Coordinating Channels for Durable Goods: The Impact of Competing Secondary Markets

A large literature in economics and marketing studies the problem of manufacturer's designing contracts that give a retailer appropriate incentives to make decisions that are optimal from the manufacturer's point of view (see, for example, Spengler 1950, Jeuland and Shugan 1983, McGuire and Staelin 1983, Lal 1990, Rao and Srinivasan 1995, Desai 1997, among others). An important result from this literature is that the manufacturer can coordinate retail price decisions by choosing a two-part tariff in which the wholesale price equals the manufacturer's marginal cost and the fixed fee extracts all the rents from the retailer. In other words, the manufacturer sells the firm to the retailer for the fixed fee and, thus, eliminates the double-marginalization problem. Although this result is well established for non-durables, researchers have not analyzed the coordination issue for durable goods manufacturers who have the added complexity of competition from used goods in secondary markets. In this paper, we show how the coordination problem for a durable goods manufacturer is fundamentally different from the traditional coordination problem of a non-durables manufacturer. In particular, the durable goods manufacturer has to solve not only the coordination problem but also the time-consistency problem (see, for example, Coase 1972, Bulow 1982, Purohit 1995). Our objectives in this paper are to investigate whether or not the insights from the channel coordination literature, that has developed principally with non-durable goods in mind, are also applicable to durable goods. In order to do this, we develop a dynamic, two-period model in which a manufacturer sells its products to a retailer who sells the product to consumers. Products sold in the first period become used goods in the second period and compete with sales of new units. Starting from consumer utilities, we derive inverse demand functions for new and used goods and consider a number of different contracts between the manufacturer and the retailer. We start with a simple contract in which the manufacturer offers a wholesale price for a period at the beginning of that period. As one would expect, this contract does not solve either the channel coordination problem or the time-consistency problem. We then consider a number of two-part tariff contracts. Given the well-established results from the existing channel coordination literature, we begin with a contract in which the manufacturer offers per-period two-part tariffs in which all wholesale prices are set at marginal cost. We find that not only does this contract fail to achieve channel coordination, but the retailer sells a higher quantity than an integrated manufacturer would sell. This is in contrast to the traditional double marginalization problem in which the retailer sells a lower quantity than an integrated manufacturer would sell. We then allow the wholesale prices to be different from marginal costs. We show that using this more general two-part tariff contract, the manufacturer can achieve channel coordination. That is, the total channel profit is the same as the profit of an integrated seller. However, the equilibrium wholesale price in the first period is strictly above the marginal cost. Next, we consider a contract in which the manufacturer uses a single fixed fee, announced at the beginning of the first period. The per-period wholesale prices are still at the marginal cost level in this contract. This contract is identical to "selling the firm to the retailer" at the price of the fixed fee. Here we find that the contract can achieve channel coordination. However, the contract is not an equilibrium solution. In particular, the manufacturer increases wholesale prices to above marginal cost levels. Although some of the contracts above solve the double marginalization problem, none of them mitigates the time consistency problem. In order to solve both these problems, the contract must yield total channel profit equal to an integrated renter's profit. Because the renter does not have a problem with time consistency, an integrated renter earns the highest profits in a durable goods channel. We derive a contract that solves both of these problems. In this contract, at the beginning of period 1, the manufacturer writes a contract with the retailer specifying a fixed fee and two per-period wholesale prices, both of which turn out to be strictly above the marginal cost. Interestingly, with this contract, the manufacturer makes more money by selling through the retailer rather than selling directly to consumers. We contribute to the coordination literature by examining coordination issues in a dynamic, durable goods context and identifying a new coordination problemunlike the traditional coordination models, a durable goods manufacturer may have to provide the retailer incentives to sell less rather than to sell more. Clearly, the traditional "selling the firm to the retailer," approach does not solve this new problem. We also contribute to the durable goods literature by showing how a durable goods manufacturer can sell its product and solve its time consistency problem. Effectively, this allows the manufacturer to earn the same profits as it would get if it could commit to prices or if it could rent its product. When committing to individual consumers or renting can only be achieved through additional costs, our solution is the optimal strategy for a durable goods manufacturer.

Dual Distribution Channels: The Competition Between Rental Agencies and Dealers

Managerial decisions involving marketing channels are among the most critical that an organization must make. Part of the reason for this importance is that relationships between manufacturers and their intermediaries usually involve long-term commitments that are difficult to change. On the other hand, in order to respond to the realities of the market place, an organization must be ready to adapt its distribution practices—sometimes under considerable uncertainty about the long-term consequences. Such a problem faces the U.S. automobile industry, which has led manufacturers to experiment with various channel structures. When manufacturers first changed their distribution policies, they were clear about the short-term effect on sales, but were unsure about its longer term impact on profitability. In this article, we develop a model to analyze the marketing of durable products through multiple channels. Our analysis suggests that, even though it was not apparent at the time, manufacturers were indeed behaving optimally when they changed their policies. Our model provides insights not only to automobile manufacturers but also to practitioners and academics who are interested in understanding the unique problems associated with marketing durable products through multiple channels. We develop a two-period model by assuming that a single manufacturer markets a durable product through two retailers—a rental agency and a dealer. The rental agency focuses mainly on renting the product in a daily rental market while the dealer focuses on selling the product to a different set of customers in the sales market. To model the development of channels in the U.S. automobile industry, we analyze three different channel structures. The first structure, a , reflects the state of the industry through most of the 1980s, when rental agencies were franchised solely to rent and dealers solely to sell the cars. In response to a decrease in overall sales, manufacturers encouraged rental agencies to sell their “slightly used” rental cars in the consumer market, resulting in the second structure, an . Dealers did not like this arrangement, however, and in the next experiment, a , some manufacturers began buying back used rental cars and selling them through dealers. In terms of the consumer side of the model, we assume that consumers are heterogeneous and have product valuations that are distributed uniformly between a low and a high value. In addition, they recognize that as the durable depreciates with use, its secondhand market value decreases. While both sold and rented goods depreciate with use, we assume, based on an analysis of market prices, that sold goods depreciate at a higher rate than rented goods. Given these different depreciation rates and consumers' underlying utility functions, we develop the market demand functions in the dealer's and rental agency's markets. Then for each of the channel structures, we solve the intermediaries' and manufacturer's problems. The main contribution of this article is that it allows us to evaluate the profitability associated with various channel structures for all the players in our analysis—the dealer, the rental agency, and the manufacturer. In terms of the intermediaries, we find that the overlapping channel is the most profitable structure for the rental agency; on the other hand, it is the least profitable for the dealer. In terms of manufacturer profitability, our model suggests that the separate channel is the least profitable, and the overlapping channel is the most profitable. It is interesting to note that the distribution structure in existence today is more akin to a buyback channel. This strikes us as a compromise channel, which alleviates dealer concerns with the overlapping channel, and yet does not harm rental agencies as much as a separate channel. These are surprising results because conventional wisdom has been that the overlapping channel was competing away profits for all players. This suggests to us that automobile manufacturers were indeed on the right track when they began experimenting with the structure of their distribution channels.marketing channels, durable goods, channel conflict, automobile industry

Exploring the Relationship Between the Markets for New and Used Durable Goods: The Case of Automobiles

Given that durable products are long-lived, there exists the possibility of secondary markets for used products as well as the potential for product obsolescence. This is an important issue in markets where technology changes rapidly, because the introduction of new versions of a product can make earlier versions obsolete. More generally, prices of older versions in the secondary market adjust in response to changes incorporated in new versions of the product. Thus, another method of evaluating consumers' response to a new product is by looking at the variation in market prices of the old product. This paper develops a general model to explore the relationship between primary markets for new cars and secondary markets for used cars. The results suggest that the depreciation of used cars is influenced strongly by the types of changes in new model cars.automobile primary and secondary markets, product obsolescence, enhancement, depreciation, model discontinuation

What Should You Do When Your Competitors Send in the Clones?

This paper develops a model to address an important problem facing a manufacturer of a durable product. That is, how can it plan its new product introductions to minimize the obsolescence of the old product, preserve its market for the new product, and keep copycat products at bay? We analyze these issues by developing a two-period model in which a firm sells an “old” product in period 1 and a “new” product in period 2. We consider various new product introduction strategies such as product replacement, line extension, and upgrading. We find that the optimal response to a threat of competitive clones is to increase the level of product innovation. This increase in innovation coupled with the entry of a competitive product implies that the incumbent firm has less of an incentive to leapfrog the old product or shelve the new product.competitive strategy, game theory, product policy

Leasing and Selling: Optimal Marketing Strategies for a Durable Goods Firm

This paper analyzes the problems associated with marketing a durable through leases and sales. Academic research in this area has argued that in a monopolistic environment, leasing dominates selling. Hence, leasing and selling should not co-exist and the firm should concentrate its efforts solely on leasing. We show that the relative profitability of leasing and selling hinges on the rates at which leased and sold units depreciate. In particular, we find that leasing does not dominate selling in all cases; if sold units depreciate at a significantly higher rate than leased units, a monopolistic firm is better off by only selling its product. In addition, we find that if leaded and sold products depreciate at different rates, then the optimal strategy for the firm involves a combination of both leasing and selling. We conclude the paper with an empirical analysis of the depreciation rates of leased and sold units of a popular car model. We find that the depreciation rate of leased cars has been significantly lower than the depreciation rate of sold cars.Leasing, Selling, Durable Goods, Automobiles

Durable Goods and Product Obsolescence

The issue of product obsolescence is addressed by examining the optimal sales strategy of a monopolist firm that may introduce an improved version of its current product. Consumers' expectations of a forthcoming product lowers the price that they are willing to pay for the current product because of its loss in value due to obsolescence. The new product is characterized by consumers' increased willingness to pay and by its competitive interaction with the old product. These characteristics affect the tradeoff that the firm makes between the cost of waiting for new product sales versus the cost of cannibalizing these sales. We analyze the effect of these characteristics of the new product on the firm's optimal sales strategy. We consider the various policy measures available to the firm, including limiting initial sales in order to lower cannibalization of the new product, buying back the earlier version of the product in order to generate greater demand for the new product, and announcements of future product introductions. We find that, for modest levels of product improvement, the firm's optimal policy is to phase out sales of the old product, while for large improvements a buy-back policy is more profitable. Lastly we find that the firm is better off if it informs consumers whether a new product is forthcoming.durable goods, product obsolescence, buy-backs, cannibalization

“Let Me Talk to My Manager”: Haggling in a Competitive Environment

Although negotiating over prices with sellers is common in many markets such as automobiles, furniture, services, consumer electronics, etc., it is not clear how a haggling price policy can help a firm gain a strategic advantage or whether it is even sustainable in a competitive market. In this paper, we explore the implications of haggling and fixed prices as pricing policies in a competitive market. We develop a model in which two competing retailers choose between offering either a fixed price or haggling over prices with customers. There are two consumer segments in our analysis. One segment, the , has a lower opportunity cost of time and a lower haggling cost than the other segment, the . When both retailers follow the same pricing policy, then a haggling policy is more profitable than a fixed-price policy only when the proportion of nonhagglers is sufficiently high. We find two kinds of prisoners' dilemma: under some conditions, a more profitable haggling policy can be broken by a fixed-price policy, and under other conditions, a fixed-price policy can be broken by a haggling policy. Surprisingly, we show that under some conditions, an asymmetric outcome with one retailer haggling and the other offering a fixed price is also an equilibrium.competitive strategy, marketing strategy, price discrimination, game theory