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Conventional wisdom would suggest that any manufacturer that chooses to offer its products for sale directly over the Internet does so at the expense of its retail partners in traditional brick-and-mortar channels. However, our research spanning numerous manufacturers in many industries indicates that such a decision, though not without risk for the retailers, can be of benefit throughout the supply chain if the manufacturer commits to price-matching — selling at price points equal to, or greater than, those charged by its retail partners.
In our January 2005 paper, “Boiling Frogs: Pricing Strategies for a Manufacturer Adding a Direct Channel That Competes With the Traditional Channel,” (forthcoming in Production and Operations Management) we use consumer utility theory to analyze how different pricing strategies in such a scenario would affect manufacturer and retailer market shares and profits. The basic assumption is that a customer will buy a product if it provides positive utility after accounting for the subtractive effects of the price of the product and the effort expended in acquiring it. The latter factor is inversely proportional to the convenience of the channel through which it is purchased. Using this model, we find that there may be a number of good reasons for a manufacturer to introduce its own Internet selling channel by at least initially adhering to a price-matching strategy.
First and foremost, although most retail partners are not likely to be thrilled with their manufacturer/supplier entering the retail market as a competitor, price matching can greatly allay the partners’ concerns in that the manufacturer is not taking an unfair predatory advantage. Second, while the new channel does introduce competition, it may also provide a means of segmenting the market in a way that could benefit the manufacturer, the retailer and the customer. The reason? Assuming the manufacturer’s direct channel is more convenient for at least some customers, it puts downward pressure on retail prices and, by extension, on “wholesale” prices as well. This means that the traditional retailer not only loses sales but also has to charge lower retail prices. But those negative effects are more than compensated for by the reduction in the wholesale price at which they buy from the manufacturer. Thus, counter to expectations, the manufacturer’s introduction of an Internet channel (with price matching) is ultimately profitable for both the manufacturer and the retailer. The retail customer also benefits from lower prices compared with the single-channel scenario.
But there is a rub. Like the proverbial frog that jumps out if thrown into a pot of boiling water but boils to death if put into water that is then slowly heated, the traditional retailer may be comfortable at first with the presence of the manufacturer as a competitor who chooses not to undercut. But if the manufacturer subsequently chooses to abandon its price-matching policy in its new channel, the retailer could find itself in what has slowly evolved into a life-threatening situation.
Many manufacturers that have recently introduced an Internet channel appear to have adopted a price-matching policy. Our model indicates that strategy is reasonable for the manufacturer only as long as the Internet channel is significantly less convenient for most customers than the traditional retail channel. If the Internet channel, on average, becomes as convenient as, or more convenient than, the traditional channel and the manufacturer then decides to undercut prices, its profit gains will come at the traditional retailer’s expense. This phenomenon can already be seen in the travel industry and is increasingly observed in the music, software and video download markets.
In general, although retailers can benefit from a manufacturer’s introduction of a direct channel, they should be wary of the long-term ramifications. Retailers might do well to monitor the success and convenience of a manufacturer’s channel to gauge if the manufacturer will have increasing incentive to cut prices and become a dangerous competitor. One defensive strategy for retailers is to increase the quality of the purchase experiences they offer in ways that are difficult for the direct channel to match. This could include a greater emphasis on in-store environment or on adding services.