VERTICAL STRATEGIC INTERACTION - IMPLICATIONS FOR CHANNEL PRICING STRATEGY

This paper examines two strategic pricing decisions within channels: u sing foresight (i.e., price leadership) and considering category impli cations (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 question s, we address some major concerns of both marketing practitioners and scholars interested in channel management issues. In addition, this st udy provides an indepth discussion on why previous analytic studies pr oduced answers to these questions that depend upon the choice of the f orm of demand functions. As such, this study should significantly reso lve the debate among analytic marketing modelers about the ''right'' d emand specification. At the core of our discussion lies the concept of vertical strategic interaction, which is defined in terms of the dire ction of a channel member's reaction to the actions of its channel par tner within a given demand structure. Specifically, if a channel membe r's best reaction is to reduce its margin when its channel partner inc reases its margin, the type of vertical strategic interaction is refer red to as vertical strategic substitutability (VSS). If the best react ion is to increase the margin, the environment is referred to as verti cal strategic complementarity (VSC). If the best reaction is no margin change, it is referred to as vertical strategic independence (VSI). U sing a game theoretic approach, we demonstrate that these three types of vertical strategic interactions represent a key driving force for o ptimal 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 carrie d by two competing retailers. As such, the model allows for retailer p roduct Line pricing as well as manufacturer and retailer level competi tion. In addition, this general model can be used to analyze three mor e restrictive industry settings often found in the channels literature , i.e., a bilateral monopoly (Jeuland and Shugan 1983), two competing manufacturers selling through competing franchised retailers (McGuire and Staelin 1983), and two competing manufacturers selling through one common retailer using product line pricing (Choi 1991). Unlike many o ther channel studies, most of our analyses are performed without assum ing particular functional forms of demand curves. Thus, this payer pro vides 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 diffe rent rules for how prices are set: The manufacturer uses foresight, th e retailer uses foresight, and neither channel member uses foresight. We then show a one-to-one mapping between the type of vertical strateg ic interaction and the optimality of channel price leadership. Specifi cally, a channel member finds it profitable to be a price leader for V SS 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 u nder which a retailer might see a reduction in profits when it changes its policy from non-product line pricing to product line pricing. Suc h conditions arise when the retailer is not a price leader and the env ironment 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 usi ng 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 ty pe 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 End that linearity of d emand is not a necessary condition for any of the three types of verti cal strategic demand function. Consequently, in evaluating the robustn ess of analytic analyses, it may be more important to determine the ty pe of vertical strategic interaction assumed instead of whether the de mand is linear or nonlinear. Finally, our results are limited to situa tions where the channels are not coordinated and the retailer's precom mitment to particular pricing policy and decision is credible. Althoug h such situations still capture a significant portion of reality, we a cknowledge that the insights from this study might not be applicable i n all situations.