PRODUCTION AND OPERATIONS MANAGEMENT

1 Boiling Frogs: Pricing Strategies for aManufacturer Adding a Direct Channel thatCompetes with the Traditional ChannelKyle Cattani Wendell Gilland Hans Sebastian Heese Jayashankar SwaminathanThe Kelley School of Business, Indiana University, Bloomington, Indiana 47405-1701, USAThe Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, Chapel Hill, North Carolina27599-3490, USAThe Kelley School of Business, Indiana University, Bloomington, Indiana 47405-1701, USAThe Kenan-Flagler Business School, The University of North Carolina at Chapel Hill, Chapel Hill, North Carolina27599-3490, USAWe analyze a scenario where a manufacturer with a traditional channel partner opens up a directchannel in competition with the traditional channel. We first consider that in order to mitigatechannel conflict the manufacturer, who chooses wholesale prices as a Stackelberg leader, commits tosetting a direct channel retail price that matches the retailer s price in the traditional channel.

2 We findthat the specific equal-pricing strategy that optimizes profits for the manufacturer is also preferred by theretailer and customers over other equal-pricing strategies. We next consider the implications of theequal-pricing constraint through a numerical experiment that indicates that the equal-pricing strategy isappropriate as long as the Internet channel is significantly less convenient than the traditional the Internet channel is of comparable convenience to the traditional channel, then the manufacturerhas tremendous incentive to abandon the equal-pricing policy, at great peril to the traditional words: supply chain MANAGEMENT ; direct channel; channel conflict; pricingSubmissions and Acceptance: Submitted January 2004; revised September 2004, November 2004, January2005; accepted February 2005 by Eric IntroductionThe introduction by a manufacturer of a new, Internet-based distribution channel provides an opportunity toincrease sales and/or decrease costs.

3 An increasedcustomer base may become accessible, and the mar-ginal cost of reaching these customers may be negli-gible. On the other hand, the introduction of a newchannel may threaten existing channel challenge of appeasing current channel partners isproblematic for many manufacturers that might oth-erwise quickly adapt to and experiment with an Inter-net-based outlet. Some manufacturers, such as Daim-ler-Chrysler, Nikon, and Rubbermaid, thus have usedthe Internet as a medium to provide information abouttheir products and/or to point the Internet surfer tothe nearest retailer carrying the product, but do notoffer the product for sale over the Internet. Many othermanufacturers offer the product for sale over the In-ternet, but only at full-retail price, presumably to pre-vent channel conflict with existing distributors. Forexample, a replacement tricolor ink cartridge for thewidely used Hewlett Packard (HP) Deskjet 600 seriesprinter can be obtained for $ at the manufactur-er s (HP) web site.

4 This price matches exactly thenon-sale price at HP s traditional retailers such as Table 1, we display a sample of recent pricescharged for several products that are sold boththrough a manufacturer s web site and through tradi-tional retailers. For these examples of products in sev-eral categories, including electronics, athletic equip-ment, and toys, we note that the Internet price chargedby the manufacturer and the in-store price charged bya traditional retailer are exactly or nearly identical. WePOMSPRODUCTION AND OPERATIONS MANAGEMENTVol. 15, No. 1, Spring 2006, pp. 40 56issn1059-1478 06 1501 040$ 2006 PRODUCTION and OPERATIONS MANAGEMENT Society40are unaware of any comprehensive empirical studycomparing prices between manufacturer-owned websites and traditional retail locations, although a recentsurvey by Ernst and Young (2001) reports that nearlytwo thirds of companies price products identically fortheir on-line and off-line some product categories, we are beginning to seeexamples where prices on the manufacturer s websiteare lower than prices in the traditional retail CDLos Lonely Boyscan be purchased at $ , while it was simultaneously priced at$ at Wal-Mart and $ at Best Buy.

5 QuickenDeluxe, a personal financial software program, isavailable online at for $ , yet costs$10 more at both Best Buy and Office Depot. As will bediscussed later, our research provides theoretical jus-tification for why this pricing behavior may be ema-nating from the music and software paper is motivated from our interactions withmanagers at a leading computer manufacturer whowere considering the introduction of a direct channelthat would be in competition with their traditionalchannel. The managers sought insights about the ef-fect of different pricing strategies on profitability toboth the manufacturer and the traditional thus explore a scenario where a manufacturerwith a traditional channel partner ( , a retailer)opens a direct channel that is in competition with thetraditional channel. For our discussion, we will con-sider the direct channel to be Internet based, althoughit could be any direct channel.

6 We begin with theassumption that the manufacturer, who is a Stackel-berg leader, chooses wholesale prices for the tradi-tional channel along with retail prices for the directchannel in such a way that the retail prices in thetraditional channel and the direct channel are identi-cal, consistent with prevalent this general assumption of equal prices acrossthe two channels, we use consumer utility theory todevelop a model that determines the effect on profitsand market shares of the manufacturer and the retailerfor specific strategies that keep wholesale prices asthey were before (Strategy 1), keep retail prices as theywere before (Strategy 2), or set wholesale and retailprices to optimize the manufacturer s profit (Strategy3). For each of these strategies, we determine how theresulting prices compare to the single-channel prices,and we determine the resulting profits for the supplychain and its two players.

7 Counter to our intuition, wefind that the pricing strategy that optimizes the man-ufacturer s profit (Strategy 3) also tends to be pre-ferred by the retailer over the other two , the end customer also prefers Strategy 3in most cases, benefiting from lower prices. This is incontrast to Strategy 1, which creates upward pressureon retail prices. In general, we conclude that under anequal-pricing framework, the retailer does not need toview the manufacturer s addition of a direct channelas harmful competition but rather as a mechanism forsegmenting the market in a way that benefits both themanufacturer and the next show, through a numerical experiment,that the equal-pricing strategy is reasonable for themanufacturer as long as the Internet channel is signif-icantly less convenient and/or more costly than theretail channel. If the Internet channel becomes moreconvenient and less costly than the traditional chan-nel, we show that an equal-pricing strategy signifi-cantly restricts profits for the manufacturer, who atthis point has tremendous incentive to use the directchannel to undercut traditional channel prices.

8 In do-ing so, the manufacturer s large gains in profit come atthe retailer s expense. Thus, the manufacturer s intro-duction of a direct channel that competes with a tra-ditional channel has very different effects on the retailpartner depending on the manufacturer s pricingstrategy, which itself is affected by the relative costsand convenience of the two propose an analogy to the parable of the boilingfrog. The parable states that a frog thrown into a pot ofboiling water will quickly jump out. But a frog throwninto a pot of temperate water may stay even if thetemperature is slowly raised to boiling, leading to theuntimely demise of the frog. By introducing an Inter-net channel with equal pricing, the manufacturer hasplaced the retailer in a mildly competitive positionwhere the retailer may even benefit if the Internet ismore costly and less convenient on average to thepopulation of customers.

9 But if, as we imagine, thecosts and average convenience of the Internet channelbecome more favorable over time, then the manufac-turer will be in a position to use the direct channel toundercut the prices in the traditional channel, and boil the traditional rest of the paper is organized as follows. InSection 2, we discuss related literature. We introduceTable 1 Price Comparison of Selected Products (September, 2003)ProductManufacturer sweb priceTraditionalretail priceSony 32 Flat Tube HDTV$1, $1, 57 HD Projection TV$2, $2, Climacool 2 M Shoes$ $ Air Kantara Shoes$ $ Triax Stamina Watch$ $ Snowboard Superpipe$ $ s Sporting et al.:Boiling Frogs: Pricing Strategies for a Manufacturer Adding a Direct Channel that Competes with the Traditional ChannelProduction and OPERATIONS MANAGEMENT 15(1), pp. 40 56, 2006 PRODUCTION and OPERATIONS MANAGEMENT Society41the demand generation model and present our analyt-ical model and results in Section 3.

10 We provide com-putational insights in Section 4, and conclude in Sec-tion Related LiteratureThere are a number of recent papers that study issuesrelated to supply chains in e-business. Swaminathanand Tayur (2003) in their comprehensive review ofanalytical models related to Internet-based supplychains identify managing multiple distribution chan-nels (that include an Internet channel) as one of thekey areas of supply chain research. Cattani et al.(2004b) survey recent research related to the coordi-nation of traditional and Internet supply chains whileTsay and Agrawal (2004a) review competitive modelsof traditional and Internet supply and Shugan (1983) define channel coordi-nation as the setting of all manufacturer- and retailer-controlled variables at the levels that maximize chan-nel profits. Our paper relates to work done towardunderstanding the conflicts that arise given the differ-ent objectives of channel members.