Channel differentiation strategy in a dual-channel supply chain considering free riding behavior

Highlights

• We study channel differentiation strategy in a dual-channel supply chain with free riders.

• Free riding behavior is more pronounced under differentiated products than homogeneous one.

• If consumer heterogeneity is high, horizontal differentiation is high, but vertical one is low.

• The win-win strategy for both manufacturer and retailer exists under certain conditions.

• Channel differentiation strategy is robust to horizontal differentiation/channel integration.

Abstract

The emergence of e-commerce has compelled original brand manufacturers to adopt cross-channel strategies. This research investigates how a manufacturer facing free riders should decide on channel differentiation strategy, i.e., selling homogeneous or differentiated products through his own online channel and via an independent retailer. We consider horizontal differentiation across channels and identify the optimal strategy. In addition, we develop an agent-based model with vertical and horizontal differentiation to derive managerial insights for more complex situations. We have analytically found: (1) consumers are more likely to engage in free riding when faced with differentiated products than homogeneous products, as the price gap across channels is larger under the former scenario; (2) the manufacturer should offer differentiated products if the free rider's online factor is high. Similarly, if the retailer's service cost is low (high), and online (offline) shopping cost is low, differentiated products should be offered. (3) Under different conditions, offering homogeneous or differentiated products could respectively be a win-win strategy for the manufacturer and the retailer. (4) The proposed channel differentiation strategies remain robust to the horizontal differentiation decision and integration of the retail channel. Through agent-based computational experiments, we derive several insights. Namely, (1) if consumers are highly heterogeneous, the manufacturer should horizontally differentiate products across channels; (2) the manufacturer should narrow the vertical differentiation between the two products in dual channels; and (3) the manufacturer should differentiate products if consumers are familiar with the products.

Introduction

In the past two decades, original brand manufacturers, such as Nike, Sony, Panasonic and Estee Lauder, have witnessed significant and rapid growth of Internet sales and have expanded their direct online sales capabilities. However, cross-channel cannibalization inevitably emerges, causing the online channel and the brick-and-mortar (B&M) retailer in the decentralized retail channel to aggressively compete with each other. The retailer has the advantage of providing an in-store experience and human assistance (e.g., offering a tactical testing experience and support from sales clerks). Such service enables consumers to attain non-digital information and become better acquainted with the product, which improves consumer appreciation and enhances retailer revenue. In contrast, the online channel often offers a lower price to attract consumers due to lower operations costs (e.g., warehouse rent, labor, and insurance). Many consumers exploit both channels, by attaining tangible service at the B&M retailer and then purchasing online at discount. These consumers are termed free riders, and their behavior is referred to as free riding behavior.

Free riding behavior intensifies cross-channel cannibalization: the in-store service generates no sales for the B&M retailer. To maintain a relationship with the retailer, the original brand manufacturer (OBM) may choose to differentiate the products offered in his online channel and the retailer. For instance, Chow Tai Fook, a leading Chinese jewelry maker, deliberately segments his online products and designates many items as simpler and cheaper ones, which are not available in the B&M stores. Due to the OBM's differentiation of online products, the B&M retailer can establish a price based on characteristics of the given store.

Product differentiation across channels (i.e. channel differentiation) reduces shop-offline, buy-online and therefore may reduce cross-channel cannibalization, mitigate free riding, and benefit both the OBM and B&M. However, Xia and Rajagopalan (2009) and Xiao, Choi and Cheng (2014) find that product differentiation results in extra costs to the OBM (e.g., research and development expenditure), which may compel the OBM to raise unit wholesale price, further exacerbating double marginalization and hurting both the OBM and the retailer. Thus, our goal is to help OBM who faces free riders to decide whether to differentiate products across channels and to optimize his channel differentiation strategy.

Free riding behavior is prevalent in the experience goods market, where quality or value is difficult to assess until the product is tested. Online information about the experience good is usually incomplete, and the consumer must “experience” the product to further acquire non-digital information. Jewelry, high-tech electronic products, fashion apparel, artwork and perfume are examples of experience goods. Many of those shoppers are millennials, who are generally familiar with the Internet and have a propensity for free riding.

OBMs in the Internet age may offer homogeneous or differentiated products through their online and B&M channels. Many OBMs, such as Zara, Huawei, and Lenovo, offer homogeneous product. Zara's website offers full range of products identical to those in B&M stores. On the other hand, some OBMs differentiate products horizontally or vertically. In horizontal differentiation, products are of the same quality, but consumers may favor one over another depending on their personal preferences in color, style, etc. For example, Nike horizontally differentiates products by offering customized products online and standardized products in physical stores. Fashion brands such as H&M, Levi's, Hollister, Urban Outfitters, and Uniqlo sell certain styles exclusively online to differentiate with B&M products. Some well-known brands (e.g., Tommy Hilfiger and Martha Stewart) provide select products exclusively to Macy's. Conversely, vertical differentiation results in products of different qualities or values. For instance, Sharp Electronics offers more advanced high-tech products in physical malls, as opposed to regular/outdated products online. Li-Ning has an online sportswear discount channel, directly selling dated inventory with discounted price, while B&M retailers sell seasonal products with no discount. In short, channel differentiation strategy is an extant and important business decision for OBMs.

To explore the OBM's channel differentiation strategy and understand its impact on supply chain members’ profits and pricing decisions, we focus on the following research questions:

• What is the optimal channel differentiation strategy for the OBM who faces free riding shoppers? Should the OBM offer homogeneous or differentiated products across (online and offline) channels? How to implement channel differentiation strategy when considering both horizontal and vertical product differentiation across channels? Is there a win-win strategy that serves both the OBM and the B&M retailer?

• How does channel differentiation strategy affect consumer's buying behavior? How does the free riding behavior influence the demands and profits of supply chain members?

To address these questions, we model a supply chain with one OBM, one B&M retailer and dual channels (i.e. a B&M retail channel and an OBM online channel). The OBM sells experience products through his own online channel as well as through the independent B&M retailer. We first consider the case with predetermined horizontal product differentiation and investigate the impact of various key factors on the channel differentiation strategy. Then, we explore the OBM's decision on the optimal horizontal differentiation. Further, we examine vertical as well as horizontal differentiation across channels, develop an agent-based model, and conduct computational experiments to assess the robustness of our findings. Our analysis yields some interesting results. For instance, counterintuitively, free riding behavior is more pronounced when the products across channels are differentiated rather than homogeneous. It is because when products are differentiated, the price gap between the two channels is high (i.e. the product online is cheaper than that in the physical store). As a result, consumers are more likely to switch to the online channel after taking advantage of the in-store service. That is, shoppers are motivated to free ride. We further identify the OBM's optimal channel differentiation strategy under various parameter settings (i.e. free rider's online product valuation, online and offline shopping costs, service cost per visit, consumer heterogeneity, and ex-ante product familiarity). Finally, we identify win-win strategies for both the OBM and the B&M retailer.

The contributions of this research are fourfold. First, from the perspective of information-acquisition offline and purchase-fulfillment online, we enrich the study of dual-channel strategy by analyzing the impact of consumer's free riding behavior. Second, in addition to price optimization, we highlight channel differentiation strategy of the OBM across (online and offline) channels. We address exogenous and endogenous settings of horizontal differentiation, which contributes to product-differentiation research. Third, the findings from studying the impact of channel differentiation on consumer's free riding behavior enrich pertinent literature and improve practitioner's decision making. In particular, we identify win-win strategies for both the OBM and the retailer under different conditions, and provide managerial insights into the dual-channel supply chain when free riders are present.