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The bright side of supplier encroachment.

Article Excerpt
The common wisdom is that a retailer suffers when its wholesale supplier encroaches on the retailer's operations by selling directly to final consumers. We demonstrate that the retailer can benefit from encroachment even when encroachment admits no synergies and does not facilitate product differentiation or price discrimination. The retailer benefits because encroachment induces the encroaching supplier to reduce the wholesale price in order not to diminish unduly the retailer's demand for the manufacturer's wholesale product. The lower wholesale price and increased downstream competition mitigate double marginalization problems and promote efficiency gains that can secure Pareto improvements.

Key words: channels of distribution; encroachment; market entry; retailing and wholesaling

History: This paper was received May 17, 2007, and was with the authors 1 month for 2 revisions.

1. Introduction

Manufacturers have competed with retailers for the loyalty of retail customers for many years. Such competition--often referred to as "encroachment"--has taken different forms, including company-owned franchises, catalog sales, direct telemarketing, and manufacturer outlets (Tannenbaum 1995). The recent proliferation of online supply channels has raised concerns about encroachment to a fever pitch (Tedeschi 2005). Although retail competition typically is viewed as a healthy economic force, competition from a retailer's own supplier has not met with universal approval. Dissent often is expressed as outrage that mercenary manufacturers, bent on becoming vertical behemoths, are viciously exploiting their faithful retailers. (1)

The primary purpose of this paper is to demonstrate that contrary to the conventional wisdom, an incumbent retailer may benefit from encroachment by its wholesale supplier. The gain for the retailer arises from the lower wholesale price that can naturally accompany encroachment. Although a higher wholesale price can afford the encroaching supplier a competitive edge in the retail market, the higher price also reduces retailer demand for the supplier's product.

Importantly, the increased competition from encroachment can render a retailer's demand more sensitive to wholesale price increases. As a result, an encroaching supplier finds it profitable to lower its wholesale price in order to increase the retailer's purchases of the wholesale product. (2) When the retailer is particularly adept at serving customers, the encroaching manufacturer finds it optimal to reduce the wholesale price to such an extent that the retailer (like the manufacturer and consumers) gains from supplier encroachment.

We identify these Pareto gains from encroachment in a simple model that precludes the most apparent reasons for such gains. In particular, we rule out product complementarity by focusing on a Cournot model with a homogeneous retail product. Our model with a single market-clearing price also precludes price discrimination that, in principle, could be facilitated by the dual marketing channels that arise under supplier encroachment (Hendershott and Zhang 2006). (3)

By abstracting from these issues, we emphasize that Pareto gains can arise from supplier encroachment even when it introduces intense competition with no apparent synergistic gains.

To abstract from other well-known effects of encroachment, we assume the retail demand function is not affected by encroachment. Therefore, the possibility that encroachment might undermine a retailer's incentive to promote a product or provide customer assistance (Fein and Anderson 1997) or affect the coordination of complementary demand-enhancing activities (Bell et al. 2003, Tsay and Agrawal 2004) does not arise in our model. We also abstract from the possibility that encroachment might promote brand awareness (Blair and Lafontaine 2005, Chapter 8) or dilute brand image (Frazier and Lassar 1996). (4)

Our analysis is related to those of Sibley and Weisman (1998) and Chiang et al. (2003) in that all three studies identify conditions under which wholesale suppliers undertake actions that assist retail competitors. In a setting with an exogenous (regulated) wholesale price, Sibley and Weisman (1998) find that a regulated vertically integrated provider may refrain from sabotaging the operation of its retail rival in order to enhance wholesale demand. Chiang et al. (2003) demonstrate that Pareto gains can arise when a manufacturer threatens to establish a direct distribution channel. This threat compels the retailer to lower its retail price in order to convince the manufacturer not to enter its market. In anticipation of the low retail price, the manufacturer offers concessions. Our work differs in part by identifying circumstances in which a retailer benefits when its supplier actually implements a direct distribution channel and encroaches on the retailer's territory. We find that encroachment benefits all parties because it induces lower wholesale prices to support the wholesale demand of the weakened incumbent retailer.

Our analysis proceeds as follows. Section 2 describes the key elements of our basic model. Section 3 presents our central findings. Section 4 extends the analysis to incorporate differentiated products, price competition, and nonlinear costs. Section 5 provides concluding observations.

2. The Basic Model

Consider a standard model of a vertical supply chain in which a manufacturer (supplier) sells a wholesale product to a retailer that, in turn, sells the product to final consumers. In addition, the manufacturer may sell the product directly to consumers, perhaps by establishing its own online store. This initial focus on a setting where the manufacturer and retailer are the only potential retail sellers is adopted primarily for expositional and analytic simplicity. However, the setting may reflect circumstances in which the retailer is particularly efficient (e.g., Wal-Mart) or serves an exclusive territory (perhaps because of an exclusive franchise, for example). The effects of additional retail competition are examined in [section] 3.4.

Consumer demand for the product is represented by a linear, downward sloping, (inverse) demand function P = a - bQ, where a and b are strictly positive constants and where P and Q are the price and the quantity of the product, respectively. The manufacturer produces the good at a constant unit (marginal) cost which is normalized to zero. In addition, we normalize the retailer's unit selling cost to zero and let c [member of] [0, a) denote the manufacturer's...

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