Implications of Product Substitutability in a Distribution Channel

This paper examines the effect of product substitutability on the equilibrium profits in a distribution channel, where two symmetric manufacturers sell substitutable products to consumers through a non-exclusive retailer. Conventional wisdom suggests that the retailer will be better off while the manufacturers will be worse off, the more substitutable are the manufacturers’ products, owing to the competition effect of substitutability. By contrast, we identify the hitherto neglected demand effect of substitutability that could alter this result. As products become more substitutable, upstream competition is intensified but the demand may expand. In a Manufacturer-Stackelberg game facing a class of aggregate demand functions with a constant product substitutability, we show that the interests of the retailer and manufacturers can be aligned in terms of product substitutability. Surprisingly, the conventional result can be even completely reversed such that the manufacturers benefit from a certain level of substitutability. In the extensions, we examine alternative utility-based Hotelling model and different bargaining power balance, respectively, further validating the important role of demand effect. For example, as the retailer gains more bargaining power under linear demands, the (negative) demand effect can overshadow the (positive) competition effect such that a higher degree of substitutability could actually hurt the retailer. Our findings have substantive implications for persuasive advertising and category management.