Retailors market power and the optimal channel strategies of a manufacter in electric commerce

KAIST Business School WORKING PAPER SERIES Retailer.s Market Power and the Optimal Channel Strategies of a Manufacturer in Electronic Commerce Jae-Cheol Kim Se-Hak Chun November 2010 KCB-WP-2010-011 This paper can be downloaded without charge at: KAIST Business School Working Paper Series Index: http://www.business.kaist.ac.kr/main.asp?cate_code=20091008101934&gourl=/program/case_ work.asp&resource=3&cate=2 and http://www.ssrn.com/link/KAIST-Business-School.html Social Science Research Network eLibrary: http://papers.ssrn.com/sol3/displayabstractsearch.cfm ⓒ2007 All works posted here are owned and copyrighted by the author(s) Papers may be downloaded for personal use only Electronic Electroniccopy copyavailable availableat: at:https://ssrn.com/abstract=1713044 http://ssrn.com/abstract=1713044 Retailer’s Market Power and the Optimal Channel Strategies of a Manufacturer in Electronic Commerce Jae-Cheol Kimy and Se-Hak Chunz yGraduate School of Management, KAIST, 87 Hoegiro, Dogdaemun-gu, Seoul 130-722, Korea, jckim@business.kaist.ac.kr zDepartment of Business Administration, Seoul National University of Science and Technology, 138 Kongrungdonggil, Nowon-gu, Seoul 139-743, Korea, shchun@snut.ac.kr Abstract Even though many manufacturers today are increasingly adopting dual channels to sell their products through their traditional retail channels and their own direct online channels, there are still few theoretical studies on manufacturers’optimal channel management strategies and pricing strategies in electronic commerce Previous studies tend to rely on simulation approaches or empirical approaches and their methods are not su¢ cient to draw equilibrium prices for a dual-channel supply chain design As well, previous studies on channel management have tried to analyze a manufacturer’s channel management strategy from the perspective of channel con‡ict between a manufacturer and a retailer; thus, they tend to focus on pricing strategies of the Electronic Electroniccopy copyavailable availableat: at:https://ssrn.com/abstract=1713044 http://ssrn.com/abstract=1713044 manufacturer and start from an assumption that there are both o- ine and online channels initially This paper begins by asking a question why both channels exist at the same time We are particularily interested in a manufacturer’s optimal channel strategies when a manufacturer sells its products through both a retail channel and its direct online channel Then, under what conditions both a traditional retailer and a vertically integrated direct channel coexist or when does a manufacturer use a traditional channel only? Also, when may a manufacturer dispense with an existing retailer and use a direct online channel only? We investigate these questions from the perspective of customer choice behavior considering several factors, including the degree of the consumer’s online convenience and the degree of customer heterogeneity between a traditional retail channel and online channel We discuss how these are related to a manufacturer’s channel strategies and pricing strategies in an electronic market enviroment In particular, we consider the retailer’s market power (or competitiveness in a retail market), which have been rarely considered in previous studies We discuss the channel conict issue from a diÔerent view of the retailer’s market power Traditional approaches have focused on the fact that o- ine markets are larger than online, so the retailer has more bargaining power Our perspective also considers the opposite point of view In particular, we examine how this retailer’s market power is related to a manufacturer’s channel Electronic Electroniccopy copyavailable availableat: at:https://ssrn.com/abstract=1713044 http://ssrn.com/abstract=1713044 strategy, pricing strategy, strategic behaviors and channel con‡ict We also discuss strategic implications on the market player’s behavior when a manufacturer adds a direct online channel Keywords: Economics of IS, Electronic Commerce, Channel Management, Retailer Market Power, Channel Con‡ict, Clicks-and-Mortar, Online and O- ine Channel, Optimal Prices, Equilibrium Prices, Supply Chain Management Introduction The prevailing popularity of the Internet has led thousands of manufacturers, such as IBM, Hewlett-Packard, Pioneer Electronics, Sony, Kodak, Minolta, Panasonic, Cisco, the former Compaq, Mattel, Estee Lauder and Nike, to add direct online channels to their existing retail networks (Chiang et al., 2003; Hua et al., 2010; Kumar, 2008; Tedeschi, 1999, 2000; Tsay and Agrawal, 2004) With advantages, such as reduced search costs and increased reach, the Internet enables a manufacturer to increase its market coverage and pro…ts through its own direct online channel Nowadays, many manufacturers sell their products online as well as o- ine; however, some manufacturers such as JVC, NEC, 3M, Nikon, Cannon, Olympus, Samsung and LG, have used the Internet as a mere medium to provide information about their products without selling via their websites (Kumar, 2008) For example, Samsung at Electronic copy available at: https://ssrn.com/abstract=1713044 one time sold its products through its own website; however, it ceased its initiative for online sales Also others, such as Levi Strauss, H.E Butt Grocery Company, Wes & Willy, Colgate-Palmolive have adopted a passive Internet channel strategy, choosing to use their Web sites to support existing intermediaries and provide information about their brands and products to customers rather than sell its brands online (Lee et al., 2003) Moreover, some industries such as newspapers, media, broadcasting, …nance, insurance, tourism, etc., tend to focus on online business by dispelling or reducing their current o- ine businesses These examples show that the adoption of a multi-chanel strategy by the manufacturers is very complicated according to the characteristics of manufacturers and retail categories Why manufacturers use multi-channel strategies diÔerently? This motivates us to analyze the manufacturers optimal multi-channel strategies Even though many manufacturers today are increasingly adopting dual channels to sell their products through their traditional retail channels and their own direct online channels, there are still few theoretical studies on manufacturers’optimal channel management strategies and pricing strategies in electronic commerce As well, previous studies tend to rely on simulation approaches or empirical approaches and their methods are not su¢ cient to draw equilibrium prices for a dual-channel supply chain design Previous studies on channel management have tried to analyze a manufacturer’s channel management strategy from the perspective of channel con‡ict between Electronic copy available at: https://ssrn.com/abstract=1713044 a manufacturer and a retailer; thus, they tend to focus on pricing strategies of the manufacturer and start from an assumption that there are both o- ine and online channels initially This paper begins by asking why both channels exist at the same time We are particularily interested in a manufacturer’s optimal channel strategy when the manufacturer sells its products through both the retail channel and its direct online channel Then, under what conditions both the traditional retail channel and the vertically integrated direct channel coexist? When does a manufacturer use a traditional channel only? When may a manufacturer dispel an existing retailer and use a direct online channel only? We investigate these questions from the perspective of customer choice behavior considering several factors including the degree of the consumer’s online convenience and the degree of customer heterogeneity between a traditional retail channel and online channels We discuss how these are related to a manufacturer’s channel strategies and pricing strategies in an electronic market enviroment In particular, we consider a retailer’s market power (or competitiveness in a retail market), which has been rarely considered in previous studies We discuss the channel conict issue from the diÔerent view of the retailer’s market power by considering either the online or o- ine channel as dominant Contrary to previous studies, we discuss the retailer’s strategic behavior and a possible pure-play strategy of the manufacturer, which may use its direct online channel only for selling products Electronic copy available at: https://ssrn.com/abstract=1713044 The strategy comes from the perspective of incomplete analysis because the retailer is usually assumed to have greater bargaining power and a more loyal customer base We also examine how this retailer’s market power is related to a manufacturer’s channel strategy, pricing strategy, strategic behaviors and channel con‡ict, which has been rarely investigated in previous studies This paper shows that if all types of consumers become homogeneous in their receptiveness to online shopping, then a manufacturer uses the direct channel only and it may eliminate an existing retail channel Also, if consumers are very heterogenous with regard to their receptiveness to online shopping (or when both o- ine and online consumer types are very well segmented), then a manufacturer uses both channels to sell its products If both types of consumers are neither similar nor very diÔerent in their receptiveness to online shopping (or markets are not well segmented), a manufacturer uses the traditional o- ine retail channel only This paper shows that price diÔerences between both channels should be illuminated by the degree of online convenience; thus, actual online prices include the price itself and re‡ect the degree of online perception In general, the higher the market power of the retailer or the relative maket size, the higher the chance of the retailer’s price being greater than the direct online channel Literature on channel con‡ict usually shows that a manufacturer uses a matching pricing strategy when it adds a new online channel, the situational assumption is that the retailer’s market power is larger than manufac- Electronic copy available at: https://ssrn.com/abstract=1713044 turer’s or the o- ine market size is noticably larger than the new online market Also this paper discusses the manufacturer’s pricing strategies under dual channel situations comparing other channel strategies and an extensible model, which may explain that the direct online channel can be a manufacturer’s own direct o- ine channel in addition to its existing independent indirect retailer base This paper shows a diÔerent approach when analyzing a channel con‡ict issue From a traditional perspective of channel con‡ict, as the retailer’s market power increases, a manufacturer does not use an online channel, which assumes that the o- ine market size is larger However, this paper can explain the reverse situation where the retailer’s market power increases, so the manufacturer can use an online channel, or a retailer voluntarily reduces its market power when we consider that the online market size is larger The remainder of this paper is organized as follows: Section presents literature review and section presents the basic model Section analyzes the dual channel model Section discusses optimal channel strategies and implications In Section 6, conclusions and future research are discussed Literature Review Even though many manufacturers today are increasingly adopting dual channels and channel management is a growing research area, there are still few theoretical studies on a manufacturer’s optimal multi-channel strategies in electronic commerce Most Electronic copy available at: https://ssrn.com/abstract=1713044 previous studies in dual channel management area have focused on competition in price and/or marketing (Bell et al 2002, Chiang et al 2003, Tsay and Agrawal 2004, Cattani et al 2006,Cai et al., 2009, Huang and Swarminathan, 2009) Chiang et al (2003) analyze a dual-channel supply chain model by assuming that all consumers have a common positive preference toward a traditional retailer They show that a direct online channel plays the role of exerting potential competitive pressure on the existing retailer by increasing the manufacturer’s negotiation power and reducing double marginalization in the retail market, even though its pro…t is nonpositive Cai et al (2009) evaluate the impact of price discount contracts when a manufacturer discounts the wholesale price to a certain portion of the retail price, and they investigate price schemes on the dual-channel supply chain competition They show a consistent price scheme— the direct channel and the retail channel are priced the same— can reduce the channel con‡ict by inducing more pro…t for the retailer Their results including other channel con‡ict literature seem to be based on the assumption that the portion of loyal customers of o- ine retailers is larger than toward online channels They discuss a manufacturers distribution strategy focusing on diÔerent cost structures between the two channels and show that manufacturers use both channels when the direct channel cost is not very high Cattani et al (2006) study a price coordination issue for a dual-channel supply chain, in which they assume the equal-price strategy in which the manufacturer commits to set a direct online Electronic copy available at: https://ssrn.com/abstract=1713044 channel price that matches the o- ine retail price They show that an equal-pricing strategy is appropriate as long as the retail channel is signi…cantly more convenient than the Internet channel, which implies that the manufacturer doesn’t use a direct online channel aggressively as a sales channel Huang and Swaminathan (2009) study optimal pricing strategies when a retailer sells its product though two channels, such as the Internet and a traditional channel Forman et al (2009) empirically examine the trade-oÔ benet between buying online and buying in a local retail store They show that when a store opens locally, people steer away from online purchasing; however, o- ine entry decreases as consumers’ receptivity to online price discounts increases Wu et al (2008) examines how information technology aÔects a monopoly manufacturers distribution problem in an environment where product information is important for consumers to identify their ideal product They show that a manufacturer is less likely to sell through both channels when the proportion of consumers who have access to the electronic channel is very high Chen et al (2008) study a dual-channel model where a retailer chooses its service level and a manufacturer sets the delivery time They study the manufacturer’s optimal dual channel strategies according to the costs of managing a direct online channel and retailer inconvenience using a simulation method They show that a manufacturer uses both channel, when the direct channel cost is high and the retailer inconvenience cost is low, while the manufacturer Electronic copy available at: https://ssrn.com/abstract=1713044 it becomes easier to segment consumer groups 4.2.2 Pure Play Strategy: Online Channel Only Suppose that the manufacturer decides to sell its product only through the direct e= online channel Letting L (p2 ; ; ) + q(p2 ; ) be the Lagrangian and be the corresponding Lagrangian multiplier Let the optimal solution be pv2 ( ; ) and ( ; ) and v (pv2 ( ; ); ; ): From the …rst order conditions, we obtain ( ; ) pv2 ( ; ) = pm ( ) ev @L = @ De…ne e( ) = + + 1+ (1 )( ) ( ; ) + ( ; ) 2b (1 + ) + 0; ( ; ) 0; ( ; ) ev @L = 0: @ It is easy to see that b( ) < e( ) < :5 Lemma (i) The optimal solutions are as follows: e( ) ( ; ) pv2 ( ; ) pm ( ) q2d ( ; ) + 1+ (ii) v b( ) > + 1+ 2b ( (1+ ) (1 (1+ )(e( ) )( ) ) 1+ ( >0 + (1 e( )) > > pd2 ( ; ) = c + ( ; ) is decreasing in x = > e( ) >c and : x(1 + )) > 28 Electronic copy available at: https://ssrn.com/abstract=1713044 (iii) v ( ; )R d ( ; 1) if and only if S : Proof Easy and omitted As long as the manufacturer pools consumers and serves them at the direct online channel, it is natural that if any type of consumers feel less comfortable with online shopping, it adversely aÔects the manufacurers prots 29 Electronic copy available at: https://ssrn.com/abstract=1713044 The Optimal Channel Strategies and Implications The discussion so far is summarized in the …gure below Π, π Π d (α , β ) Π d (α , ∞) π ωm = Π d (α * , ∞) = Π v (α * ,α * ) Π v (α , β ) Πd (α*, β) Πv (α* , β) α α * β C (α ) β B (α) * β (α ) β (α ) β Figure The Pro…t Fuctions according to Channel Strategies Pro…t curves as functions of to see that m ! are drawn given From discussions so far, it is easy does not depend on and and is equal to d ( ; 1) and 30 Electronic copy available at: https://ssrn.com/abstract=1713044 v ( ; ): Furthermore, if = ; On the other hand, v d ( ; ) decreases and reaches its minimum at m ! These are shown as dotted lines in Figure Note that v ( ; ) for : Then, both This is true if d v ( ; ) and same By contrast, if = b( ; ) increases and reaches its maximum at ( Suppose that > d ; both ) ( ; ) and increases slightly above ( ; ) shift downward given decreases slightly below d dominates = b( ) m ! while ( ; ) and remains the v ( ; ) shift upward as shown as solid lines We discuss the channel and pricing strategies of the manufacturer below Note that given B are appropriate for C 2[ ; ( )); ; Strategy C, Strategy A and Strategy < 2[ C ( ); B ( )) and 2[ B ( ); 1): Implication 1: The manufacturer opens up the direct online channel if only if type- consumers are receptive to online shopping ( < ): Implication 2: The decision of the manufacturer to own its direct online channel is independent of type- consumers’receptiveness to online shopping If both types are similar in receptiveness, ( they are very diÔerent ( > B < C ( )); the manufacturer uses Strategy C while ( )); it uses Strategy B Implication 3: If type- consumers are receptive and both types of consumers are neither similar nor very diÔerent in receptiveness ( C ( ) B ( )), hav- ing a direct online channel is not in the interest of the manufacturer and then, the manufacturer uses Strategy A For Strategy C, the manufacturer needs to set a low enough price to entice type- consumers Similalry for Strategy B, it needs to set a 31 Electronic copy available at: https://ssrn.com/abstract=1713044 low enough price so as not to lose type- consumers Implication 4: When the manufacturer uses dual channel for distribution, it is not clear whether the o- ine or online prices are higher For example, suppose that d m d > b( ) so that pd1 = pm and p2 ( ) = p2 ( ) Then, p1 pd2 ( ) = x + any sign If x = so that the retailer has no market power and typeprefer online shopping to buying from the retailer ( c < can be consumers < 0), then the direct online channel charges a higher price than the retailer This is because while the retailer has to set a competitive price, the direct online channel secures rather loyal consumers However, this is a rather supercial observation because the eÔective price type- consumers pay is pd2 ( ) + Then, the price diÔerence is x > so that the retailer commands a higher price In general, given ; the higher the market power of the retailer or the relative maket size, the higher the chance of the retailer’s price being greater than the direct online channel’s Implication 5: Suppose that the manufacturer uses dual channels for distribution and pm 1( b( ) so that both prices are oÔ the respective monopoly prices, pd ( ; ) = b ) and pd2 ( ; ) = pm ( )+ 2( b ) Although the direct channel does not serve type- consumers, its pricing depends on how those consumers feel about online shopping If such type- consumers become less inclined to shop online, the manufacturer can increase the retailer’s price and at the same time lower the direct online channel’s price for larger sales and more pro…ts 32 Electronic copy available at: https://ssrn.com/abstract=1713044 Implication 6: So far, we have assumed that x is …xed But it is conceivable that the retailer may voluntarily restrain its market power For example, suppose that = B ( ) and the retail market is served by the retailer and the direct online channel The retailer’s pro…t is (1 d ) m If the retailer reduces x a little, both m w and ( ; ) shift upward and therefore, the manufacturer will not serve type- conumers through the direct online channel The retailer can secure all type- consumers The loss of reduced per-consumer pro…t ( m is an increasing in x) is of the second-order in magnitude but the increased pro…t from selling more by serving type- consumers is of the …rst-order Therefore, it pays the retailer not to exert its market power to the full extent This means that the possibility of the manufacturer opeing up a new direct online channel and the existence of elastic consumers discpline the retailer to behave more competitively In other words, self-created competition in the retail market alleviates the problem of double-markup to some extent The manufacturer and the retailer are winners Type- consumers are winners because pm decreases However, type- consumers lose because pd2 ( ) + pd1 = pm ( )+ pm = x < In other words, these consumers are forced to move to the retailer for shopping Implication 7: The model is easily used to examine a situation where the manufacturer vertically intergrates the retailer In this case, the manufacturer’s problem boils down to utilization of two vertically integrated distribution channels, o- ine and online The model needs to be modi…ed in two respects First, the market power 33 Electronic copy available at: https://ssrn.com/abstract=1713044 of the retailer x is now a choice variable of the maufacturer Second, the manufacturer’s pro…t from the retailer is the sum of previously, d ( ; ) and v (p1 ) and w (p1 ): However, as discussed ( ; ) are maximized when the retailer does not exert its market power, that is, when x = 0: In this case, the retailer is w (p1 ): (p1 ) = so that pro…t from As a result, all the above implications continue to hold with appropriate modi…cations considering that = For example, the manufacturer opens up the direct online channel if and only if type- consumers prefer shopping online to shopping o- ine Implication 8: The model explains channel conict issues from a diÔerent perspective According to the traditional perspective of channel con‡ict, the manufacturer tends to use the Internet as a mere medium for providing product information rather than selling its products online This is due to the assumption that an o- ine retail market is larger than the direct online market, and usually a retailer has stronger bargaining power than the manufacturer Our model views channel con‡ict issues from the perspecitive of the retailer’s market power without assuming that an o- ine market size is larger If we can also interpret x as the degree of channel con‡ict, then this model shows a possible reverse situation where the retailer’s market power increases (or thus, channel con‡ict becomes severe from a manufacturer’s perspective), so the manufacturer can use an online channel, or the retailer voluntarily reduces its market power This explanation is closely related to Implication However, we 34 Electronic copy available at: https://ssrn.com/abstract=1713044 not consider the retailer’s responses in that it can eliminate the manufacturer’s products from its o- ine showroom depending on the manufacturer’s strategy if it perceives the manufacturer’s strategy as a threat Conclusion This paper discusses the channel and pricing strategies of the manufacturer in electronic commerce It also discusses strategic behavior and its strategic implications when a manufacturer adds a direct online channel This paper examines how this retailer’s market power is related to the manufacturer’s channel strategy, pricing strategy, strategic behavior and channel con‡ict, which has been rarely investigated in previous studies This paper provides a new view that analyzes channel con‡ict issues from the perspective of the retailer’s market power and retailer’s strategic behavior However, limitation of this study is that we not to consider the retailer’s response of cancelling the contract with the manufacturer References Bell, D R., Y Wang, V Padmanabhan 2002 An Explanation for partial forward integration: Why manufacturers become marketers Working paper, Wharton School, University of Pennsylvania, Philadelphia 35 Electronic copy available at: https://ssrn.com/abstract=1713044 Cai G., Zhang Z., and Zhang M., 2009 Game theoretical perspectives on dualchannel supply chain competition with price discounts and pricing schemes International Journal of Production Economics, 117, 80-96 Cattani K., Gilland W., Heese H S., and Swaminathan J M., 2006 Boiling frogs: Pricing strategies for a manufacturer adding a direct channel that competes with the traditional channel, Production and Operations Management, 15 (1), 40-56 Chiang, W K., Chhajed D., and Hess J D., 2003 Direct marketing, indirect profits: A strategic analysis of dual-channel supply chain design Management Science, 49(1), 1–20 Chen K-Y., Kaya M., and Ozer O 2008 Dual Sales Channel Management with Service Competition, Manufacturing and Service Operations Management 10(4), 654– 675 Desiraju, Ramarao, Sridhar Moorthy 1997 Managing a Distribution Channel Under Asymmetric Information with Performance Requirements Management Science, 43, 1628-1644 Forman C., Ghose A., and Goldfarb A., 2009 Competition Between Local and Electronic Markets: How the Bene…t of Buying Online Depends on Where You Live, Management Science, 55(1) 47–57 Hua G., Wang S., and Cheng T.C.E., 2010 Price and lead time decisions in dualchannel supply chains European Journal of Operational Research, 205, 113–126 36 Electronic copy available at: https://ssrn.com/abstract=1713044 Huang, W and Swaminathan J.M., 2009 Introduction of a second channel: Implications for pricing and pro…ts, European Journal of Operational Research, 194, 258–279 Kuma, N., Ruan, R., 2008 On Complementing the retail channel with a direct online channel Quantitative Marketing and Economics Lee Y., Lee J., and Larsen R.T., 2003 Coping with Internet channel con‡ict Communications of the ACM, 46(7), 137-142 37 Electronic copy available at: https://ssrn.com/abstract=1713044 Tsay A.A., and Agrawal N., 2004 Channel Con‡ict and Coordination in the E-Commerce Age, Production and Operations Management, 13(1), 93–110 Tedeshi, B 2000 Compressed data; 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Likewise, there is still a lack of clarity in the explanation for optimal channel strategies and pricing strategies of the manufacturer when it adds a direct online channel in electronic commerce Channel. .. studies in dual channel management area have focused on competition in price and/ or marketing (Bell et al 2002, Chiang et al 2003, Tsay and Agrawal 2004, Cattani et al 2006,Cai et al., 2009, Huang and. .. time They study the manufacturer’s optimal dual channel strategies according to the costs of managing a direct online channel and retailer inconvenience using a simulation method They show that a