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Article Excerpt
Even profit-maximizing firms will have an incentive to act in a manner that is perceived as fair if the individuals with whom they deal are willing to resist unfair transactions and punish unfair firms at some cost to themselves ... willingness to enforce fairness is common. (Kahneman et al. 1986, p. S285)
1. Introduction
Our objective in this paper is to examine how firms' concerns about fairness affect the nature of optimal contracts in a marketing channel. There are two main motivations for us to take this initial step. First, research in behavioral economics in the past two decades has shown that "there is a significant incidence of cases in which firms, like individuals, are motivated by concerns of fairness" in business relationships, including channel relationships (Kahneman et al. 1986, p. S287). Studies in economics and marketing have long documented cases where fairness plays an important role in developing and maintaining channel relationships (Okun 1981; Frazier 1983; Heide and John 1988, 1992; Kaufmann and Stern 1988; Anderson and Weitz 1992; Hackett 1994; Geyskens et al. 1998; Corsten and Kumar 2003, 2005). For instance, through a large-scale survey of car dealerships in the United States and Netherlands, Kumar et al. (1995) convincingly show that fairness is a significant determinant of the quality of channel relationships. Subsequent research has also documented cases where both manufacturers and retailers sacrifice their own margins for the benefit of their counterpart because of fairness concerns (Olmstead and Rhode 1985, Kumar 1996, Scheer et al. 2003). Indeed, some practitioners go as far as to say that maintaining fairness in a distribution channel "should be the supplier's first concern" (McCarthy 1985, p. 33). Therefore, fairness concerns are a factor that analytical modelers in marketing may not want to ignore as they strive to develop good descriptive models of channel coordination. Analytical models on channel coordination in the past typically assume that all channel members care only about their monetary payoffs. This focus on monetary payoffs has produced well-known conclusions. For instance, in a conventional dyadic channel consisting of one manufacturer selling a product to a single retailer at a constant wholesale price, using a price that does not vary with the quantity of purchase results in the well-known problem of "double marginalization" and the channel profit is always suboptimal. A creative remedy for this problem is for the manufacturer to use quantity discounts (Jeuland and Shugan 1983). Moorthy (1987) carefully shows that other nonlinear pricing contracts, such as a two-part tariff, can also coordinate the dyadic channel. However, it is not known if these managerial prescriptions apply to a channel where some or all channel members care about monetary payoffs as well as fairness. It is also unknown if new managerial prescriptions are required when the channel members are fair-minded.
Second, as noted some time ago by Holmstrom and Milgrom (1987), incentive contracts in the real world frequently take simpler forms than what theory often predicts. This can happen because, aside from the cost of writing and implementing an intricate contract, a simple contract may be the optimal one in "a richer real-world environment." This can also happen because firms have little to lose using a simpler contract (Raju and Srinivasan 1996). In a channel context, we also observe in some cases that channel transactions are "governed by simple contracts defined only by a per unit wholesale price" (Lariviere and Porteus 2001, p. 293). Of course, in some cases, channel contracts may only appear simple because the complexity is absorbed by trade promotions and various allowances. However, we believe intriguing to investigate whether the simplicity of the channel contract may also be due to "a richer real-world environment" where channel members care about fairness in their transactions.
Past theoretical models have devoted considerable attention to channel issues. McGuire and Staelin (1983), Coughlan (1985), and Coughlan and Wernerfelt (1989), for instance, examine the manufacturers' choice of channel structure. Gerstner and Hess (1995) investigate the channel coordination role of pull promotions and Weng (1995) examines that of quantity discounts from an operations management perspective, all in the context of a dyadic channel. Chu and Desai (1995), Desai and Srinivasan (1995), and Desai (1997) study the mechanisms for channel coordination to achieve customer satisfaction and to align the interests of the franchisor and franchisees in the context of demand uncertainty and heterogeneity. Ingene and Parry (1995a, b, 2000) and Iyer (1998) study channel coordination in a competitive context. More recently, Ho and Zhang (2004) use a reference-dependent approach to study the double-marginalization problem in a dyadic channel. We attempt to contribute to this growing body of literature by examining the implications of fairness in a channel context.
As a first step, we shall start with the simplest channel structure--the dyadic channel, and introduce distributive fairness in a parsimonious, tractable way as inequity aversion. The history of the intellectual discourse on distributive fairness can be traced to Plato's Republic and Aristotle's Nichomachean Ethics (Cohen 1987). In modern times, Adams (1965) saw the relevance of distributive fairness in commercial relationships. Concerns of distributive fairness are not just limited to individuals as economic agents. Researchers in sociology, marketing, psychology, and other disciplines have found that distributive fairness can play an important role in firms' transactions with each other. This is because, as Macneil (1980) argues in advancing a long intellectual tradition (Adams 1963, Adams and Freedman 1976, Blumstein and Weinstein 1969), the norm of mutuality between parties (e.g., partnering firms) in contracts requires some kind of evenness that assures adequate returns to each instead of requiring strict equality when dividing the exchange surplus. This view of commercial relationships is apparently quite influential in marketing as well, as discussed previously. (1)
We first analyze a model where the retailer is fair-minded. Then, we extend our analysis to the case where, instead of merely reacting to the retailer's fairness concerns, the manufacturer also cares about fairness. For ease of exposition, we define a channel where one or more of its members cares about fairness as a fair channel.
Our analysis shows that the manufacturer can use a constant wholesale price to align the retailer's interest with the channel's and coordinate the channel with a wholesale price higher than its marginal cost. Said differently, the double-marginalization problem does not always arise when the manufacturer uses a simple pricing contract. Through careful analysis, we also identify the mechanism through which a simple wholesale price coordinates the channel. In this regard, we find that the intuition gained from studying a conventional channel where only monetary payoffs matter does not necessarily carry over to the case where channel members care about fairness; indeed, a simpler contract can be optimal in a richer channel environment.
2. Constant Wholesale Price and Channel Coordination
Consider the standard dyadic channel where a single manufacturer sells its product to consumers through a single retailer. For our basic model, we assume that the manufacturer moves first (2) and charges a constant wholesale price w. Then, taking the wholesale price w as given, the retailer sets his price p. For simplicity, we assume that only the manufacturer incurs a unit production cost c > in this channel, (3) and the market demand is given by D(p) = a - bp, where b > 0. This demand specification abstracts away from the issues related to consumer fairness concerns about price changes motivated by "fair reasons" (cost factors) versus "unfair reasons" (demand factors). We will come back to these issues in the conclusion section. The maximally achievable profit for the whole channel is given by [[PI].sub.c](p*) = (p* - c)D(p*) at the channel coordinating retail price p* = arg max [[PI].sub.c](p) = (a + bc)/2b. It is well known that as long as all channel members care only about their own monetary payoffs, the manufacturer cannot achieve the maximum channel profit with only a constant wholesale price (Jeuland and Shugan 1983). In that case, as illustrated in Figure 1, the manufacturer will optimally choose to set her...
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