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Article Excerpt
1. Introduction
Managing proliferating product lines has become increasingly challenging as firms are broadening and deepening product offerings to cater to changing consumer lifestyles and needs (e.g., variety of consumer electronics offered by Philips and shampoo products offered by Procter & Gamble (P&G)). The traditional product-focused marketing organization that assigns different managers to different products, each responsible for his own profit and loss (also known as "brand" management structure that P&G developed in the 1930s), has been criticized for leading to cannibalization or ignoring potential synergies within a firm's product offerings. A different organizational decision-making philosophy, customer-focused approach, has started to find favor with many manufacturers and retailers. Although interpreted and implemented differently in different industries, customer-focused approach in essence refers to product management that takes into account buyer behavior and the demand interdependency among various products, and emphasizes the coordination of all activities related to managing a market segment or a product category, including assortment, product introduction, merchandising, and pricing.
In the retail industry, the customer-focused approach is manifest in the much-advocated category management through the efficient consumer response (ECR) initiative in grocery supply chains. In category management, a grouping of closely related products (interrelated, complements, or substitutes) is treated as a self-contained business unit run by a category manager. The category manager looks at the category as a consumer would, integrating buying and merchandising decisions to increase the profitability of his business. Successful category management by a retailer requires a substantial amount of support from the manufacturers for accessing information on consumer behavior and market trends, conducting category-level analysis, and making tactical recommendations (Blattberg and Purk 1996). Some manufacturers, like P&G and other consumer package goods manufacturers (Zenor 1994, Business Wire 2004), are also advocating category management within their own organizations, as opposed to brand management. Essentially, a change of marketing organization at one level of the supply chain leads to its trading partners' reconsideration of their own marketing organization.
Pricing is a fundamental decision in category management. Whereas it is obvious that a firm would benefit if it were the only player in the market by jointly setting prices of its products, also known as product line pricing (PLP), what is less obvious is whether such an action would be beneficial when a firm is part of a supply chain and the other participants in that chain act strategically when the focal firm decides to use PLP. (1) Based on the premise that pricing scheme decisions at different levels of a supply chain are interdependent, this paper addresses the following two fundamental questions: (1) In equilibrium, will firms in a decentralized supply chain use PLP within their own organizations? What are the effects of relative balance of power in the channel, product demand interdependence (substitutes versus complements), and vertical strategic interaction between channel partners on the equilibrium? The answer helps us understand various factors that could affect the adoption of category management in different industries. (2) Is the equilibrium Pareto efficient (an equilibrium is Pareto efficient if there exists no other feasible strategy that makes no firm worse off and at least one firm better off)? The answer reveals potential pitfalls in firms' PLP decisions.
We address the above questions in a stylized two-stage bilateral monopoly in which a manufacturer of two partially substitutable/complementary products sells to a retailer. In the first stage, both firms simultaneously choose between (a) nonproduct line pricing (NPLP), where prices of the products are determined independently (denoted by N) and (b) PLP (denoted by P), and commit credibly to their chosen pricing schemes. We denote the four possible outcomes of the first stage, manufacturer's choice first and retailer's choice second, as N-N, P-N, N-P, and P-P. The assumption that the choice of a pricing scheme is credible in the second stage is realistic in category management because it is an expensive undertaking in an organization involving changes in organizational structures, information systems, and redeployment of employees, etc. (2) In the second stage, the two firms engage in a pricing game. We assume a general symmetric demand function, and consider two types of pricing games in the second stage to reflect the two possible balance-of-power scenarios in the channel: vertical Nash and leader-follower games. When the second-stage game is vertical Nash, the vertical strategic interaction between the two firms plays a critical role in determining the equilibrium. We discuss two types of such interactions: vertical strategic substitutability/complementarity (VSS/VSC). (3) Lee and Staelin (1997) establish the link between the type of vertical strategic interaction and demand functions through firms' best-response functions in the pricing game. Under VSS (VSC), a firm's best response to its channel partner's margin change is to adjust its margin in the opposite (same) direction of that of the channel partner; in the context of product line pricing, linear (multiplicative) demand function implies VSS (VSC). Table 1 presents the scope of this study.
Table 1 Study Scope in Terms of Demand Interdependence and Second-Stage
Pricing Game
Second-stage Substitutes Complements
pricing game
Manufacturer Manufacturer
Stackelberg Retailer N-N P-N Retailer N-N P-N
leader-follower N-P P-P N-P P-P
Manufacturer Manufacturer
Vertical Nash Retailer N-N P-N Retailer N-N P-N
(VSS, VSC) N-P P-P N-P P-P
Note: P (N) represents PLP (NPLP); notation a-b represents the
combination that the manufacturer's strategy is a and the retailer's
strategy is b.
Existing literature on product line pricing provides important economic insights that serve as building blocks of our study. Lee and Staelin (1997), in a study of one retailer selling two substitutable products of two competing manufacturers (cases N-N and N-P in our paper), point out that whether the retailer's profit is higher under PLP is affected by who assumes price leadership and the nature of vertical strategic interaction, because the retailer's move from NPLP to PLP may trigger manufacturers to adjust prices to negate the profit advantage of PLP. When the retailer is the leader in the pricing game, he is always better off with PLP, because the manufacturers' (as the followers) response functions are the same as in the case when the retailer uses NPLP. When the retailer is the follower, he may be worse off under PLP, because the manufacturers (as the leaders) may charge a different equilibrium wholesale price than in the case when the retailer uses NPLP. When the pricing game is vertical Nash and the demand function implies VSC, using PLP may reduce the retailer's profit. However, it is not clear under exactly what condition the pricing game deters the retailer from using PLP.
In this paper, we explore how the lack of price leadership enables a firm to benefit from using NPLP, why the drivers are different for different second-stage pricing games, and, in equilibrium, which pricing schemes are adopted in the supply chain. The answers become evident once the questions are examined in an "experimental design" type study (as shown in Table 1), where demand interdependence (substitutable or complementary) and the manufacturer's endogenous pricing scheme decision are added as "treatment" variables. We first show that the necessary condition for a firm to adopt NPLP as the equilibrium pricing scheme is that NPLP leads to a lower channel partner's optimal profit margin than that under PLP. The manifestation of this necessary condition is different for the two types of second-stage games. When the second-stage pricing game is leader-follower, the leader, because she fully anticipates the follower's response, is always better off with PLP regardless of the follower's pricing scheme. For the follower, we find that it is the elasticity of demand to the leader's margin that determines how the leader adjusts her margin upon the follower's change in his pricing scheme. The follower may adopt NPLP in equilibrium if NPLP causes the demand to be more sensitive to the leader's margin, and hence inhibits the leader from charging a high margin under NPLP. The possible equilibria are P-N and P-P when the second-stage pricing game is leader-follower and the manufacturer is the leader of the game.
When the second-stage pricing game is vertical Nash, we find that VSS/VSC alone does not tell the whole story. It is the coupling of vertical strategic interaction and demand interdependence that affects firms' equilibrium pricing scheme decisions. When the vertical strategic interaction and the demand interdependence of products are of the same nature--i.e., VSS-substitutes or VSC-complements--P-P is the unique equilibrium. N-P, P-N, or N-N can become the equilibrium only if the vertical strategic interaction and the demand interdependence are of the opposite nature, under condition VSS-complements or VSC-substitutes. This is because under VSC-substitutes (VSS-complements), a firm that uses PLP on substitutable (complementary) products charges higher (lower) profit margins than using NPLP, the complementarity (substitutability) vertical strategic interaction leads the channel partner to respond by charging higher margins; therefore, the benefit of using PLP may be reduced or canceled out through decreasing sales.
The full-scale equilibrium analysis also allows us to examine the Pareto efficiency of the different equilibria. Although in...
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