Manufacturer Competition and Trade Promotions in the Presence of a Strategic Retailer

Casual observation suggests manufacturers continue offering trade promotions while complaining that trade promotions are unprofitable. Recent empirical work finds that retailer response to trade promotions can be better understood by viewing retailers as maximizing category profits rather than reacting to the promoted brand alone. This paper characterizes equilibrium pricing by two competing manufacturers selling through a retailer maximizing category profits. Departing from much of extant work we model brand demand as continuous in retail prices instead of assuming a mass of consumers whose switching behavior is discontinuous. We find that, if demand is sufficiently price sensitive, equilibrium manufacturer pricing is in mixed strategies. We interpret this as manufacturers offering trade promotions. In our model, these turn out to be unprofitable even if competitors don't match promotions. Our result thus reconciles the apparent contradiction in packaged goods manufacturers' complaints on profitability of promotions while continuing to offer them. Another implication of our analysis is that promotions affect how regular prices are determined endogenously under manufacturer competition. The possibility that competitors may promote is a check on raising regular prices. Thus, manufacturer competition is as much about choosing regular prices as about formulating promotions strategy. An important result of our analysis is that trade promotions occur because of the presence of the strategic retailer, maximizing category profits. Retail pass-through depends on the wholesale prices difference, not merely the wholesale price of the promoted brand. Further, retail pass through occurs, only if the wholesale price difference exceeds a threshold value, depending on the price sensitivity. If price sensitivity is low, there are no trade promotions. At the other extreme, if price sensitivity is high, the equilibrium is in mixed strategies and this mixed strategy equilibrium has two support points: corresponding to regular price and promotion price. We know that manufacturers such as Procter and Gamble have tried to implement various pricing strategies that either eliminate or reduce trade promotions. One reason could be that promotions are unprofitable. Our model suggests an additional possible reason. For intermediate values of the price sensitivity parameter, manufacturer pricing has three equilibria: one in pure strategies and two in mixed strategies. It turns out that the equilibrium in pure strategies yields the highest profits for both firms. It would then pay them both to coordinate on the desirable equilibrium, by eliminating trade promotions. We also use our model to analyze competition between two asymmetric manufacturers. We find that the regular price of the stronger brand is relatively low, and is an aggressive strategy to combat the weak brand's promotions while its promotion price is a defensive strategy to make promotions unprofitable for the weak brand. In contrast, for the weak brand promotions are frequent and constitute an aggressive strategy, while its regular prices are relatively high taking advantage of the strategic retailer who reacts only to price differences that exceed a threshold. The implications for brand managers based on this is that they should use promotions for different purposes depending on their brand strength.