Luxury Goods: The Perils and Profits in Lower-Priced Markets

A study uses game theory to suggest when designer companies should license their names for down-market goods

Luxury brands, like indie bands, often find there’s a tradeoff between being cool and being popular.

Shoppers value luxury goods in large part for their exclusivity; not just anyone can afford to carry a Louis Vuitton bag or wear an Hermès scarf. This market is relatively limited, though, and to grow beyond it, mature brands look to a much larger group of aspirational buyers who, if they could afford to, would love to wear Gucci-branded eyeglasses or Burberry cosmetics.

The growth vehicle is licensing, which can extend a brand’s reach and can be a lucrative source of new revenue. But there’s a risk: Licensing can lead to excessive popularity, which can tarnish a brand enough that luxury shoppers bolt.

In a working paper, University College London’s Kenan Arifoğlu and UCLA Anderson’s Christopher S. Tang use a game theory model to examine how a luxury brand’s decision to license is affected by the desire for exclusivity among “snobs” and the aspirations of the large group of “followers.”

Their findings suggest that if a brand has a monopoly in a luxury market, licensing is unprofitable when buyers place a high value on exclusivity. But for two brands in a competitive market, the model suggests that licensing is always profitable and that a fixed-fee licensing arrangement is preferable to other types of license contracts.

Luxury-brand licensing exploded in the 1970s and ’80s, only to see the deals drastically curtailed in the ’90s because of the corrosive effect on brands’ luxe reputations. Since then, licensing is again returning as a way to capture demand from a growing number of brand-conscious aspirational consumers.

In the view of economists, the problem with licensing is that it creates a negative popularity effect among snobs; the more popular a brand becomes, the less it is valued. At the same time, it has a positive popularity effect on followers, whose opinion of a brand increases the more it is valued by snobs.

With their model, the authors unpack how these effects interact. In one case, they consider two brands that compete to sell products in one category, such as handbags, and that seek to license in a different category, such as eyewear. Both brands, the researchers found, can profit by licensing through a fixed-fee contract, no matter how little they charge in license fees ― even if fees fall to zero.

How? Imagine that one brand, Brand A, chooses to license and then increases its price in the luxury market. Supply and demand predict that its competitor, Brand B, will gain share in that luxury market and Brand A’s share will fall. But because snobs buy fewer of Brand A’s goods, its licensed items become less desirable among followers, and then sales fall. This makes its luxury products even more exclusive, and therefore more desirable, among snobs, who will buy even if they have to pay a higher price.

As a result, both brands can raise the price they charge to snobs without, in the end, losing market share. “In a duopoly setting,” the authors write, “it’s always beneficial for luxury brands to license their names because licensing can soften competition in the snob market and brands can charge more and earn more.”

However, there’s a complication. While both brands are better off if they choose to license, the situation sets up a “prisoner’s dilemma”: If one brand chooses not to license, the other one is also better off not licensing. If Brand B doesn’t license, Brand A gains a monopoly in the followers market and its brand becomes completely unattractive to snobs. It has to give up licensing to maintain its foothold in the more profitable luxury market.

The model also suggests that other arrangements are less profitable than fixed-fee contracts. Under royalty contracts, which pay brands based on the number of units sold, license revenues grow as demand among followers grows. To encourage that growth, a brand can’t afford to lose cachet among snobs, so in a competitive market it is forced to lower prices of its luxury goods to maintain share.

The authors also consider umbrella branding, where, instead of licensing, a brand offers a variety of lower-cost goods under its own name. Supply chain researchers in previous studies find that this approach should be more efficient than licensing. That, the authors’ model suggests, might be true in a monopoly where the brand has enough control over pricing, supply and demand in the followers’ market to make sure that luxury sales aren’t undermined.

But in a duopoly, both brands again have to lower prices significantly on their luxury products to maintain share in that market. They’re better off not going after the followers market at all.