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Keywords:

  • multi-channel management;
  • retail operations;
  • electronic commerce;
  • game theory

Abstract

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

Rapid advances of information technology in recent years have enabled both the manufacturers and the retailers to operate their own Internet channels. In this study, we investigate the interaction between the capabilities of introducing the Internet channels, the pricing strategies, and the channel structure. We classify consumers into two segments: grocery shoppers attach a higher utility from purchasing through the physical channel, whereas a priori Internet shoppers prefer purchasing online. We find that when the Internet shoppers are either highly profitable or fairly unimportant, the manufacturer prefers to facilitate the channel separation either through his own Internet channel or the retailer's. In the intermediate region, however, the manufacturer encroaches the grocery shoppers and steals the demand from the retailer's physical channel. With horizontal competition between retailers, a priori symmetric retailers may adopt different channel strategies as a stable market equilibrium. The manufacturer may willingly give up his Internet channel and leverage on the retailer competition. When the manufacturer sells through an online e-tailer, Internet shoppers may be induced to purchase through the physical channel. This reverse encroachment strategy emerges because selling through the e-tailer leads to a more severe double marginalization problem.

1. Introduction

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

In recent years, the Internet channel has provided a convenient and secure environment for the manufacturer/retailer and the consumers to make transactions, thereby leading to the “clicks-and-mortar” phenomenon. A report from the US Census Bureau's Quarterly Retail E-Commerce Sales shows that the online quarterly sales have increased to at least $33.6 billion as of the second quarter of 2007 (an around 28% increase in 7 years). The concurrent increase of the average growth rate for the total retail sales was only 4.5% (US Census Bureau 2007). Examples of the manufacturers that have adopted the dual channel structure include, but are not limited to, leading firms in the computer industry (such as Apple, IBM, and Cisco), cosmetics manufacturers (e.g., Estee Lauder), beverage and food manufacturers (Budweiser Beer, Coca Cola, and Campbell Soup), sports goods producers (e.g., Nike), and electronics suppliers (e.g., PalmOne, Samsung, and Sony). In addition, some leading US retailers (e.g., Barnes & Noble, Bestbuy, Bloomingdales, Wal-mart, Target, etc.) also have gone online.

However, in this Internet era, there is still a significant portion of retailers that focus exclusively on the physical channels, and a number of leading manufacturers insist on selling through the direct channels. For example, the giant retailers 7-Eleven and Carrefour do not provide the online purchase option for the consumers. Examples that abandon the Internet channels span various industries, including consumer electronics (Pricesmart), apparel (Tween Brands, Citi Trends, Dress Barn, Ross Stores), food (Spartan Stores), fabrics (Duckwall-Alco), home fashion (TJX Inc., Family Dollar), plastics (Collective Brands), pharmacy (Watsons), and grocery retailers (Pantry, Retail Enterprises, Ingles Markets, and RT-MART).2 On the manufacturers' side, firms that sell exclusively through independent retailers expand across various product categories such as Acer, Colgate, Gillette, Heinz, Kellogg's, and Tylenol.

Given the consistent profitability and large organizations, the aforementioned manufacturers and retailers are apparently capable of operating their Internet channels; thus, these channel management decisions seem to be strategic rather than operational. Additionally, there is a large variation of the online purchasing option across different categories and locations; sometimes the Internet channel is owned by the manufacturer, whereas in other cases it is the retailer that runs the Internet channel. Operational concerns such as shipping costs from the manufacturers' side and transportation costs from the consumers' side may not provide a good answer to this variation; it is hard to explain why consumers can order beers and soups via Budweiser's and Campbell's websites, but are prohibited from purchasing laptops or video game consoles directly online.

This study attempts to provide an answer to when and why the manufacturer and the retailer should introduce their Internet channels, given that they both are capable of doing so and actively respond to their channel parties' channel and pricing decisions. In pursuit of this goal, we construct a stylized supply chain with a manufacturer, an independent retailer, and a continuum of consumers with heterogeneous preferences. The retailer operates a physical channel and sells the products for the manufacturer to the consumers. There are two consumer segments: grocery shoppers attach a higher (gross) utility from purchasing the product through the physical (offline) channel, whereas Internet shoppers obtain a higher utility if purchasing online.

To isolate the strategic concerns of these two channel parties, we start with two benchmark scenarios with manufacturer-operated or retailer-operated Internet channels. When only the manufacturer is capable of introducing the Internet channel, we find that two strategies can emerge as the market equilibrium. If the Internet shoppers are sufficiently profitable, a natural channel separation arises: Internet shoppers are induced to purchase online, whereas grocery shoppers buy in the physical channel. On the other hand, when the grocery shoppers become more important, the manufacturer shall set a low selling price in his Internet channel to attract the low-valuation consumers from the physical channel. This strategy allows the manufacturer to encroach the grocery shoppers without creating the channel conflict. When instead only the retailer can introduce the Internet channel, a similar channel separation strategy arises. Nevertheless, the aforementioned grocery encroachment strategy is no longer desirable. If the Internet shoppers are relatively important, a niche targeting strategy is implemented: the retailer abandons the physical channel and targets only the Internet shoppers through her Internet channel.

We then investigate the market equilibrium when both parties are capable of operating the Internet channel. When the Internet shoppers are either highly profitable or fairly unimportant, the manufacturer prefers to facilitate the channel separation. In the intermediate region, however, the manufacturer intends to encroach the grocery shoppers and steal the demand from the retailer's physical channel. To understand this result, observe that when the Internet shoppers are highly profitable, the manufacturer certainly prefers to go direct to capture this segment. At the other extreme, when the Internet shoppers are fairly unimportant (compared to the grocery shoppers), it is in the manufacturer's best interest to delegate both channels to the retailer. In the intermediate region, the manufacturer faces two conflicting forces. Facilitating channel separation via his own Internet channel induces too much competition from the retailer, but completely delegating to the retailer leaves her a significant portion of revenue. In such a scenario, the manufacturer prices aggressively in his Internet channel so as to steal some grocery shoppers.

Finally, we consider some extended models with retail-level competition. We find that with retailer competition, in any equilibrium channel structure exactly two supply chain parties introduce their Internet channels. Even if the retailers are perfectly competitive, the manufacturer intends to induce them to both introduce the Internet channels, and in equilibrium both retailers willingly do so. On the other hand, our results also suggest that even if the retailers are a priori symmetric, asymmetric channel structures may emerge as a stable market equilibrium. When the manufacturer sells through an online retailer (e.g., Amazon), he may induce Internet shoppers to purchase through the retailer's physical channel. This reverse encroachment strategy emerges since all the Internet channels are “indirect,” that is, not directly controlled by the manufacturer. The retailer's physical channel becomes appealing (from the manufacturer's viewpoint) because the retailer intends to set the margin low so as to attract grocery shoppers. Consequently, the double marginalization problem is less severe.

Since we investigate the strategic choice of channel structure, our work is related to the vast literature on channel management. Earlier literature focuses on the benefit of adding an Internet channel when the firm can sell directly to the end consumers (Alba et al. 1997, Balasubramanian 1998, Bernstein et al. 2008, Kumar and Ruan 2006, Lal and Sarvary 1999, Peterson et al. 1997). In the context of the supply chain, researchers typically focus exclusively on the situations in which only the manufacturer is able to introduce the Internet channel (see e.g., Balasubramanian 1998, Cattani et al. 2006, Chiang et al. 2003, Druehl and Porteus 2005, Hsiao and Chen 2012, Tsay and Agrawal 2004). Unlike all the aforementioned studies, we allow both the manufacturer and the retailer to introduce their own Internet channels. We also highlight the interactions between the retailer's and e-tailer's Internet channels.

Our analysis regarding the horizontal competition is related to Cattani et al. (2007), who study how competition among the Internet retailers (grocers) influences the channel management strategies. They document the nuance connection among the product perishability, channel structure, and competitive nature and show that the results are robust against the inclusion of capacity constraint. As a complement of Cattani et al. (2007), we introduce the manufacturer into this competitive retailer context, and show that this vertical–horizontal supply chain relationship generates various channel structures in market equilibria.

The rest of this article is organized as follows. In section 'Model', we describe the model. Section 'Equilibrium Analysis' derives the equilibrium behavior and compares the manufacturer's and the retailer's incentives for introducing their Internet channels. Section 'Discussion' examines different forms of retail competition. Finally, we draw our conclusions in section 'Conclusion'. All proofs are in the online Appendix.

2. Model

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

We consider a supply chain with a manufacturer, an independent retailer, and a continuum of consumers with heterogeneous preferences. The manufacturer produces the product at a constant marginal cost, which is normalized to zero for ease of exposition. The retailer operates a physical channel and sells the products for the manufacturer to the consumers. As our primary goal is to evaluate the manufacturer's and the retailer's incentives for introducing an Internet channel, we allow both the manufacturer and the retailer to introduce their own Internet channels. All the supply chain parties are risk neutral and therefore aim at maximizing their expected profits/utilities. The bilateral monopoly setting in our basic framework is adopted for ease of exposition. The case with horizontal competition is investigated in section 'Discussion'.

2.1. Consumer Preferences

Each consumer is willing to purchase at most one unit of product, and the population of consumer is normalized to 1. We categorize the consumers into two segments that differ in their preferences toward purchasing online or offline. Consumers in the first segment attach a higher (gross) utility from purchasing the product through the physical channel, whereas consumers in the second segment obtain a higher utility if purchasing online. To model this discrepancy, we assume that a consumer whose valuation from purchasing in the physical channel is v will obtain a gross utility inline image if purchasing online; the parameters inline images satisfy inline image and represent their channel preferences. For ease of presentation, in the sequel we call the first segment the “grocery shoppers,” and the second segment “Internet shoppers.” These terms indicate the consumers' inherent preferences over the physical and Internet channels.

In the majority of the dual channel literature, consumers are assumed to express a lower willingness to pay while purchasing online due to either the privacy concern or trust issues (see, e.g., Chiang et al. 2003, Kacen et al. 2001, Liang and Huang 1998, for the micro-foundation of grocery shoppers). Nevertheless, it is possible that some consumers may incur a higher cost upon visiting the physical channel. This is because all the transactions can be made only when the consumers actually go to the physical retail store, whereas if purchasing online everything is just “a click away.” This provides a justification of the Internet shoppers: the effective payoff of a consumer may be affected by transportation cost, the possibility of seeing a stock-out, the time spent in figuring out the exact location of the product in the shelf space, etc.

2.2. Grocery vs. Internet shoppers

Although we label these two segments as grocery and Internet shoppers, their actual purchasing behaviors shall depend on the price comparisons, as we demonstrate in section 'Equilibrium Analysis'. We use 1−α and α to denote the proportions of consumers in the first and second segments. Thus, α serves as a proxy of how favorable the online channel is a priori from the consumers' viewpoints. We denote v as the “intrinsic” valuation of a consumer, and it is assumed to be uniformly distributed over [0,V]. This distributional assumption is made to facilitate closed-form expressions of all the equilibrium outcomes.

2.3. Manufacturer's and Retailer's Strategies

Given that both the manufacturer and the retailer can introduce their Internet channels, the relevant pricing decisions are specified as follows. We use w to denote the wholesale price, p to denote the retail price in the physical channel, and inline image and inline image to denote the (retail) price in the manufacturer-owned and retailer-owned Internet channels, respectively (the subscript d stands for the “direct” channel). Given these prices, if a consumer with valuation v purchases from the physical channel, her net utility is v − p. On the other hand, she obtains utility inline image (inline image) if purchasing from the manufacturer-owned (retailer-owned) Internet channel. To account for the manufacturer's additional services or brand management effort, we use f to denote the manufacturer's operating cost for the Internet channel. This cost f is assumed to be reasonably small to avoid trivial results; if the operating cost were prohibitively high, the manufacturer would have no incentive to introduce his Internet channel and the problem degenerates. Additionally, we use inline image and inline image to denote the manufacturer's and retailer's equilibrium payoffs. A graphic illustration of the channel structure is given in Figure 1, and Table 1 summarizes the notation used in this article.

Table 1. Summary of Notation
NotationDefinition
v Consumer valuation from purchasing in the physical channel
inline image Scaling factor for purchasing online, i = 1,2
V Upper bound of v
α Proportion of Internet shoppers
w Wholesale price
p Retail price in the physical channel
inline image Retail price in the manufacturer-owned Internet channel
inline image Retail price in the retailer-owned Internet channel
f Manufacturer's operating cost for the Internet channel
image

Figure 1. Channel Structure of the Basic Framework

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Having described the channel structure and the objectives of these channel parties, in the next section we derive the equilibrium behaviors in this supply chain.

3. Equilibrium Analysis

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

In this section, we investigate the strategic interactions between the manufacturer and the retailer. To isolate the strategic concerns of these two channel parties, we start with two benchmark scenarios. In the first scenario, only the manufacturer is capable of operating the Internet channel, whereas in the second scenario the retailer is the only party that can introduce her Internet channel; see the graphic representations of these two scenarios in Figures 2 and 3, respectively. These two scenarios serve as the benchmark cases that allow us to examine the manufacturer's (retailer's) incentive for introducing the Internet channel. Following these, we then articulate the market equilibrium when both parties are capable of operating the Internet channel, which provides the full picture of the general model.

image

Figure 2. Manufacturer-Operated Internet Channel

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image

Figure 3. Retailer-Operated Internet Channel

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3.1. Manufacturer-Owned Internet Channel

Let us first consider the case in which only the manufacturer is able to operate the Internet channel. Our goal is to compare this scenario with the existing literature and use this benchmark to highlight the strategic role of the Internet channel for both the manufacturer and the retailer.

3.1.1. Timing

The sequence of events is as follows. (i) The manufacturer determines whether to introduce an Internet channel, (ii) the manufacturer offers the wholesale price to the retailer and determines the price offered to the consumers in his Internet channel if any, (iii) the retailer responds by determining the appropriate retail margin, and (iv) the consumers decide which channel to purchase the products from. Since the game involves multiple rounds of strategic interactions, we adopt the subgame perfect Nash equilibrium as our solution concept (Fudenberg and Tirole 1991).

3.1.2. Effective Demands

By backward induction, we first derive the effective demands in the physical channel and retailer-owned Internet channel. To this end, we shall discuss the consumers' purchasing decisions. Note that in equilibrium it must be 0 ≤ p ≤ V and inline image if there are actual transactions in both channels. First, a type-v Internet shopper buys the product on the Internet if and only if inline image and inline image. It means that inline image. Further, inline image if and only if inline image. A type-v Internet shopper buys the product in the physical channel if and only if v − p ≥ 0 and inline image. Thus, inline image, and the set is non-empty if and only if inline image.

Second, a type-v grocery shopper buys the product on the Internet if and only if inline image and inline image. It means that inline image, and the set is non-empty if and only if inline image. On the other hand, a type-v grocery shopper buys the product in the physical channel if and only if v − p ≥ 0 and inline image. It means that inline image. Further, inline image if and only if inline image.

Therefore, given 0 ≤ p ≤ V and inline image, the demand in the physical channel, denoted as Q, is

  • display math

and the demand on the manufacturer-owned Internet channel, denoted as inline image is

  • display math
3.1.3. Manufacturer's Channel Strategy

These demand functions provide a clear picture of market segmentation via this supply chain and suggest that, depending on the prices posted, the retailer may have access to either one consumer segment or both segments. Subsequently, we characterize the retailer's optimal pricing decisions using these demand functions as inputs. Following this, we then investigate the manufacturer's optimal decisions on the prices and the channel structure. While we relegate the remaining analysis to the Appendix, our first result identifies the manufacturer's channel strategy and the corresponding equilibrium outcomes.

Proposition 1. Suppose that only the manufacturer can introduce the Internet channel. There are two possible equilibrium strategies:

  • Channel separation strategies (CS-M and CS'-M): Internet shoppers are induced to purchase online, whereas grocery shoppers buy in the physical channel (these two strategies differ only in whether the manufacturer's pricing decision is the interior or corner solution);
  • Grocery encroachment strategy (GE-M): Only the high-valuation grocery shoppers buy in the physical channel, and others purchase online.

Accordingly, the resulting equilibrium prices are:

Strategy inline image inline image inline image
GE-M inline image inline image inline image
CS’-M inline image inline image inline image
CS-M inline image inline image inline image

The corresponding payoffs are:

Strategy inline image inline image
GE-M inline image inline image
CS’-M inline image inline image
CS-M inline image inline image

From Proposition 1, we observe that the benefit of introducing the Internet channel primarily comes from two sources. On one hand, including an Internet channel allows the manufacturer to price discriminate the consumers through their self-selection behaviors. As some consumers are willing to pay more in the Internet channel, the manufacturer can set prices appropriately to induce them to purchase in different channels. Second, the introduction of Internet channel allows the manufacturer to sell the products directly to the consumers instead of by way of the retailer, thereby avoiding the double marginalization problem that is present in the physical channel.

Given that grocery shoppers a priori prefer purchasing in the physical channel and Internet shoppers prefer going online, a natural conjecture is that the manufacturer shall simply induce them to purchase separately through these two channels. However, Proposition 1 shows that this is true only when there are sufficiently many Internet shoppers who a priori enjoy buying online (the CS-M strategy). When a large proportion of consumers a priori prefer to purchase in the physical channel (α is small), the manufacturer shall set a low selling price in his Internet channel to attract the low-valuation consumers from the physical channel (the GE-M strategy). We illustrate numerically the market conditions under which the grocery encroachment strategy emerges as the equilibrium in Figure 4 (where we fix inline imageV = 8, and f = 1; the same parameters apply to all the subsequent figures). Notably, we can verify that all the equilibria in different regions are unique because of the sequential nature of our games. We highlight our finding in the following corollary.

image

Figure 4. Equilibrium Channel Strategies with a Manufacturer-Owned Internet Channel

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Corollary 1. Suppose that only the manufacturer can introduce the Internet channel. The grocery encroachment strategy is more likely to be implemented when the Internet shoppers are rather unimportant (i.e., when α and inline image are small).

Corollary 1 indicates the precise regime for this grocery encroachment strategy to be profitable. To understand this result, recall that in the physical channel the retailer demands a markup, and therefore the double marginalization effect gives rise to a relatively high selling price. This high selling price inevitably forces the manufacturer to exclude some consumers with relatively low valuations. If the manufacturer is able to retain the selling business through his Internet channel, he can then set a relatively low price online to recoup these low-valuation consumers. This is precisely the rationale for the GE-M strategy; thus, occasionally it may dominate the intuitive channel separation strategy. In the extreme case where the Internet shoppers are unimportant, the benefit from market segmentation cannot justify the hassle of operating the Internet channel. Consequently, the manufacturer simply abandons it and sells everything through the physical channel.

Note that in order to attract the low-valuation grocery shoppers to purchase online, the manufacturer necessarily keeps the selling price low in his Internet channel. The downside of this strategy is to forgo the rent extraction from the Internet shoppers. If instead the Internet shoppers constitute a highly profitable segment, extracting revenue from the Internet shoppers becomes the manufacturer's primary concern. In such a scenario, the manufacturer purposely gives up those low-valuation consumers and leave all grocery shoppers in the (retailer's) physical channel. Collectively, we observe that the manufacturer's pricing strategies reflect how concerned he is about different consumer segments.

3.2. Retailer-Owned Internet Channel

In the second scenario, the Internet channel can only be operated by the retailer. The modified sequence of events is as follows. (i) The retailer determines whether to introduce an Internet channel. (ii) The manufacturer offers the wholesale price to the retailer. (iii) The retailer responds by determining the retail margin for the physical channel and that for her Internet channel (if available). (iv) The consumers decide which channel to purchase the products from. Note that in this case, the manufacturer can only indirectly affect the consumers' purchasing behaviors via setting a single wholesale price.

By backward induction, the first step is to examine the consumers' purchasing decisions. As this step is similar to that in section 'Manufacturer-Owned Internet Channel', we omit the details and simply summarize their collective actions as the following demand functions. The demand in the physical channel Q is

  • display math

and the demand on the Internet inline image is

  • display math

Having characterized the effective demands for these channels, we can then return to the retailer's and the manufacturer's strategies in two stages. In the next proposition, we characterize the equilibrium strategies in this scenario, whose detailed derivations are given in the Appendix.

Proposition 2. Suppose that only the retailer may introduce the Internet channel. There are two possible equilibrium strategies:

  • Channel separation strategy (CS-R): Internet shoppers are induced to purchase online, whereas grocery shoppers buy in the physical channel;
  • Exclusive online strategy (EO-R): Internet shoppers are induced to purchase online, and grocery shoppers and the physical channel are abandoned.

Accordingly, the resulting equilibrium prices are:

Strategy inline image inline image inline image
CS-R inline image inline image inline image
EO-R inline image  > V inline image

The equilibrium payoffs and the feasibility conditions are:

Strategy inline image inline image Condition
CS-R inline image inline image inline image
EO-R inline image inline image inline image

Proposition 2 identifies two strategies for the retailer to differentiate the consumers based on their heterogeneous preferences in the presence of retailer-owned Internet channel. When the Internet shoppers are not very profitable (i.e., with a small population or when their average valuation is not very high), the retailer will implement the natural channel separation strategy: inducing the first consumer segment to purchase in the physical channel and the second consumer segment to shop online. As aforementioned, this strategy facilitates the price discrimination through different channels. When the Internet shoppers are relatively important, the retailer now instead uses a niche targeting strategy. Incidentally, the equilibrium price under this strategy (EO-R) indicates that the retailer effectively abandons the physical channel: as inline image, she sets a high selling price so that only the Internet shoppers purchase in the Internet channel.

It is worth mentioning that unlike the case with the manufacturer-owned Internet channel, here the retailer has no intention to implicitly split the consumers from the same segment, i.e., the grocery encroachment strategy is no longer desirable. While the manufacturer intends to use his Internet channel to subsidize the downside of the double marginalization problem, this initiative is absent when the retailer coordinates the selling prices over different channels. We hereby highlight this result as a corollary and provide a numerical illustration in Figure 5.

image

Figure 5. Equilibrium Channel Strategies with a Retailer-Owned Internet Channel

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Corollary 2. Suppose that only the retailer can introduce the Internet channel. The exclusive online strategy is more likely to be implemented when the Internet shoppers are rather important (i.e., when α and inline image are large). In addition, in equilibrium grocery shoppers never purchase online, whereas Internet shoppers never go to the physical channel.

Incidentally, this niche targeting strategy in Corollary 2 can never emerge as an equilibrium outcome with only the manufacturer-owned Internet channel. This is because, compared with this targeting strategy, the manufacturer also benefits from inducing some grocery shoppers to purchase in the physical channel in the first scenario, even if he has to share the revenue with the retailer. Thus, completely abandoning the physical channel is not preferable from the manufacturer's perspective.

3.3. Both the Manufacturer and the Retailer Can Introduce Internet Channels

Having articulated the benefits and consequences of introducing the Internet channel for the manufacturer and the retailer, we now incorporate the possibility that both parties are able to operate independent Internet channels. The sequence of events follows the above two subsections except that at the beginning the manufacturer and the retailer determine simultaneously whether to introduce an Internet channel. The possible equilibrium strategies are characterized in the following proposition.

Proposition 3. When both the manufacturer and the retailer can sell the products through their own Internet channels, there are four possible equilibrium strategies:

  • Grocery encroachment strategy (GE-M): Only the high-valuation grocery shoppers buy in the physical channel, and others purchase in the manufacturer-owned Internet channel.
  • Channel separation strategy with retailer's Internet channel (CS-R): Internet shoppers are induced to purchase in the retailer-owned Internet channel, whereas grocery shoppers buy in the physical channel;
  • Channel separation strategies (CS-M, CS'-M): Internet shoppers are induced to purchase online, whereas grocery shoppers buy in the physical channel.

From Proposition 3, we observe that strategy EO-R is no longer sustainable. Recollect that in the absence of a manufacturer-owned Internet channel, the exclusive online (EO-R) strategy indicates that the retailer may abandon the physical channel and set a high price to serve only those Internet shoppers. When the manufacturer is also capable of operating his Internet channel, this niche targeting strategy may ignite the manufacturer's counteraction. Since the retailer attempts to give up the physical channel, the manufacturer will certainly undercut the retailer's price to capture all the consumers. Pushing this idea further, the manufacturer can raise the wholesale price to deactivate both the physical channel and the retailer's Internet channel. To counteract the retailer's exclusive online strategy, the manufacturer can meticulously design the wholesale price and operate his Internet channel to facilitate the maximum benefit of channel separation. This provides an economic rationale for why the retailer always maintains her physical channel. In addition to keeping her core competence (as the conventional wisdom), the retailer strategically uses this physical channel to avoid the vindictive behavior from her supply chain partner.

Notably, Proposition 3 suggests that the manufacturer may willingly give up selling online, but nevertheless his capability of operating the Internet channel still has a direct impact on the market equilibrium. Thus, retaining this capability has a strategic value, as it allows the manufacturer to counterbalance the retailer's pricing power. This result is somewhat related to a recent industry report by Brohan (2012), who explicitly mentions that most manufacturers that operate their Internet channels do not really generate additional sales that live up to the market's expectation. As Brohan (2012) explains, this phenomenon occurs only to those manufacturers who rely on their long-term retailer partners; it can therefore be regarded as a consequence of manufacturers' attempts to avoid the channel conflict.

Given the above discussion, a natural question is when these strategies emerge as the market equilibria in different scenarios. While Proposition 3 lays out the precise conditions that identify the optimal strategies among the three via routine algebra, we find it more illustrative to show this graphically in Figure 6. From Figure 6, we observe that when the Internet shoppers are either highly profitable (when α and inline image are large) or fairly unimportant (when α and inline image are small), the manufacturer prefers to facilitate the channel separation either through his own Internet channel or the retailer's. In the intermediate region, however, the manufacturer intends to encroach the grocery shoppers and steal the demand from the retailer's physical channel.3 To understand this result, observe that when the Internet shoppers are highly profitable, the manufacturer certainly prefers to go direct to capture this segment. Thus, using his Internet channel is the most effective way to avoid double marginalization and materialize the benefit. At the other extreme, when the Internet shoppers are fairly unimportant (compared to the grocery shoppers), the manufacturer's primary goal is to avoid channel conflict. In this case, it is in the manufacturer's best interest to delegate both channels to the retailer. In the intermediate region, the manufacturer faces two conflicting forces. Facilitating channel separation via his own Internet channel induces too much competition from the retailer, whereas completely delegating to the retailer leaves a significant portion of revenue to the retailer's side. In such a scenario, the manufacturer sets a low price in his Internet channel so as to attract some low-valuation grocery shoppers to purchase online (strategy GE-M). This low-price strategy allows the manufacturer to steal the obscure market of grocery shoppers at no cost of channel conflict.

image

Figure 6. Equilibrium Channel Strategies in the Full Module

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4. Discussion

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

In this section, we consider some variants of our model characteristics.4 To avoid repetition, we will only highlight the primary differences and focus on the new implications that are absent in the basic framework.

4.1. Retailer Competition

In our basic model, we assume away the horizontal competition and study the bilateral monopoly setting. However, in reality, the manufacturer typically sells through multiple retailers that compete against each other. In such a scenario, there are multiple physical channels, and each retailer can determine whether to introduce her own Internet channel. A natural question is therefore how the equilibrium channel structure is influenced by the horizontal competition.

To address this question, we consider an extended model in which the manufacturer sells through two independent retailers, indexed as 1 and 2. We allow both retailers (as well as the manufacturer) to introduce their own Internet channels. The sequence of events proceeds as follows. (i) The manufacturer and the retailers simultaneously determine whether to introduce an Internet channel. (ii) The manufacturer offers the wholesale price to the retailers. (iii) The manufacturer and the retailers simultaneously determine the selling prices of their own channels (if available). (iv) The consumers decide which channel to purchase the products from. Figure 7 presents a graphic illustration of the possible channel structure.

image

Figure 7. Channel Structure under Retailer Competition

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As in section 'Equilibrium Analysis', we can also examine the consumers' purchasing decisions and express them in the form of effective demands for different channels. Afterwards, we then use backward induction to characterize the equilibrium strategies of the manufacturer and the retailers. These detailed derivations are given in the online Appendix, and we summarize the main findings below.

Proposition 4. With retailer competition, in any equilibrium channel structure, exactly two supply chain parties introduce their Internet channels. Moreover, given any primitive parameter combination, it is always an equilibrium that the manufacturer abandons his Internet channel and both retailers introduce their own.

Proposition 4 shows that retailer competition can significantly influence the equilibrium channel structure, and it gives rise to various kinds of channel structures we observe in practice. A notable observation is that even if the retailers are perfectly competitive, the manufacturer intends to induce them to both introduce the Internet channels, and in equilibrium both retailers willingly do so. To elaborate the intuition behind this, recollect that the economic rationale for the manufacturer to introduce his own Internet channel is to fight against the double marginalization problem. Thus, this direct channel allows the manufacturer to bypass the retailer's markup and at the same time induces the retailer to reduce the selling price in the physical channel. In the presence of retailer competition, however, this direct channel is no longer required. Specifically, the intense competition between the retailers effectively eliminates the double marginalization problem and the price competition automatically drives down the selling prices in the physical channels. In light of this, the manufacturer does not need to go through the hassle of opening his own Internet channel. This might explain why in reality some leading manufacturers (such as Acer, Colgate, Gillette, Heinz, Kellogg's, and Tylenol) do not offer their Internet channels.

On the other hand, our results also suggest that even if the retailers are a priori symmetric, asymmetric channel structures may emerge as a stable market equilibrium. This possibility prevails even if these retailers are selling the same products and compete head-to-head for the end consumers. The primary reason is that when the opponent has already opened the Internet channel, introducing another one does not mitigate the competition and therefore is not beneficial for the retailer. Thus, we document the possibility of asymmetric equilibrium channel structure. Our analysis provides a partial answer to the prevalent phenomenon that a significant portion of retailers focus exclusively on the physical channels in this Internet era. As mentioned in the Introduction, this applies to the following retailers: 7-Eleven, Carrefour, Pricesmart, Tween Brands, Citi Trends, Dress Barn, Ross Stores, Spartan Stores, Duckwall-Alco, TJX Inc., Family Dollar, Collective Brands, Watsons, Pantry, Retail Enterprises, Ingles Markets, and RT-MART.

Finally, we offer a graphic illustration of when these channel structures may emerge as the market equilibrium in Figure 8. From Figure 8, we observe that the manufacturer is willing to give up his Internet channel only when the Internet shoppers are relatively less important (when α and inline image are both small). On the other hand, the aforementioned asymmetric channel structures appear in various scenarios. The economic forces have been elaborated in section 'Both the Manufacturer and the Retailer Can Introduce Internet Channels', as the manufacturer's concern about the consequence of retailers' counteractions is more pronounced with a less important segment of Internet shoppers. Notably, even if the double marginalization problem in the physical channels is largely eliminated by the horizontal competition, the channel conflict concern remains salient.

image

Figure 8. Equilibrium Channel Strategies with Retailer Competition

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4.2. Selling through an E-tailer

We now consider the scenario wherein the manufacturer sells through an online retailer (e.g., Amazon). In this scenario, the modified sequence of events becomes the following. (i) The manufacturer determines the wholesale prices w and inline image for the physical and Internet channels, respectively. (ii) The retailer and e-tailer determine their selling prices p and inline image simultaneously. (iii) Consumers make their purchasing decisions. When both the manufacturer and the retailer can introduce Internet channels, in stage (ii) the retailer also determines her online selling price.

The primary departure from our basic framework is that both online channels are in a sense “indirect:” one operated by the retailer and the other operated by the e-tailer. Figure 9 presents a graphic illustration of the channel structure in this modified setting. As we verify in the Appendix, most of the equilibrium properties in the basic framework are preserved. Nonetheless, a new equilibrium channel strategy may arise, as highlighted in the following proposition.

image

Figure 9. Channel Structure with an E-tailer

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Proposition 5. Suppose that the manufacturer sells through an e-tailer and a dual-channel retailer. In equilibrium, the manufacturer may induce Internet shoppers to purchase through the retailer's physical channel.

Proposition 5 suggests that the manufacturer now has a stronger incentive to sell through the physical channel. In our basic framework, the manufacturer may encroach the grocery shoppers via his own Internet channel (the GE-M strategy). This is because the direct channel effectively bypasses the retailer's markup. Nevertheless, when the Internet channel is facilitated by the e-tailer, selling online does not allow the manufacturer to escape from the double marginalization problem. This substantially changes the manufacturer's channel management strategy, as now the manufacturer captures some Internet shoppers via the physical channel. The retailer's physical channel becomes appealing (from the manufacturer's viewpoint) because the retailer intends to set the margin low so as to attract grocery shoppers. Consequently, the double marginalization problem is less severe. In contrast, the e-tailer targets Internet shoppers who have high valuations upon online shopping. Thus, the e-tailer is more inclined to set a high margin. We have also verified via numerical experiments that such a new strategy indeed emerges as an equilibrium in some situations. We omit the details here to avoid repetition.

5. Conclusion

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

In this study, we examine the rationale for introducing the Internet channels of the manufacturer and the retailer. We identify three equilibrium strategies that feature channel separation, consumer encroachment, and exclusive selling. When the Internet shoppers are either highly profitable or fairly unimportant, the manufacturer prefers to facilitate the channel separation either through his own Internet channel or the retailer's. In the intermediate region, however, the manufacturer intends to encroach the grocery shoppers and steal the demand from the retailer's physical channel. With horizontal competition between the retailers, a priori symmetric retailers may adopt different channel strategies as a stable market equilibrium. Furthermore, the manufacturer may willingly give up his Internet channel and leverage on the retailer competition. When the manufacturer sells through an online retailer, he may induce Internet shoppers to purchase through the retailer's physical channel. Our results provide an economic rationale for the apparent discrepancy among various market phenomena in the Internet channel adoptions.

Our analysis reveals several economic rationales for introducing/abandoning the Internet channels. Naturally, there are other reasons why the retailers' Internet channels exist, such as one-stop shopping of multiple products, loyalty programs, and etc. While these issues have their own merits and perhaps warrant a separate analysis, it seems rather difficult to incorporate all the possible ingredients in a single model. Nevertheless, one-stop shopping and loyalty programs are two crucial components for the success of prevalent retailer-owned Internet channels, and they remain a research priority. In addition, while our model excludes all the possible restrictions on the pricing strategies, there are situations in which the manufacturer may be forced to use the same (retail) price in the Internet channel as the wholesale/retail price in the physical channel. As aforementioned, the retail price in the manufacturer's Internet channel may be necessarily higher than the wholesale price in the physical channel in order to eliminate the retailer's arbitrage opportunity (Chiang et al. 2003). The (retail) prices in different channels may be set equal to alleviate the channel conflict (Chiang et al. 2003). These restrictions on the pricing strategy in the Internet channel definitely affect the manufacturer's/retailer's incentive to introduce the Internet channel.

Acknowledgments

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information

We thank Vishal Gaur (the department editor) and the review team for the detailed comments and many valuable suggestions that have significantly improved the quality of the paper. We have also benefited from the discussions with Gangshu Cai, Jane Gu, Daniel Lin, Olga Perdikaki, Jiong Sun, Chi-Cheng Wu, Wenqiang Xiao, and Xuying Zhao. Hsiao acknowledges the financial support by the National Science Council in Taiwan (NSC 98-2410-H-005-005). All remaining errors are our own.

Notes
  1. Lu Hsiao's address in now Department of Business Administration, National Chung Hsing University, Taichung 40227, Taiwan, R.O.C.

  2. 2

    Most of the above retailers are selected as the top/hot retailers by Stores.com based on their dominant performance and/or the remarkable growth rates (source:http://www.stores.org/Top_100_new/Top_100_landing_page.asp).

  3. 3

    We choose to vary inline image because the conditions that distinguish different regimes (strategies) all depend on inline image. Thus, through this one-dimensional change, we can conveniently illustrate all possible strategies in one figure for a fixed set of other parameters. We have also conducted an alternative numerical experiment where we change inline image and inline image simultaneously. We find that the effect of increasing inline image is essentially the same as that of decreasing inline image.

  4. 4

    We thank an anonymous reviewer for suggesting these extensions.

References

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  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information
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Supporting Information

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Model
  5. 3. Equilibrium Analysis
  6. 4. Discussion
  7. 5. Conclusion
  8. Acknowledgments
  9. References
  10. Supporting Information
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poms12051-sup-0001-appendix.pdfapplication/PDF106K

Appendix A. Basic Framework: Bilateral Monopolies

Appendix B. Retailer Competition

Appendix C. Selling Through an E-tailer

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