Vertical Strategic Interaction: Implications for Channel Pricing Strategy

This paper examines two strategic pricing decisions within channels: using foresight (i.e., price leadership) and considering category implications (i.e., product line pricing). Are price leadership and product line pricing always the best pricing strategies for a channel member? If not, when does this occur and why? By investigating these questions, we address some major concerns of both marketing practitioners and scholars interested in channel management issues. In addition, this study provides an indepth discussion on why previous analytic studies produced answers to these questions that depend upon the choice of the form of demand functions. As such, this study should significantly resolve the debate among analytic marketing modelers about the “right” demand specification. At the core of our discussion lies the concept of vertical strategic interaction, which is defined in terms of the direction of a channel member's reaction to the actions of its channel partner within a given demand structure. Specifically, if a channel member's best reaction is to reduce its margin when its channel partner increases its margin, the type of vertical strategic interaction is referred to as vertical strategic substitutability (VSS). If the best reaction is to increase the margin, the environment is referred to as vertical strategic complementarity (VSC). If the best reaction is no margin change, it is referred to as vertical strategic independence (VSI). Using a game theoretic approach, we demonstrate that these three types of vertical strategic interactions represent a key driving force for optimal decisions on channel price leadership and product line pricing. Our investigation involves mathematical analyses of an industry model composed of two manufacturers selling competing products, both carried by two competing retailers. As such, the model allows for retailer product line pricing as well as manufacturer and retailer level competition. In addition, this general model can be used to analyze three more restrictive industry settings often found in the channels literature, i.e., a bilateral monopoly (Jeuland and Shugan Jeuland, Abel, Steven M. Shugan. 1983. Managing channel profits. Marketing Sci. 2(Summer) 239–72.), two competing manufacturers selling through competing franchised retailers (McGuire and Staelin McGuire, Timothy W., Richard Staelin. 1983. An industry equilibrium analysis of downstream vertical integration. Marketing Sci. 2(Spring) 161–92.), and two competing manufacturers selling through one common retailer using product line pricing (Choi Choi, S. Chan. 1991. Price competition in a channel structure with a common retailer. Marketing Sci. 10(Fall) 271–96.). Unlike many other channel studies, most of our analyses are performed without assuming particular functional forms of demand curves. Thus, this paper provides greater assurance that the insights from this stream of research are broadly applicable, not only across industry structures but also across demand conditions. The paper starts out by defining three different rules for how prices are set: The manufacturer uses foresight, the retailer uses foresight, and neither channel member uses foresight. We then show a one-to-one mapping between the type of vertical strategic interaction and the optimality of channel price leadership. Specifically, a channel member finds it profitable to be a price leader for VSS but prefers to be a follower for VSC. For VSI, channel members are indifferent to the channel price leadership issue, as it has no effect on channel member profits. We also show that there exist conditions under which a retailer might see a reduction in profits when it changes its policy from non-product line pricing to product line pricing. Such conditions arise when the retailer is not a price leader and the environment is characterized by VSS or VSC. At a more general level, this study suggests not only the value but also the cost to a firm for using superior knowledge (i.e., foresight and/or product line pricing) in making strategic marketing decisions. In this way, “ignorance can be bliss.” We also explore the link between demand characteristics and the three types of vertical strategic interaction. We show that the type of vertical strategic interaction present in a given environment is closely related with the convexity of the demand curve and the level of demand for a given price. Interestingly, we find that linearity of demand is not a necessary condition for any of the three types of vertical strategic demand function. Consequently, in evaluating the robustness of analytic analyses, it may be more important to determine the type of vertical strategic interaction assumed instead of whether the demand is linear or nonlinear. Finally, our results are limited to situations where the channels are not coordinated and the retailer's precommitment to particular pricing policy and decision is credible. Although such situations still capture a significant portion of reality, we acknowledge that the insights from this study might not be applicable in all situations.