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

Retailer’s Market Power and the Optimal Channel Strategiesof a Manufacturer in Electronic Commerce Jae-Cheol Kimy and Se-Hak Chunz yGraduate School of Management, KAIST, 87 Hoegiro, Dogd

KAIST Business School

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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.krzDepartment 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 line channels, there are still few theoretical studies on manufacturers’optimal channelmanagement strategies and pricing strategies in electronic commerce Previous stud-ies tend to rely on simulation approaches or empirical approaches and their methodsare not su¢ cient to draw equilibrium prices for a dual-channel supply chain design

on-As well, previous studies on channel management have tried to analyze a turer’s channel management strategy from the perspective of channel con‡ict between

manufac-a mmanufac-anufmanufac-acturer manufac-and manufac-a retmanufac-ailer; thus, they tend to focus on pricing strmanufac-ategies of the

manufacturer and start from an assumption that there are both o- ine and onlinechannels 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 onlinechannel Then, under what conditions do both a traditional retailer and a verticallyintegrated direct channel coexist or when does a manufacturer use a traditional chan-nel 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 behaviorconsidering several factors, including the degree of the consumer’s online convenienceand the degree of customer heterogeneity between a traditional retail channel and on-line channel We discuss how these are related to a manufacturer’s channel strategiesand pricing strategies in an electronic market enviroment In particular, we considerthe retailer’s market power (or competitiveness in a retail market), which have beenrarely considered in previous studies We discuss the channel con‡ict issue from adi¤erent view of the retailer’s market power Traditional approaches have focused onthe fact that o- ine markets are larger than online, so the retailer has more bargain-ing power Our perspective also considers the opposite point of view In particular,

strategy, pricing strategy, strategic behaviors and channel con‡ict We also discussstrategic implications on the market player’s behavior when a manufacturer adds adirect online channel.

Keywords: Economics of IS, Electronic Commerce, Channel Management, tailer Market Power, Channel Con‡ict, Clicks-and-Mortar, Online and O- ine Chan-nel, Optimal Prices, Equilibrium Prices, Supply Chain Management

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 onlinechannels 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 theirproducts without selling via their websites (Kumar, 2008) For example, Samsung at

one time sold its products through its own website; however, it ceased its initiative foronline 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 informationabout 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 orreducing their current o- ine businesses These examples show that the adoption of

a multi-chanel strategy by the manufacturers is very complicated according to thecharacteristics of manufacturers and retail categories Why do manufacturers usemulti-channel strategies di¤erently?

This motivates us to analyze the manufacturer’s optimal multi-channel strategies.Even though many manufacturers today are increasingly adopting dual channels tosell their products through their traditional retail channels and their own direct on-line channels, there are still few theoretical studies on manufacturers’optimal channelmanagement strategies and pricing strategies in electronic commerce As well, previ-ous studies tend to rely on simulation approaches or empirical approaches and theirmethods are not su¢ cient to draw equilibrium prices for a dual-channel supply chaindesign Previous studies on channel management have tried to analyze a manufac-

a manufacturer and a retailer; thus, they tend to focus on pricing strategies of themanufacturer and start from an assumption that there are both o- ine and onlinechannels initially.

This paper begins by asking why both channels exist at the same time Weare particularily interested in a manufacturer’s optimal channel strategy when themanufacturer sells its products through both the retail channel and its direct onlinechannel Then, under what conditions do both the traditional retail channel andthe vertically integrated direct channel coexist? When does a manufacturer use atraditional channel only? When may a manufacturer dispel an existing retailer anduse a direct online channel only? We investigate these questions from the perspective

of customer choice behavior considering several factors including the degree of theconsumer’s online convenience and the degree of customer heterogeneity between atraditional retail channel and online channels We discuss how these are related to

a manufacturer’s channel strategies and pricing strategies in an electronic marketenviroment In particular, we consider a retailer’s market power (or competitiveness

in a retail market), which has been rarely considered in previous studies We discussthe channel con‡ict issue from the di¤erent view of the retailer’s market power byconsidering either the online or o- ine channel as dominant Contrary to previousstudies, 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

The strategy comes from the perspective of incomplete analysis because the retailer isusually assumed to have greater bargaining power and a more loyal customer base Wealso examine how this retailer’s market power is related to a manufacturer’s channelstrategy, pricing strategy, strategic behaviors and channel con‡ict, which has beenrarely investigated in previous studies.

This paper shows that if all types of consumers become homogeneous in their ceptiveness to online shopping, then a manufacturer uses the direct channel only and

re-it may eliminate an existing retail channel Also, if consumers are very heterogenouswith regard to their receptiveness to online shopping (or when both o- ine and onlineconsumer 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 ent in their receptiveness to online shopping (or markets are not well segmented), amanufacturer uses the traditional o- ine retail channel only This paper shows thatprice di¤erences between both channels should be illuminated by the degree of onlineconvenience; thus, actual online prices include the price itself and re‡ect the degree

di¤er-of online perception In general, the higher the market power di¤er-of the retailer or therelative maket size, the higher the chance of the retailer’s price being greater thanthe direct online channel Literature on channel con‡ict usually shows that a man-ufacturer uses a matching pricing strategy when it adds a new online channel, the

turer’s or the o- ine market size is noticably larger than the new online market Alsothis paper discusses the manufacturer’s pricing strategies under dual channel situa-tions comparing other channel strategies and an extensible model, which may explainthat the direct online channel can be a manufacturer’s own direct o- ine channel inaddition to its existing independent indirect retailer base This paper shows a di¤er-ent 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 notuse an online channel, which assumes that the o- ine market size is larger How-ever, this paper can explain the reverse situation where the retailer’s market powerincreases, so the manufacturer can use an online channel, or a retailer voluntarilyreduces its market power when we consider that the online market size is larger.The remainder of this paper is organized as follows: Section 2 presents literaturereview and section 3 presents the basic model Section 4 analyzes the dual channelmodel Section 5 discusses optimal channel strategies and implications In Section 6,conclusions and future research are discussed

previous studies in dual channel management area have focused on competition inprice 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 thatall consumers have a common positive preference toward a traditional retailer Theyshow that a direct online channel plays the role of exerting potential competitivepressure on the existing retailer by increasing the manufacturer’s negotiation powerand reducing double marginalization in the retail market, even though its pro…t isnonpositive 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 arepriced the same— can reduce the channel con‡ict by inducing more pro…t for theretailer Their results including other channel con‡ict literature seem to be based onthe assumption that the portion of loyal customers of o- ine retailers is larger thantoward online channels They discuss a manufacturer’s distribution strategy focusing

on di¤erent cost structures between the two channels and show that manufacturersuse 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

channel price that matches the o- ine retail price They show that an equal-pricingstrategy is appropriate as long as the retail channel is signi…cantly more convenientthan the Internet channel, which implies that the manufacturer doesn’t use a directonline channel aggressively as a sales channel Huang and Swaminathan (2009) studyoptimal pricing strategies when a retailer sells its product though two channels, such

as the Internet and a traditional channel Forman et al (2009) empirically examinethe trade-o¤ bene…t between buying online and buying in a local retail store Theyshow that when a store opens locally, people steer away from online purchasing;however, o- ine entry decreases as consumers’ receptivity to online price discountsincreases

Wu et al (2008) examines how information technology a¤ects a monopoly ufacturer’s distribution problem in an environment where product information is im-portant for consumers to identify their ideal product They show that a manufacturer

man-is less likely to sell through both channels when the proportion of consumers who haveaccess to the electronic channel is very high Chen et al (2008) study a dual-channelmodel where a retailer chooses its service level and a manufacturer sets the deliverytime They study the manufacturer’s optimal dual channel strategies according tothe costs of managing a direct online channel and retailer inconvenience using a sim-ulation method They show that a manufacturer uses both channel, when the directchannel cost is high and the retailer inconvenience cost is low, while the manufacturer

uses the direct channel only when the direct channel cost is low.

The decision to adopt a new direct channel can be a dilemma faced by the ufacturers (Lee et al., 2003), since its adoption a new direct channel can turn themanufacturer into a competitor in the eyes of the retailers Thus, many studies havetried to analyze a manufacturer’s channel management strategies from the perspec-tive of channel con‡ict between a manufacturer and a retailer; thus, they tend tofocus on pricing strategies of the manufacturer and start from the assumption thatthere are both o- ine and online channels initially Also, they tend to rely on simula-tion approaches or empirical approaches and their methods are not su¢ cient to drawequilibrium prices for a dual-channel supply chain design Likewise, there is still alack of clarity in the explanation for optimal channel strategies and pricing strategies

man-of the manufacturer when it adds a direct online channel in electronic commerce.Channel management and pricing strategies are very closed intewined, however, thetwo research areas have been studied disjointedly We focus on analyzing the manu-facturer’s optimal channel and pricing strategies in a holistic model that links them

In particular we present a new view that analyzes channel con‡ict issues from theperspective of the retailer’s market power and retailer’s strategic behavior

3 The (Basic) Model

Consider a (monopolist) manufacturer who produces a product at a constant unitcost, c > 0 Initially, the manufacturer contracts with a traditional independentretailer to sell its product For simplicity, distribution cost is assumed to be zero.The manufacturer charges the retailer a wholesale price ! per unit The retailer thensells the product at a retail price p1 The demand function of an individual consumerfor the product is q(p1) = a bp1 where a; b > 0 and a > bc For later use, we de…ne

pric-p1 = p1(!) = x(c + ) + (1 x)! (1)

where 0 x 12: x represents the retailer’s market power, the ability to set theprice without losing customers; the higher the x, the greater the market power Forexample, if x = 12; p1(!) = a+b!2b ; which is the price a monopolistic retailer charges.

At the other extreme when x = 0; p1(!) = !, which is the price a competive retailerchooses If the retailer behaves oligopolistically, it will charge an inbetween price.Clearly, p1(!) increases with x as long as a b! > 0 or ! < c + Inverting (1) for

! gives

! = p1 x(c + )

1 x :The retailer’s (per consumer) pro…t, 1(p1); is then

The …rst order condition is

@ !

@p1 =

b

1 x(2c + (1 + x) 2p1) = 0:

Let the optimal p1 be pm

1 and the resulting ! be !m: Also, let m

It is obvious that the greater the market power of the retailer, the higher the retail

price, the larger the pro…t of the retailer, the smaller the pro…t of the manufacturer.Now, suppose that the manufacturer considers owning a vertically integrated di-rect online channel itself Although both the retailer and the direct online channelsell physically the same product, consumers may perceive them as di¤erent Buy-ing the product from the online shop lowers the search and travel cost at the cost

of the lost opportunity of prepurchase evaluation in a showroom of the retail store.Some consumers may …nd the product out of stock at the retail store When theproduct is available, buyers usually have to carry it home themselves Ordering theproduct online requires waiting for delivery Some people feel more convenient withonline shopping than with visiting a physical retail store while others don’t We willincorporate this di¤erence in attitude toward shopping online by the parameter ;which measures, in monetary terms, the level of inconvenience consumers have to gothrough when shopping online rather than from the retailer Here after we call theperception parameter is relative in the sense that a positive means online shop-ping is taken as less convenient than buying the product from the retailer Therefore,can be negative, zero or positive For example, if someone gets full access to anonline network, has su¢ cient knowledge of and experience in online shopping, is notbothered much by waiting for delivery, and derives great utility from getting shoppingdone with a few key strokes, his will probably be negative The actual price anonline shopper pays is the sum of the direct online channel’s price, p2 and a nonpe-cuniary price of (in)convenience, :The demand function for the product sold at thedirect online channel is then

q(p2; ) = b(c + (p2+ )):

We assume that for p2 ab ; q = 0 and when < 0; the demand curve becomesvertical at q = a for p2

A consumer with cdemands at most a units because c is the lowest possibleprice the manufacturer will o¤er Therefore, those consumers with c are nodi¤erent to the manufacturer as far as sales and pro…ts are concerned If ab c = ;

no consumers will shop at the direct online channel As a result, it is reasonable tolimit the range of as follows:

c < < :

For later reference, consider a situation where the manufacturer distributes itsproduct only through the direct online channel Let 2(p2; ) be the pro…t (per-consumer) the manufacturer earns from a type- consumer who shops at the directonline channel The manufacturer solves

The manufacturer charges pm2 ( ) to maximize 2(p2; ): Then, we have

to be lower while when many online stores add value in the form of convenience theonline price can be higher (Bailey, 1998; Chun and Kim, 2005)

Suppose that there are two types of consumers with di¤erent perception parameters,and where < Type- consumers …nd online shopping more convenient thantype- consumers We normalize the total number of consumers to be one Thenumber of type- consumers is and that of type- consumers is 1 where 0 <

< 1 The optimal prices, when the manufacturer uses both channels, are denoted by

pdi( ; );(i = 1; 2) and the resulting pro…t by d( ; ) (pd1( ; ); pd2( ; ); ; )

when is not too large Since consumers with = 1 always buy the productfrom the retailer, we call them loyal consumers of the retailer If is not too large,type- consumers compare prices of the retailer and the direct online channel beforedeciding where to buy the good We call them elastic consumers of the retailer.

Given two channels for distribution and two types of consumers, the turer faces three alternative channel strategies (i) Strategy A–brick-and-mortarstrategy: engage only in wholesaling by contracting with the retailer to sell itsproduct(http://en.wikipedia.org/wiki/Brick_and_mortar), (ii) Strategy B–click-and-mortar strategy: open up its own direct online channel and load a portion of its sales

manufac-on the new channel(http://en.wikipedia.org/wiki/Bricks_and_clicks), and (iii) egy C–pure play strategy: terminate the business relations with the retailer and util-itze the direct online channel as the sole outlet(http://en.wikipedia.org/wiki/Pure_play).Below, we will investigate the optimal channel strategy for the manufacturer

Strat-4.1 Some Consumers are Loyal to the Retailer and Others

are Price Seeker

In this section, we assume that some consumers are loyal to the retailer or theirperception parameter is = 1:2 Admitting that this assumption is seemingly a

2 So far, we have considered that the direct channel is online This is only for convenience and not necessary The direct channel can be considered as another o- ine store owned by the manufacturer Some consumers may not know the location of it or they may reside too far away from the direct

bit strong, we nonetheless consider this case for two reasons First, such consumersalways exist in the real world Second, we derive some interesting results, which will

be extensively used in the next section when all consumers are not always loyal tothe retailer or <1

Strategy C is not available to the manufacturer in this case The manufacturernow has two alternative channel strategies We already discussed Strategy A above.For Strategy B, we note that the manufacturer has to o¤er p2 such that p2+ p1toentice type- consumers to the direct online channel Therefore, The manufacturer’sproblem is:

max

p 1 ;p 2

d(p1; p2; ;1) = (1 ) !(p1) + 2(p2; )s.t p1 p2 0

where denotes the total pro…t of the manufacturer when supplying its productthrough both channels Before proceeding, we note that the manufacturer has noincentive to set p2 at or below c; doing so results in negative pro…ts, which is dom-inated by engaging only in wholesaling In order to make the problem meaningful,

we concentrate on a situation where the optimal p2 is greater than c With as the

channel to travel In this case, they become loyal consumers of the retailer.

Lagrangian multiplier, the Lagrangian is