Borle et al. 2005) and a negative relationship in others (Dreze et al. 1994, Broniarczyk et al. 1998, Boatwright and Nunes 2001). Our analysis contributes to this literature by distinguishing the circumstances under which a deeper product assortment is positively related to category sales. Indeed, we find that the relationship between assortment depth and category sales depends critically on the degree of differentiation among variants in the category. Product categories with highly differentiated variants have higher prices and lower category sales levels than product categories with less differentiated variants; however, we find that equilibrium assortment depth follows an inverted U-shaped pattern over product differentiation, with deeper assortments in categories with an intermediary level of differentiation and shallower assortments "at the tails." Hence, in cross-sectional data, our model predicts a positive relationship between assortment depth and sales in highly differentiated product categories, but a negative relationship between assortment depth and sales in less differentiated product categories.

The inverted U-shaped pattern between assortment depth and product differentiation emerges in monopoly retail markets as well as in oligopoly retail markets due to offsetting incentives facing category managers. Highly differentiated product categories have wider retail margins than less differentiated categories, and this favors a deeper assortment because category sales rise with assortment depth. But new variants introduced in a product category cannibalize a portion of their sales from existing variants, and cannibalization is more costly when retail margins are wide than when retail margins are narrow. The nonmonotonic pattern emerges because the relative magnitude of these effects evolves with the degree of product differentiation. In categories with relatively nondifferentiated variants, deepening the assortment has little impact on category demand. Retailers respond by selecting a shallow assortment because stocking new variants is costly. In categories with more differentiated variants, assortment depth has a larger impact on category demand. Retail margins are wider in these categories relative to categories with less differentiated variants, and retailers respond by deepening their assortments. But profit per variant falls with assortment depth because new variants cannibalize a portion of their demand from existing variants in the category. Cannibalizing category sales becomes increasingly costly as retail margins rise. This effect eventually dominates, and, for categories with sufficiently differentiated variants, retailers respond to an increase in product differentiation by reducing assortment depth.

In retail markets that vary in the degree of store differentiation, the manner in which store differentiation alters the ability of consumers to switch between retailers has important implications for assortment depth. We consider a locational model of store differentiation in which the ability of retailers to exercise market power over consumers depends on how costly it is for consumers to switch from shopping with one retailer to shopping with another retailer. For given product assortments and prices, the cost of switching between retailers increases when there is a smaller number of retailers in the market (greater market concentration) or when the transaction cost of traveling to a rival retailer becomes larger, for instance, in response to retailer investments in store attributes that generate customer loyalty. When consumer switching costs increase in response to a decline in the number of retailers serving the market, we show that retailers respond by raising prices and deepening their assortments; however, when consumer switching costs increase in response to greater customer loyalty, we find that prices rise and product assortments become shallower.

The reason that the nature of the change in store differentiation matters for the equilibrium depth of the product assortment is that retailers must select prices and assortment depth jointly to serve existing customers and to attract new customers into the store. In terms of pricing, changes in store differentiation align these goals. A smaller number of retailers in the market allocates more customers to...

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