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Article Excerpt
The growing dominance of large retailers has altered traditional channel incentives for manufacturers. In this paper, we present a theoretical model to illustrate a strategic manufacturer response to a dominant retailer. In our model, a dominant and a weak retailer compete for the sale of a single product supplied by a single manufacturer. The dominant retailer has the power to dictate the wholesale price, but the manufacturer sets the wholesale price for the weak retailer. The manufacturer also has partial ability to transfer demand between retailers. In the strategic manufacturer response, the manufacturer begins by raising the wholesale price for the weak retailer over that for the dominant retailer. This makes the weak retailer the high-margin channel. The manufacturer then transfers demand to the weak retailer by engaging in joint promotions and advertising. We then use this strategic response model to derive a testable hypothesis that may guide future research in determining the source of dominant retailers' low prices.
Key words: channels of distribution; channel power; retailing; game theory
History: This paper was received March 3, 2004, and was with the authors 4 months for 4 revisions; processed by John Zhang.
1. Introduction
In a growing number of industries, a few retailers, such as Wal-Mart, Tesco, and Home Depot, are determining how consumer products are made and sold in the United States and Europe. These dominant retailers, also known as "category killers" or "power retailers," have been enormously successful. For example, Wal-Mart, with its $285 billion sales, is one of the largest companies in the world (Maier 2005). Tesco is the number one grocer in the United Kingdom, accounting for almost 30% of the supermarket sales and, by some accounts, taking in $1 out of every $11 spent on retail (Carney 2004). In the home improvement market, the total market share of Home Depot and Lowe's is more than 50% (Knight 2003).
Emergence of the dominant retailers is a result of the shift of channel power from manufacturers to retailers. This trend has been attributed to increased use of information technology by retailers, insufficient shelf space due to a large number of new product introductions, increased concentration of the retailing industry, and introduction of successful private-label brands (Kadiyali et al. 2000). Other commonly cited causes include a decline in advertising and improved quality of retail management (Messinger and Narasimhan 1995). Butaney and Wortzel (1988) show that distributors have more power when industry competition is strong and industry sales are equally distributed among industry manufacturers. Dominant retailers use finely tuned product line selections and, most importantly, competitive pricing to attack weaker channel players and attract more customers. For example, Business Week reports that on a comparable basket of grocery items, Wal-Mart's prices were, on the average, 20% lower than those of other stores (Koretz 2002).
To keep prices low, these retailers enjoy advantages that traditional retailers do not. For example, Home Depot's state-of-the-art inventory system makes it very difficult for regional firms to be competitive with Home Depot (Dunne and Kahn 1997). It has been argued that Wal-Mart's superior operating margins leave plenty of room for Wal-Mart to offer lower prices (Neff 2003). Logistical efficiencies have been attributed to Wal-Mart's cost advantage (Facenda 2004).
However, it has also been argued that the retail giant systematically uses its channel power with the manufacturers to buy products at the lowest cost possible and pass the gains on to the consumer through extremely low prices (Useem 2003). Many argue that Wal-Mart has a reputation for getting favorable wholesale terms via aggressive negotiating tactics with their suppliers (Facenda 2004, Munson and Rosenblatt 1999). For example, Business Week reported that "One multinational supplier ... says Wal-Mart buyers in Mexico were aggressive and abusive pulling his product off shelves for several months when he objected to a deep price cut that would have wiped out his profits" (Smith 2002). Fortune's report was similar: "[Wal-Mart's] suppliers are expected to give their best price period. It is not even negotiated anymore says ... of a consulting company that helps manufacturers sell to big retailers" (Useem 2003). (1)
As in the case of Wal-Mart, Tesco's remarkably low grocery prices have also been attributed to its ability to squeeze supplier margins (Carney 2004). This squeeze has been so severe, in fact, as to cause street protests against Tesco in sympathy with milk suppliers. According to a group of independent music retailers, Best Buy uses its clout to extract price concessions from major record companies, which enables it to sell new albums at lower prices (Christman 2003).
Why do these retailers have such power over the manufacturers? Potential benefits may arise for manufacturers when they work with dominant retailers. First, dominant retailers' sheer size and the velocity at which they sell their inventory allow them to sell large volumes. This helps their suppliers to benefit from scale economies in transaction costs. For example, the marginal cost of transacting with the retailer may be smaller the bigger the shipped lot. This could take the form of transportation costs or billing costs. In the home-repair category, for instance, Home Depot has won the favor of suppliers by consolidating regional buying offices into a single entity, which streamlines purchasing and helps Home Depot to pay its vendors faster (Foust 2004). Another source of suppliers' distribution efficiency is made possible by the dominant retailers' sophisticated information technologies. (2) For example, Wal-Mart in the early 90s was known to develop its "retail link," which gave many of its suppliers access to inventory positions of their products at its retail locations (Bradley and Ghemawat 2002). Wal-Mart is well known for its technological innovations. In the 1990s, Wal-Mart was a leader in applying electronic data interchange (EDI), which allows retailers and suppliers to readily exchange data. Now it is leading the industry in applying RFID, Internet-based, and scan based-trading technologies, which will bring further efficiencies not only to Wal-Mart but also to its suppliers. (3) Competing retailers of the dominant players do not enjoy the same kind of leverage with their suppliers, and therefore are at a competitive disadvantage. For example, a group of more than 100 auto parts retailers claimed that category killers, including Wal-Mart and Pep Boys, induced price discrimination and purchased auto parts from the suppliers at prices 40% less than the other retailers (Balto 2002).
How manufacturers might manage such asymmetric channel relationships is the main focus of this research. Our results indicate that when faced with a dominant retailer who dictates wholesale terms, hard-pressed manufacturers and nondominant retailers have an incentive to mitigate the power of the dominant retailer. Our analysis suggests that joint marketing initiatives with selected channel members can be used as a way to deal with the threat imposed by a power retailer in a particular industry or product category. We refer to this type of general marketing activity as a strategic manufacturer response to a dominant retailer. We make a distinction between a dominant and a weak retailer and examine the dominant retailer/manufacturer/weak retailer channel structure, in which the dominant retailer dictates the wholesale price to the manufacturer. The manufacturer then sets the wholesale price for the weak retailer in combination with joint advertising or promotion.
Our study, however, does not foreclose the notion that the dominant retailer's low prices come from its operational efficiencies. Rather, we isolate from the cost efficiency explanation the dominant retailer's ability to obtain favorable supply terms via its tough negotiating leverage. By doing so, we are able to separate the consequence of its raw ability to dictate channel terms from that arising from an efficiency advantage.
In our theoretical analysis, the weak retailer and the dominant retailer compete for the sale of a single product supplied by a manufacturer. The dominant retailer dictates the wholesale price to the manufacturer, who then sets the wholesale price for the weak retailer. The manufacturer has the ability to transfer demand from one retailer to another. The analysis reveals insights for a strategic manufacturer response to the dominant retailer pricing pressures. Specifically, by raising the wholesale price for the weak retailer over that for the dominant retailer and transferring demand from the low-margin (dominant) channel to the high-margin (weak) channel, the manufacturer can shift the distribution of channel profits away from the dominant retailer. By raising the weak retailer's wholesale price (which raises the weak retailer's consumer prices), the manufacturer induces higher prices by both retailers due to strategic complementarity, which results in higher consumer prices. Thus, the retailers are able to extract more surplus from the consumers. The manufacturer gets some part of this increased surplus through its higher wholesale price in the weak retail channel. Given this higher wholesale price for the weak retailer, the manufacturer is able to make more profits by transferring demand to this high-margin (weak retailer) channel.
The manufacturer can transfer demand from the dominant retailer to the weak retailer using different tools. For example, it can give the weak retailer cooperative advertising allowances that induce the weak retailer to promote its product. Alternatively, the manufacturer can shift some demand from the dominant retailer to the weak retailer by collaborative advertising and promotions. (4, 5)
The incentive to transfer demand to a weak retail channel has implications for detecting the source of the power retailers' low prices. A purely efficiency view would suggest that retailing efficiencies singularly enable these retailers to keep costs low. Alternatively, a channel power view would imply that the dominant retailers' ability to dictate channel terms provides an explanation to these low prices. In [section] 4, we derive a testable hypothesis that suggests the following. If it is empirically observed that manufacturers provide exclusive support for weak retailers, then dominant retailers' power in bargaining with suppliers is a contributing factor to their low prices. Otherwise, if manufacturers do not offer exclusive assistance to weak retailers, then dominant retailers' low prices are likely not a consequence of their ability to induce favorable wholesale prices from their suppliers.
There has been a sustained interest in game-theoretic modeling of marketing channels (e.g., Choi 1991, Chu and Desai 1995, Coughlan 1985, Jeuland and Shugan 1983, Kim and Staelin 1999, Lal and Narasimhan 1996, Lee and Staelin 1997, McGuire and Staelin 1983, Moorthy 1988, Purohit 1997), and different channel structures have been introduced. For example, McGuire and Staelin (1983) characterized the manufacturer Stackelberg model, in which the manufacturer sets the wholesale price for the retailer. Jeuland and Shugan (1983) described the vertical Nash model, where there is a balance between the manufacturer and the retailer in the sense that they set their prices simultaneously. Choi (1991) and Lee and Staelin (1997) used the retailer Stackelberg model, in which the retailer dictates its margin to the manufacturer. In our model, we incorporate power asymmetry between retailers. In the channel structure analyzed here, the dominant retailer has the power to dictate the wholesale price to the manufacturer, but the weak retailer does not have such power.
There is also literature in marketing on power within the channel. For example, Butaney and Wortzel (1988) demonstrate...
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