An illustrative game-theoretic model of channels : the bilateral monopoly

This chapter provides a critical review of research on pricing within a channel environment. We fi rst describe the literature in terms of increasing time horizons of decision-making in a channel setting: (1) retail pass-through (2) pricing contracts and (3) channel design, all of which occur within a given market environment. We then describe the emerging empirical literature on structural econometric models of channels and its use in (1) inferring channel participant behavior and (2) policy simulations in a channel setting. We also discuss potential areas for future research in each area. ‘Price’ and ‘channel’ are two of the four elements of the marketing mix that managers control, yet they differ fundamentally in how managers can use them to impact market demand. While price is the most fl exible, in that managers can change it most easily to impact short-run demand, the distribution channel through which fi rms reach their end consumer is the least fl exible and perhaps the costliest to change in the short run. Therefore channel design is viewed as part of a fi rm’s long-run strategy. Most importantly, in the presence of a typically decentralized distribution channel, an upstream price change by a manufacturer does not affect consumer demand directly, but only through how this upstream price change affects the retail price set downstream in the channel. In his review of the pricing literature, Rao (1984) stated that ‘the issues of pricing along the distribution channel . have not received much attention in the literature’. However, over the last 25 years, this gap has been remedied substantially. The tools of game theory have revolutionized the theoretical analysis of pricing within the channel and clarifi ed the many issues about how prices are set within a channel; more importantly, these analyses have offered insights into the optimal long-term channel strategy, given how prices will be set within the channel. A smaller but emerging empirical literature on structural models of channels has provided insights on the behavior of channel participants and tools to perform policy analysis in a channel setting. The purpose of this chapter is to provide a critical review of this literature, identify the key themes of understanding that have emerged from research to date and identify important gaps in our knowledge that would benefi t from future research. Given the short-run nature of price and the long-run nature of the channel, we organize the literature in terms of three key issues of managerial interest that progressively increase in their time horizons for the decision. The three questions are: 1. Conditional on the distribution channel (which is fi xed in the short run) and other market characteristics, how can a change in upstream price affect the downstream price seen by the end consumer? This question of ‘pass-through’ is the most short * We thank the editor Vithala Rao and Jiwoong Shin for comments and suggestions on the chapter. 320 Handbook of pricing research in marketing term of the three sets of decisions we consider. Pass-through is of interest to an upstream manager because it determines the extent to which the upstream manufacturer will change prices. 2. Conditional on the distribution channel (which is fi xed in the short run) and other market characteristics, what is the best pricing contract to offer to the downstream channel member? This is a medium-term decision, where managers set the ‘rules of their interactions’ within the existing channel structure. These contracts affect the objective function of the market participants; and managers seek contracts that maximize their profi ts given a chosen channel structure. Pricing contracts can include linear tariffs, two part-tariffs, quantity discounts, slotting allowances, resale price maintenance (RPM) etc. Note that the types of pricing contracts that can be used may be constrained by law. 3. Finally, given the market characteristics, what is the optimal channel structure and the pricing contract? This is a long-term consideration where managers decide on the nature of channel ownership given the market characteristics. Should a fi rm vertically integrate or decentralize? Or would a mixed strategy of partial integration, with the manufacturer directly selling along with independent retailers, be optimal? The emergence of the Internet as a sales channel has brought the issue of partial forward integration again into focus in recent years. Since the optimality of the channel structure depends on the nature of pricing contracts that are available to the manufacturer, channel structure design is intimately linked to the pricing strategy. Finally, all of these decisions are embedded in the market environment in which the fi rms operate. A schematic way of thinking about these three sets of managerial Channel design