On the Interaction between Taste and Distance and Its Implications on the Vertical Distribution Arrangement

Abstract

This paper studies the vertical distribution arrangement between manufacturers and retailers in a two dimensional horizontal product differentiation framework. Products are differentiated along consumers' taste and retailers' location. Consumers have to incur transportation costs to visit a retailer and substitution costs to substitute their preferred products with the available products. The objective of the paper is to analyse the incentive of manufacturers to impose an exclusive territory restriction. We employ a four-stage game. In the first stage manufacturers decide on the optimal number of retailers. In the second stage manufacturers decide on the wholesale prices. In the third stage retailers set the retail prices. Finally, in the fourth stage consumers purchase goods. We show that the relative magnitude of the transportation and substitution costs is crucial in determining the decision of manufacturers to impose an exclusive territory restriction.