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.

When Is a Preannounced New Product Likely to Be Delayed?

Consider that a firm announces a deadline for a new product introduction. Conditional on such a preannouncement, how must an external observer evaluate whether the product will be delayed beyond that deadline? Using data collected from managers in the computer hardware, software, and telecommunications industries, the authors present an analysis that demonstrates that delays in new product introductions beyond preannounced deadlines can be jointly explained by factors related to (1) the firm's motivations to delay the product, (2) the presence of constraints that prevent delay (or the availability of opportunities to delay the product), and (3) the firm's abilities pertaining to product development

Advertising Fee in Business-Format Franchising

Most franchisors charge an advertising fee in addition to the better known royalty and franchise fee. We study the role of the advertising fee in improving channel coordination. We begin our analysis with a simple case of one franchisor dealing with two identical franchisees and find that the advertising fee allows the franchisor to commit to a specific level of advertising spending at the time of contract acceptance. We also find that the lump-sum advertising fee is better than the sales-based advertising fee. These results are intriguing because most franchisors use the sales-based advertising fee. We show that when franchisees' markets differ in how advertising affects sales, the franchisor may prefer the sales-based advertising fee. There are two reasons for the higher profitability of the sales-based advertising fee. First, the sales-based advertising fee conditions the franchisor's advertising decision on the franchisees' price and service decisions, and induces them to make better price and service decisions. The second reason is that with heterogeneous franchisees, using the sales-based advertising fee does not increase the total sales-based component in the fee structure. These results also hold when the franchisor pledges to contribute a matching fraction of the advertising fee to the advertising fund.channels of distribution, franchising

Quality Segmentation in Spatial Markets: When Does Cannibalization Affect Product Line Design?

Durable goods manufacturers often design product lines by segmenting their markets on quality attributes—attributes that exhibit a “more is better” property for all consumers. Since products within a product line are partial substitutes, and consumers can self-select the products they want to purchase, multiproduct firms have to carefully consider the cannibalization problem in designing their product lines. Existing research has analyzed the cannibalization problem for a monopolist who faces consumers who differ in their quality valuations. If lower-quality products are sufficiently attractive, higher-valuation consumers may find it beneficial to buy lower-quality products rather than the higher-quality products targeted to them. That is, lower-quality products can potentially cannibalize higher-quality products. The cannibalization problem forces the firm to provide only the highest-valuation segment with its preferred (efficient) quality. All other segments get qualities lower than their preferred (efficient) qualities. When the cannibalization problem is very severe, the firm may not serve some of the lowest-valuation segments. However, not much is known about how and when the cannibalization problem affects product line design in an oligopoly. Also, consumers may differ not only in their quality valuations but also in their taste preferences. The objective of this paper is to fill these gaps by examining whether the cannibalization problem affects a firm's price and quality decisions in a model with consumer differences in quality valuations, as well as in their taste preferences, in both monopoly and duopoly settings. The paper addresses questions such as the following. With both types of consumer differences, should a firm, even a monopolist, provide efficient quality only to the top segment? Are there conditions under which other segments can also get their preferred quality levels? If so, how do consumer and firm characteristics affect the likelihood of different segments getting their preferred qualities? How does competition affect the firm's choice of qualities? I develop a model in which the market is made up of two segments, with one segment valuing quality more than the other. Consumers within each segment are distributed over Hotelling's (1929) linear city. Consumers in the two segments can have different taste preferences (transportation costs). Firm locations in the two segments may also be different. The paper begins with an analysis of the monopoly case. I find that when both segments are fully covered, the standard self-selection results of the high-valuation segment getting its preferred quality and the low-valuation segment getting less than its preferred quality do hold. Interestingly, when both segments are incompletely covered, under some conditions, the monopolist's price and quality choices are not determined by the cannibalization problem. In these cases, the monopolist finds it optimal to provide each segment with its preferred quality. Thus, the equilibrium quality levels in a second-degree price discrimination situation resemble the third-degree price discrimination solution. I characterize the relevant conditions in terms of consumer characteristics. I then consider the case of two firms competing in the market, each offering two products—one for the high-valuation segment and the other for the low-valuation segment. Here also both types of outcomes are possible, depending on consumers and firm characteristics. Under some conditions, the cannibalization problem does not affect the firms' price and quality choices, and each firm provides each segment with that segment's preferred quality. Each firm finds it optimal to serve both segments. When these conditions do not hold, only the high-valuation segment gets its preferred quality. I interpret the conditions necessary for these results to exist in terms of characteristics of the consumers and the firms. An interesting insight from the analysis is that as the taste preferences of the low-valuation segment become weaker (their “transportation cost” becomes lower), the more intense competition in the low-valuation segment makes it more attractive for the high-valuation consumers to buy the products meant for the low-valuation segment. This worsens the cannibalization problem, and the low-valuation segment may not get its preferred quality. On the other hand, when the taste preferences of the high-valuation segments are sufficiently weak, more intense competition in the high-valuation segment reduces that segment's incentives to buy the product meant for the low-valuation segment. This mitigates the cannibalization problem and makes it more likely for the low-valuation segment to get its preferred quality. Similarly, when firms are less differentiated in the low-valuation segment, stronger competition between the firms makes the cannibalization problem worse, and the low-valuation segment may not get its preferred quality. When the differentiation between the firms is sufficiently weak in the high-valuation segment, the high-valuation segment is more likely to be better off buying the product meant for it. As the high-valuation segment's incentives to buy the lower-quality product are reduced, the low-valuation segment is more likely to get its preferred quality.Cannibalization, Product Line Design, Price Discrimination, Vertical Differentiation, Horizontal Differentiation

Multiple Messages to Retain Retailers: Signaling New Product Demand

With the increase in new product introductions in consumer packaged goods categories, supermarkets are reluctant to accept new products. Therefore, it is very important for manufacturers to convince retailers of the high-demand potential of their products. We study how a high-demand manufacturer can use advertising, slotting allowances, and wholesale prices to signal its high demand to retailers. Specifically, we examine the relative importance of advertising and slotting allowance in signaling demand. That is, when is it optimal for the manufacturer to use high advertising support, and when is it optimal for it to offer slotting allowance as a signal of its demand? We show that when a high-demand manufacturer is trying to signal its demand to retailers, advertising and slotting allowance are partial substitutes of one another in the sense that the manufacturer can increase one in order to compensate for a reduction in the other. We find that the high-demand manufacturer's signaling strategy depends on three factors: the retailer's stocking costs, the intensity of retail competition, and the advertising response rate in the given product market. We begin with a model of one manufacturer dealing with one retailer. The manufacturer has private information about the potential demand for its new product. The retailer is uncertain about the likely demand of the new product and is willing to accept the product only if it is convinced that the demand is high. We characterize the high-demand manufacturer's separating equilibrium strategies. We find that the slotting allowance plays an important role in signaling when the retailer's stocking costs are high and the advertising effectiveness is low. On the other hand, the manufacturer does not offer any slotting allowance, and advertising plays a bigger role when the stocking costs are low or the advertising effectiveness is high. We then examine the effects of retail competition on the manufacturer strategy. We find that the slotting allowance plays a more important role when the retail level competition is very intense. The manufacturer may have to offer a positive slotting allowance even in the absence of retailers' demand uncertainty when the retail competition is sufficiently intense. This result shows that the slotting allowance may have an important role to play even in the absence of signaling or screening considerations. Thus, our analysis of competitive setting provides an alternative explanation for slotting allowances. It also offers support to the views of many retailers who believe that slotting allowances can help retailers recover high stocking costs in highly competitive retail markets. In the presence of retailers' demand uncertainty, the manufacturer offers a higher slotting allowance in order to signal its high demand. We also investigate the effect of retailer's uncertainty about the effectiveness of the manufacturer's advertising. We show that if the high-demand manufacturer also has a higher advertising response rate, the manufacturer provides even higher advertising support to alleviate the retailer's advertising-related uncertainty. By increasing the advertising support, the manufacturer credibly tells the retailer; that it would not be optimal for the manufacturer to provide such high advertising support unless it had high enough advertising effectiveness.Channels of Distribution, Game Theory, New Product Introductions, Signaling

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

Channel Coordination Mechanisms for Customer Satisfaction

We consider two broad categories of incentives by which a manufacturer can motivate its retailers to provide high customer satisfaction: 1) manufacturer assistance that reduces the retailer's cost of providing customer satisfaction (CS assistance); and 2) customer satisfaction index (CSI) bonus. We show that if a retailer has a long-term orientation, CS assistance is a more effective coordination mechanism that induces the retailer to expend more effort at customer satisfaction. However if the retailer has a short-term orientation, CSI bonus is a more effective coordination mechanism. We then show that a long-term retailed is more valuable to a manufacturer than a short-term oriented one. Finally, we show that the use of CSI incentives results in greater profits for both the manufacturer and the retailer

Durable Good, Extended Warranty and Channel Coordination

The marketing literature on product warranty and extended warranty has largely focused on their role as segmentation instruments in risk-averse consumer markets. Preserving this insurance rationale, we highlight the role of extended warranty in channel coordination. We derive explicit demand functions for the durable good and extended warranty from a traditional model of consumer utility. This derivation explicitly captures the complementary goods flavor of extended warranty. We then investigate the impact of different distributional arrangements commonly observed in the marketplace for market outcomes and manufacturer profitability. We show that two key forces drive the results-the complementary goods effect and the double marginalization effect. Different channel arrangements for marketing of extended warranty cause these effects occur at different levels within a distribution channel and these are shown to have significant implications for the optimal warranty policy.Channel Coordination, Dual Distribution, Warranties, Extended Warranties

“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