Bricks vs Clicks The impact of manufacturer encroachment with a dealer leasing

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Authors requiring further information regarding Elsevier’s archiving and manuscript policies are encouraged to visit: http://www.elsevier.com/copyright Author's personal copy Production, Manufacturing and Logistics ‘‘Bricks vs. Clicks’’: The impact of manufacturer encroachment with a dealer leasing and selling of durable goods Yu Xiong a,b, Wei Yan a,⇑, Kiran Fernandes c, Zhong-Kai Xiong a, Nian Guo a a School of Economics and Business Administration, Chongqing University, Chongqing, China bQueens University Management School, Queen’s University, Belfast, UK c The York Management School, The University of York, UK a r t i c l e i n f o Article history: Received 24 October 2010 Accepted 15 August 2011 Available online 23 August 2011 Keywords: E-commerce Distribution channels Durable goods Competitive strategy Game theory a b s t r a c t In durable goods markets, many brand name manufacturers, including IBM, HP, Epson, and Lenovo, have adopted dual-channel supply chains to market their products. There is scant literature, however, address- ing the product durability and its impact on players’ optimal strategies in a dual-channel supply chain. To fill this void, we consider a two-period dual-channel model in which a manufacturer sells a durable prod- uct directly through both a manufacturer-owned e-channel and an independent dealer who adopts a mix of selling and leasing to consumers. Our results show that the manufacturer begins encroaching into the market in Period 1, but the dealer starts withdrawing from the retail channel in Period 2. Moreover, as the direct selling cost decreases, the equilibrium quantities and wholesale prices become quite angular and often nonmonotonic. Among other results, we find that both the dealer and the supply chain may benefit from the manufacturer’s encroachment. Our results also indicate that both the market structure and the nature of competition have an important impact on the player’s (dealer’s) optimal choice of leasing and selling. � 2011 Elsevier B.V. All rights reserved. 1. Introduction In recent years, following the development of the Internet and information technology and the growth of third party logistics pro- viders (Tsay and Agrawal, 2004), a growing number of manufactur- ers have found it attractive to supplement their preexisting retail channels with an e-channel. This tendency is particularly notice- able in the market for durable goods. For example, many brand name manufacturers, including IBM (Narisetti, 1998), HP (Janah, 1999), Epson, and Lenovo, have adopted dual channels to market their products. Yet, despite these emerging trends, little literature on the dual-channel supply chain pays attention to the issue of product durability and its impact on the interactions between manufacturer and dealer. We therefore develop a two-period dual-channel model to analyze the problem of marketing durable goods and address certain strategic issues associated with leasing and selling. To our knowledge, this paper is the first to consider the problem of durable goods marketing in a dual-channel supply chain. Our channel model captures three characteristics salient in many of today’s durable goods markets.1 First, because the manufacturer sells the products to customers through both a manufacturer-owned e-channel and an independent retail channel, customers can purchase the product through either channel. Second, in channels of distribution for durable products, intermediaries (dealers) have an additional degree of freedom beyond what they have in channels for nondurables; that is, manufacturers typically sell their products to dealers who then either sell or lease them to consumers (Bhaskaran and Gilbert, 2009). Third, on a manufac- turer-owned e-channel, a leasing strategy may be ruled out for practical reasons. For instance, renters may abuse product leases via an e-channel because no effective supervisory mechanism is in place. Although there is a considerable body of research on dual- channel supply chains (see, e.g., Tsay and Agrawal, 2004; Arya 0377-2217/$ - see front matter � 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.ejor.2011.08.012 ⇑ Corresponding author. Tel.: +86 013212329507. E-mail address: weiyancqu@gmail.com (W. Yan). 1 The main motivation for our research comes from practices in the market for such office equipments as printers and copiers as well as our discussions with a major printer manufacturer, HP. Customers wishing to purchase an HP printer (e.g., the Designjet T1200 PostScript Version Printer) can either buy it through an e-channel (www.shoping.hp.com) or buy or lease it from a local dealer. We also see this type of practice by Epson (http://www.epson.com), Lenovo (http://www.lenovo.com.cn), and BenQ (http://shop.benq.us). European Journal of Operational Research 217 (2012) 75–83 Contents lists available at SciVerse ScienceDirect European Journal of Operational Research journal homepage: www.elsevier .com/locate /e jor Author's personal copy et al., 2007; Chen et al., 2008), the literature in this area tradition- ally assumes that the dealer can be exogenously defined as a sell- ing agency. We allow the dealer to choose whether to lease or sell durable goods to consumers. Moreover, most of these studies concentrate on nondurable goods. We, in contrast, develop a two-period dual-channel model focused on the problem of market- ing durable goods. Our overall contribution is therefore twofold. First, our model incorporates both product durability and the direct selling cost in a dual-channel supply chain and analyzes how such factors are important in shaping both parties’ policies and determining their profit. Second, although the question of whether a firm should lease or sell its products has been well stud- ied in the literature on durable goods, little is known about which strategy dominates when the downstream agent (dealer) faces encroachment from the upstream agent (manufacturer), we exam- ine how manufacturer encroachment impacts the dealer’s deci- sions on selling vs. leasing. We begin by studying the optimal strategy for a single-channel model in which no e-channel is open and all products are sold or leased only through an independent dealer. Our key finding is that the presence of the dealer introduces vertical competition that leads to the classic double marginalization problem. In addition, the optimal strategy for a dealer in a single-channel model is not to sell but to lease all his products. That is, since leasing allows the monopolist (dealer) to avoid the time inconsistency problem, the dealer is better off leasing products in Period 1. However, compared to a selling strategy, dealer leasing worsens the adverse effects of double marginalization, which lowers both the manufac- turer’s profit and the total supply chain profit. We next examine how both parties’ strategies change as the manufacturer encroaches into the market; specifically, we develop a dual-channel model in which the manufacturer sells products through both a manufacturer-owned e-channel and through an independent dealer who adopts a mixed selling and leasing strat- egy. We find that the manufacturer begins encroaching into the market in Period 1, but the dealer starts withdrawing from the re- tail channel in Period 2. In addition, as the direct selling cost de- creases, the equilibrium quantities and wholesale prices become quite angular and often nonmonotonic. We conclude by comparing the equilibrium outcomes of both parties under both the single-channel and dual-channel models. We find that both the dealer and the supply chain may benefit from manufacturer encroachment, a result that is partially con- sistent with that reported by Arya et al. (2007). However, whereas their finding applies ‘‘when the retailer’s downstream cost advantage is sufficiently pronounced or when it is suffi- ciently limited’’ (p. 655), we find that even when the dealer’s downstream cost advantage is moderate, the encroachment can also increase the supply chain profit. Our findings also suggest that both the market structure and the nature of the competition have an important impact on the dealer’s optimal choice of leas- ing and selling. The remainder of this paper is organized as follows. Section 2 reviews the related literature and explains our contributions in more detail. Section 3 describes the key elements of our basic mod- el and introduces notations. Section 4 outlines two models—the single-channel and the dual-channel model—and reports our main findings. Section 5 concludes the paper. 2. Related research Because the manufacturer is both a supplier and a competitor of the dealer, a dual-channel supply chain contains two main types of channel competition: vertical competition and horizontal competi- tion (see Fig. 1). Vertical competition induces double marginalization (Spengler, 1950): all channel members independently seek to maximize their own profit, resulting in higher retail prices and lower sales quanti- ties and profits than in a vertically integrated channel. Many remedies for such double marginalization have been proposed in the traditional supply chain literature. For example, Caldieraro and Coughlan (2007), in a study of spiffs and channel coordination, claim that in a monopolistic environment, spiffs improve manu- facturer profits, while Jeuland and Shugan (2008) report that coordination can result in all channel members receiving larger profits. Other studies investigate channel conflict and coordination (Boyaci, 2005; Cachon and Lariviere, 2005; Li and Wang, 2007; Cai, 2010; Yan, 2011). In contrast to these studies, however, in our model, the dealer determines not only the number of units to buy but also whether to lease or sell them to consumers. A considerable body of research also exists on horizontal com- petition in the dual-channel supply chain. For example, an earlier study by Balasubramanian (1998) adopts a strategic viewpoint to examine competition in a multiple-channel environment and ana- lyzes the use of market coverage as a lever to control it. Later, Yao and Liu (2005) address price competition between the two chan- nels using Bertrand and Stackelberg game models. Webb and Lambe (2007) then investigate the conflict internal to the supplier firm among the groups and individuals responsible for managing the various channels. Subsequently, Chen et al. (2008) incorporate a consumer channel choice model and study service competition in a dual-channel supply chain. Meanwhile, Agatz et al. (2008) pro- vide a systematic overview of managerial planning tasks and cor- responding quantitative models and address the specific supply chain management issues of Internet fulfillment in a multi-channel environment. Recently, Hua et al. (2010) employs a two-stage optimization technique and a Stackelberg game to examine the optimal decisions on delivery lead time and prices in both a cen- tralized and a decentralized dual-channel supply chain. All these papers conclude that when a manufacturer adopts a direct selling strategy, manufacturer encroachment will reduce the dealer’s prof- it and result in ‘‘channel conflict’’. Fortunately, there are a few notable exceptions to this latter consensus. For example, Chiang et al. (2003) demonstrate that Par- eto gains may arise when a manufacturer threatens to establish a direct distribution channel. Likewise, Tsay and Agrawal (2004) show that the addition of a direct channel alongside a reseller channel is not necessarily detrimental to the reseller. Arya et al. (2007) further demonstrate that the retailer can benefit from encroachment even when it admits no synergies and facilitates neither product differentiation nor price discrimination. In a more recent study, Chun et al. (2011) show that, under certain Fig. 1. Two types of competition in a dual-channel supply chain. 76 Y. Xiong et al. / European Journal of Operational Research 217 (2012) 75–83 Author's personal copy circumstances, both manufacturers and retailers are better off in a dual distribution channel. Nonetheless, although a great deal of research is focused on problems similar to that investigated here, our work differs in two important aspects: First, unlike these authors, we examine a durable product to address the issue of product durability in a dual-channel supply chain. Second, whereas they assume that the dealer can be exogenously defined as a selling agency, we allow the dealer to choose whether to lease or sell the durable goods to consumers. Several authors do address the issue of competition in a durable goods market. For example, Bucovetsky and Chilton (1986) find that for a durable goods monopolist facing a threat of entry, renting is the preferable strategy when such a threat is absent, but a mix of renting and selling is the optimal pre-entry contract when entry is present. Desai and Purohit (1999), using a two-period model of a duopoly in which each manufacturer chooses its optimal quantity and the fraction of units it wants to lease, find that the fraction of leased cars decreases as the manufacturers’ products become more similar and the competition between them increases. Saggi and Vettas (2000) use a dynamic duopoly model in which competing firms can combine leasing and selling in each period, show that the inefficient firm leases more than the efficient firm. Poddar (2004), in a study of the strategic impact of competing firms’ choices of renting or selling in a durable goods market, shows that selling is the firms’ unique dominant strategy. These papers, how- ever, differ from ours in two ways. First, in contrast to these authors’ assumption of a manufacturer that produces for itself and interacts directly with the consumer, we endogenize a dealer. Second, whereas they address the competition between two man- ufacturers, we examine the competition between an upstream manufacturer and a downstream dealer. 3. Model development In developing our models, we first consider a single product model comprising a manufacturer and a dealer who compete with each other in terms of quantity.2 We assume the following game be- tween them: the manufacturer announces the wholesale price to the dealer, the dealer responds by determining the optimal units of sell- ing and leasing, and the manufacturer then chooses the units to be sold through the e-channel.3 3.1. Product As is common in the literature on durable goods, to represent the longevity of a durable product, we assume that its useful life is made up of two periods: it is ‘‘new’’ when marketed in Period 1, and then classified as ‘‘used’’ in Period 2. Hence in our model, new products are only available in Period 1, but both new and used products (i.e., those marketed in Period 1) are available in Period 2. For simplicity, we assume that the product is perfectly durable; that is, it does not deteriorate over time.4 3.2. Manufacturer The manufacturer’s problem is to choose the wholesale price (wi) and the units to sell through the e-channel (qiM) in order to maximize her5 profit, where i = 1, 2 denotes Period 1 or 2. We nor- malize her marginal cost of production to zero and assume that her marginal cost of selling on the e-channel is Cd = c > 0. 3.3. Dealer The dealer is a profit maximizer who adopts a mix of selling and leasing to consumers. In Period 1, he chooses the units he intends to lease (ql) or sell (qs), meaning that in Period 1, the dealer’s opti- mal total quantity is q1R = ql + qs. In our model, we assume that the lease contract is exactly one period, meaning that, since the model ends in Period 2, selling a new product in Period 2 is equivalent to leasing it. We therefore designate the new units sold by the dealer in Period 2 as q2R; that is, we normalize the units available for leas- ing in Period 2 to zero. To ensure that the manufacturer has an advantage in production while the dealer has an advantage in dis- tribution channel, and recalling that the manufacturer’s unit direct selling cost is Cd = c > 0, we assume that, as in Arya et al. (2007), the dealer’s unit marketing cost is Cr = 0. 3.4. Consumers To enable a focus on product durability and dual-channel char- acteristics, we assume that consumers are indifferent to purchas- ing vs. leasing. As in Bulow (1982) and Purohit and Staelin (1994), we derive the inverse demand functions from the con- sumer utility functions, a derivation briefly explained below but detailed in the original studies. Letting li be the one-period lease price in Period i, the lease prices in Period 1 and 2, respectively, are given by l1 ¼ a� ðqs þ qlÞ � q1M ; ð1Þ l2 ¼ a� ðqs þ qlÞ � q1M � q2R � q2M ; ð2Þ where a is the size of the potential market, which is constant every period, and (qs + ql + q1M) and (qs + ql + q1M + q2R + q2M) are the total units for one-period use in Period 1 and 2, respectively. Since a consumer who purchases the product in Period 1 ob- tains the services of the product over both periods, the purchase price in Period 1 is p1 = l1 + ql2, where q is a discount factor denot- ing the cash flows received in Period 2. To simplify further, we as- sume that there is a zero discount rate and the discount factor q = 1.6 As discussed previously, in Period 2, there is no distinction between purchase price and lease price. Our model thus reflects certain key characteristics of durable goods. First, the price in Period 2 is affected by the units available in Period 1. Second, it recognizes that the increased quantity of the product should lead to a future drop in price, which in turn results in time inconsistency problem.7 Third, it allows the dealer has the flexibility of leasing to consumers. On the other hand, our model also reflects the two types of competition in the dual-channel supply chain: vertical competition—the dealer reacts to the wholesale prices charged by the manufacturer, who is the price leader; and horizontal competition between the e-channel and the retail channel—prices 2 Since this assumption is consistent with previous literature (see, e.g., Bulow, 1982; Bucovetsky and Chilton, 1986) and is based on the assumption that both the manufacturer and the dealer market a single product in the same market, we focus here solely on quantity competition. Nonetheless, we believe that a similar analysis using price competition also deserves attention. 3 Although a manufacturer may engage in both selling and leasing on its e-channel (i.e., both a selling and a finance leasing strategy), we focus on the case in which the lessee only uses the asset for some of its life; that is, an operating rather than a finance lease. 4 Incorporating deterioration complicates the problem substantially but does not affect our results. 5 Throughout this article, we use the feminine pronoun to refer to the manufacturer and the masculine pronoun to refer to the dealer. 6 Although allowing the discount factor 0 < q < 1 increases the complexity of the analysis, all our results remain unaffected. 7 The time inconsistency problem refers to a situation in which rational consumers, anticipate that the monopolist has an incentive to increase product availability and lower its price over time, postpone their purchases until the price falls to the competitive level. This issue is formalized in Stokey (1981) and Bulow (1982). Y. Xiong et al. / European Journal of Operational Research 217 (2012) 75–83 77