Strategic Decentralization in Channels

The purpose of this paper is to understand the effect of strategic interaction on a manufacturer's channel-structure decision. In the model I analyze, if there were no strategic interaction, then the manufacturer would prefer vertical integration to decentralization. With strategic interaction, however, decentralization can be a Nash equilibrium strategy (as McGuire and Staelin 1983a showed). So the question arises, What is it about strategic interaction that makes decentralization a Nash equilibrium strategy? The answer I give is that strategic interaction makes it possible for a manufacturer's retail demand curve to rise when he decentralizes. I show that this raising of the demand curve on decentralization can happen only if one of the following (mutually exclusive) conditions is satisfied: (1) the manufacturers' products are demand substitutes at the retail level and strategic complements at the manufacturer or retailer levels, (2) the manufacturer's products are demand complements at the retail level and strategic substitutes at the manufacturer or retailer levels. Strategic complementarity at the retailer (manufacturer) level means that if one retailer (manufacturer) raises his price, then the other retailer (manufacturer) would raise his price as well; strategic substitutability is just the opposite. These results show that what is important for decentralization to occur is not how (demand) substitutable the two manufacturers' products are (as one might have thought from earlier works in the literature), but rather the nature of coupling between demand dependence and strategic dependence.