Pricing in Marketing Channels†

K. Sudhir
Sumon Datta

Yale School of Management

†
We thank the editor Vithala Rao and Jiwoong Shin for comments and suggestions on the paper.
 Pricing in Marketing Channels
Abstract

This paper provides a critical review of research on pricing within a channel

environment. We first describe the literature in terms of increasing time horizons of decision
making in a channel setting: (1) retail pass-through (2) pricing contracts and (3) channel design;
all of which occur within a given market environment. We then describe the emerging empirical
literature on structural econometric models of channels and its use in (1) inferring channel
participant behavior and (2) policy simulations in a channel setting. We also discuss potential
areas for future research in each area.
 Pricing in Marketing Channels

“Price” and “Channel” are two of the four elements of the marketing mix that managers
control, yet they differ fundamentally in how managers can use them to impact market demand.
While price is the most flexible, in that managers can change it most easily to impact short-run
demand, the distribution channel through which firms reach their end consumer is the least
flexible and perhaps the costliest to change in the short run. Therefore, channel design is viewed
as part of a firm’s long run strategy. Most importantly, in the presence of a typically
decentralized distribution channel, an upstream price change by a manufacturer does not affect
consumer demand directly, but only through how this upstream price change affects the retail
price set downstream in the channel.
In his review of the pricing literature, Rao (1984) stated that “the issues of pricing along
the distribution channel… have not received much attention in the literature.” However, over the
last 25 years, this gap has been remedied substantially. The tools of game theory have
revolutionized the theoretical analysis of pricing within the channel and clarified the many issues
about how prices are set within a channel; more importantly, these analyses have given insights
on the optimal long-term channel strategy, given how prices will be set within the channel. A
smaller but emerging empirical literature on structural models of channels has provided us
insights on the behavior of channel participants and tools to perform policy analysis in a channel
setting. The purpose of this article is to provide a critical review of this literature, identify the
key themes of understanding that have emerged from research to-date and to identify important
gaps in our knowledge that would benefit from future research.
Given the short-run nature of price and the long-run nature of the channel, we organize
the literature in terms of three key issues of managerial interest that progressively increase in
their time horizons for the decision. The three sets of questions are:
1. Conditional on the distribution channel (which is fixed in the short run) and other market
characteristics, how can a change in upstream price affect the downstream price seen by the
end consumer? This question of “pass-through” is the most short-term of the three sets of
decisions we consider. Pass-through is of interest to an upstream manager because it
determines the extent to which the upstream manufacturer will change prices.
2. Conditional on the distribution channel (which is fixed in the short run) and other market
characteristics, what is the best pricing contract to offer to the downstream channel member?
This is a medium term decision, where managers set the “rules of their interactions” within
the existing channel structure. These contracts affect the objective function of the market
participants; and managers seek contracts that maximize their profits given a chosen channel
structure. Pricing contracts can include linear tariffs, two part-tariffs, quantity discounts,
slotting allowances, resale price maintenance (RPM) etc. Note that the types of pricing
contracts that can be used may be constrained by law.
3. Finally, given the market characteristics, what is the optimal channel structure and the
pricing contract? This is a long-term decision where managers decide on the nature of
channel ownership given the market characteristics. Should a firm vertically integrate or
decentralize? Or would a mixed strategy of partial integration, with the manufacturer directly
selling along with independent retailers be optimal? The emergence of the Internet as a sales
channel has brought the issue of partial forward integration again into focus in recent years.
Since the optimality of the channel structure would depend on the nature of pricing contracts
that would be available to the manufacturer, channel structure design is intimately linked to
the pricing strategy.
Finally, all of these decisions are embedded in the market environment in which the firms
operate. A schematic way about thinking about these three sets of managerial decisions
embedded within a market environment is given in figure 1, where we have laid out each of these
questions within concentric circles. The answers to the pass-through questions are linked to the
pricing contracts, which are in turn linked to the questions about channel design, which in turn
are linked to the market environment in which the firms operate. Since no one paper can exhaust
all possible combinations within the above framework to give us a complete understanding of the
tradeoffs involved, one objective of this article is to identify generalizable themes across multiple
papers that model different combinations of market environments, channel structures and pricing
contracts. This exercise should also help us identify key gaps in the literature.
We also describe the complementary empirical literature on structural models of channels
that have emerged over the last decade. Such models serve to (1) describe manufacturer-retailer
interactions that best describe the market and (2) perform policy analysis of various channel
decisions.

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 Market Environment

Channel Design

Pricing Contracts

Pass-through

Figure 1: Pricing Within a Channel: Key Issues

Section 2 describes a basic game-theoretic model of channels to illustrate the key modeling
issues. Section 3 discusses the pass-through literature, Section 4 discusses the pricing contracts
and Section 5 discusses the literature on optimal channel structures. Section 6 reviews the
literature on structural econometric models. Section 7 concludes.

2. An Illustrative Game-Theoretic Model of Channels: The Bilateral Monopoly

McGuire and Staelin (1983) laid the foundation for game theoretic analysis of channels in
marketing. At the heart of the channel pricing game-theoretic literature is the concept of double
marginalization (Spengler 1950). The concept is applicable whenever there are multiple decision
makers setting prices in stages; but to make the idea concrete we illustrate double
marginalization in the simplest setting of a bilateral monopoly.
Consider the following bilateral monopoly setting as shown in Figure 2: a manufacturer
who produces at a unit cost c, sets a wholesale price w to his retailer who in turn sets a retail
price p to the consumer. Consumer demand follows a linear demand model: q = 1 − p .

3
 c

Figure 2: A Model of Bilateral Monopoly

Given the sequential nature of the game, we solve for the optimal retail and wholesale
prices by backward induction. We begin by choosing retail price p to maximize the retailer’s
objective function: Π R = ( p − w)q ( p ) = ( p − w)(1 − p ) . Taking the first order conditions with

∂Π R 1+ w
respect to p, gives = 1+ w − 2 p = 0 ⇒ p = . Therefore retail pass-through measured in
∂p 2
∂p 1
this model is given by = .
∂w 2
The manufacturer then chooses wholesale price w to maximize the manufacturer’s
⎛ 1+ w ⎞ ⎛ 1− w ⎞
objective function: Π M = ( w − c) q( p( w)) = ( w − c) ⎜ 1 − ⎟ = ( w − c) ⎜ ⎟ . Taking the first
⎝ 2 ⎠ ⎝ 2 ⎠
∂Π M 1 + c − 2w 1+ c
order conditions with respect to w, gives = =0⇒ w= . Hence retail price is:
∂w 2 2
1 1+ c 3 + c
p= + = .
2 4 4
At the chosen retail and wholesale prices, the manufacturer and retailer profits are:
⎛ 1 − c ⎞ ⎛ 1 − c ⎞ (1 − c) ⎛ 1 − c ⎞ ⎛ 1 − c ⎞ (1 − c)
2 2
ΠM = ⎜ ⎟⎜ ⎟ = ; Π R
= ⎜ ⎟⎜ ⎟ = . The total channel profits is
⎝ 2 ⎠⎝ 4 ⎠ 8 ⎝ 4 ⎠⎝ 4 ⎠ 16
3
ΠM + ΠR = (1 − c) 2 .
16
As a point of comparison, it is useful to compare the retail prices and total channel profits
if the manufacturer owned the retailer and set the final retail price. In that case, the
manufacturer’s (or the channel’s) optimal price is obtained by maximizing

4
Π c = ( p − c)q( p) = ( p − c)(1 − p) . Taking the first order conditions with respect to p, gives

∂Π c 1+ c (1 − c) 2
= 1+ c − 2 p = 0 ⇒ p = . The total channel profit is given by: Π c = . The total
∂p 2 4
profit from the vertically integrated channel is therefore greater than profit from the
decentralized channel.
The key takeaways from the above model are: First, price in the vertically integrated
channel is lower than the price in the decentralized channel; i.e., in the decentralized channel the
retail price is distorted upward from the price that would be observed in the integrated channel.
At each stage the monopolist marks up the price; therefore in the integrated channel, there is only
one monopoly markup, while there are two markups in the channel (one by the manufacturer and
one by the retailer). This “double markup” is referred to as the “double marginalization” and
lends itself to the joke: “From the consumer’s point of view, what is worse than a monopoly? A
chain of monopolies.” Second, the total channel profit with vertical integration is greater than
the profits in the decentralized channel; therefore in this case, it would be optimal for the
∂p 1
manufacturer to set up an integrated channel if it were feasible. Finally, given that = in
∂w 2
equilibrium, only 50% of the change in wholesale prices is passed through to the consumer.
In this model, we allowed for only a linear price contract between the manufacturer and
the retailer. Suppose the manufacturer could use another contract such as a two part-tariff, where
the retailer pays not only a unit cost, but also a fixed fee. In such a scenario, it is easy to see from
the earlier analysis that the optimal strategy for the manufacturer would be to set the wholesale
price at the manufacturer’s marginal cost c, and the retailer would set the price at the vertically
1+ c
integrated retail price of . The manufacturer can then extract the entire profits that would
2
(1 − c) 2
result in the form of fixed fees. Thus using a two-part tariff, the manufacturer can obtain
4
the vertically integrated channel outcome, without having to integrate the channel.
The above illustrative model outlines the issues involved in the three managerial
questions raised in the introduction. First, the pass-through with either a linear contact or two-
part tariff is 50%. Second, the optimal pricing contract for the manufacturer between a unit price
and two-part tariff is the two-part tariff. Finally, the profit from the vertically integrated channel

5
and the bilateral monopoly structure is identical for the manufacturer when allowing for both a
linear price contract and two-part tariff. But if the manufacturer is restricted to a linear price
contract, the total channel profit is greater with a vertically integrated structure.
In the bilateral monopoly model above, a single manufacturer sold a single product at a
linear unit price to a single retailer, who in turn sold only that product to the end customer. The
demand was modeled using a linear demand model. It was also deterministic and, so there was
no uncertainty about the market demand. Finally, manufacturers and retailers had no ability to
affect demand, except through the change in price.
Markets of course can differ on every one of these dimensions described above. For
instance, there could be competition among manufacturers, and competition among retailers.
Each manufacturer or retailer could sell more than one product. Market participants may use
objectives such as category profit maximization or only choose to maximize profits of any given
product without considering the externalities on other products.
Rather a linear price, the manufacturers could use other pricing contracts. Examples
include nonlinear quantity discounts and two part-tariffs, which is common among franchisers.
They could also impose a maximum retail price that retailers can charge, i.e., employ resale price
maintenance (RPM). In the short-term, they could also offer trade promotions or slotting
allowances which involve transfers from manufacturers to the retailer.
Finally, uncertainty in demand can be important. If, manufacturers and retailers can affect
demand through their actions such as better service, then in the presence of demand uncertainty,
the issue of whether participants put in the optimal level of effort to create demand becomes a
challenge. The issues of moral hazard and free-riding in terms of services at both the
manufacturer and retailer level becomes critical. Researchers have also observed that the
functional form used to model demand affects retail pass-through and optimal equilibrium
strategies. Indeed, the range of possible institutional and market characteristics is very large. We
summarize the key characteristics that have been modeled in current research in the table below.
Channel Manufacturers ƒ Monopoly/Competition
Structure ƒ Single/Multiple products
ƒ Observability of actions
Retailer ƒ Monopoly/Competition/Provision of Exclusive Territories
ƒ Single/Multiple products/Provision of Exclusive Dealing
ƒ Observability of actions/Types
Pricing ƒ Linear Pricing

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Contracts ƒ Two Part Tariffs
ƒ Quantity Discount
ƒ Resale Price Maintenance
ƒ Trade Promotions
ƒ Slotting Allowances
Market ƒ Deterministic versus Uncertain Demand
Environment ƒ Relative power between manufacturers and retailers
ƒ Presence of store brands
ƒ Appropriate model of demand: linear, logit, exponential etc.

3. Retail Pass-through
The theoretical literature on pass-through follows two broad streams. The first stream
assumes that manufacturers change wholesale prices in response to changing demand and cost
conditions (e.g., Moorthy 2005). The second is based on the price discrimination motive; here
trade promotions serve to price discriminate between price sensitive and brand-loyal customers
(e.g., Lal and Villas-Boas 1998). In practice, both reasons coexist in the market. Empirical
research typically has not drawn a distinction between the different reasons.
3.1. Models where wholesale price changes due to changes in demand and costs
As in our illustrative example in Section 2, own pass-through for a product, ‘j’, is
∂p j
typically measured using the comparative static (e.g., Tyagi 1999; Sudhir 2001; Moorthy
∂w j

2005). With multiple products, the extent to which a retailer changes the price of another product
‘i’ in response to a wholesale price change for product, ‘j’, is termed cross pass-through and is
∂pi
operationalized as .
∂w j

The literature has highlighted five factors that affect pass-through: (1) Retailer
objective/pricing rule (2) Demand characteristics (3) manufacturer-retailer interaction (4)
manufacturer competition and (5) retail competition. We organize the discussion of the results
along these factors. Table 2 provides a summary of the key results in the literature.
Depending on the retailer’s sophistication, a retailer may use a simple mark-up rule (a
constant mark-up would imply 100% own pass-through and 0% cross pass-through) or maximize
profits. The theoretical literature on pass-through is based on the assumption that the retailer
maximizes a profit objective. Retailers may maximize brand profits, category profits, or when
cross-category effects are important, maximize profits across categories.

7
 A profit-maximizing retailer sets the retail price where marginal cost equals marginal
revenue. A reduction in the wholesale price reduces the retailer’s marginal cost, and therefore, it
must reduce its price to reduce its marginal revenue by the same amount. As the responsiveness
of the marginal revenue to a change in retail price depends on the concavity of the demand
function, the change in retail price corresponding to a change in wholesale price, or the pass-
through, depends on the functional form of demand (Lee and Staelin 1997; Tyagi 1999a).1
Lee and Staelin create a typology of vertical strategic interactions between channel
∂pi
members with pass-through between 0 and 100% ( 0 < < 1 which they refer to as vertical
∂wi
∂pi
strategic substitutability), pass-through over 100% ( > 1 , vertical strategic complementarity)
∂wi
∂pi
and pass-through of 100% ( = 0 ,vertical strategic independence). Tyagi characterizes
∂wi
demand functions with pass-through greater than or below 100% in terms of the convexity of the
demand curve. While standard demand functions, such as the linear and the logit (or any concave
function) lead to vertical strategic substitutes, the multiplicative demand function (and other, but
not all, convex demand functions) leads to vertical strategic complements (also see Sudhir,
2001). When a retailer carrying multiple products maximizes category profits, the magnitude of
own pass-through is independent of the product’s market share in a linear demand specification
(Shugan and Desiraju, 2001) but is inversely proportional to own share in a logit demand
specification (Sudhir, 2001).
The level of competition between manufacturers (or products from the same
manufacturer) affects cross pass-through. Shugan and Desiraju (2001) show that with a linear
demand function the cross pass-through depends on the substitutability of the products. If the
cross-price slopes are asymmetric, then cross pass-through will be positive for one product and
negative for the other, depending on the direction of asymmetry.
In terms of the effect of manufacturer-retailer relationship on pass-through, the three
common relationships studied are: (1) Manufacturer-Stackelberg, where the manufacturers set
the wholesale prices and then the retailer takes these wholesale prices as given when setting the
retail price, (2) Vertical Nash, where manufacturers and retailers set prices simultaneously and

1
See Tyagi (1999a) for a more detailed explanation as to how the demand function influences pass-through.

8
(3) Retailer-Stackelberg, where retailer sets the retail price and the manufacturer then responds
with a wholesale price.
Finally, Moorthy (2005) extends the pass-through results to the case of competing
retailers (see also Basuroy et al. 2001). Moorthy studies both the linear and nested logit model,2
and arrives at a large number of results on pass-through and cross pass-through. For the nested
logit model, which brand gets a greater pass-through from a retailer depends not so much on its
strength vis-à-vis the other brand (as in Sudhir, 2001), but rather on the relative strengths of the
brands at the two retailers. In particular, he finds that pass-through at a retailer for the nested
logit model can be greater than or less than 100%, depending on whether the brand has lower or
greater market share at that retailer.
Moorthy’s results show that pass-through for a brand is linked to the extent of retail
competition in the market. If retail competition is limited as is probably true in categories which
are not major drivers of store traffic, one can use the predictions of the single retailer models. For
categories that drive store traffic, retail competition can be critically important, and therefore the
extent of pass-through needs to consider relative brand strengths at the retailers.
Cross pass-through also depends on the extent of retail competition (see Table 2 for key
results). Moorthy also discusses the cases when wholesale price changes are retailer specific or
common across retailers. When wholesale price changes are retailer specific, own pass-through
is less than 100% and cross pass-through is always negative. But when wholesale price changes
are common, cross pass-through can be positive or negative. These differences in results,
suggests intriguing possibilities about how manufacturers should time trade deals (synchronously
or asynchronously) to different retail chains within the market.
3.2. Models where wholesale price changes induce price discrimination
Varian (1980) and Narasimhan (1988) introduce models which seek to discriminate
between brand-loyal and price sensitive customers through promotions. In these models,
promotions are characterized as mixed-strategy equilibria. Hence, wholesale prices may change
with the motive of price discrimination and not necessarily as a result of changes in demand or
costs. In contrast to the models that are concerned with demand functional forms (or models like
the Hotelling model that generate linear demands), the analytical literature on price
discrimination explicitly model consumer segments in terms of their price sensitivity and loyalty.

2
In the nested model, consumers make a retailer choice in the first stage and a brand choice in the second stage.

9
 Lal and Villas-Boas (1998) study price promotions in the context of two competing
retailers. Consumers may be loyal to manufacturers, retailers, both or none. A retailer is
guaranteed retailer-loyal customers (denoted by R) and the brand-retailer-loyal customers who
are committed to the brand (manufacturer) and the retailer (MR). But the retailer has to compete
for brand or manufacturer loyal customers (M) who are not loyal to a particular retailer and the
completely price sensitive customer group who are neither loyal to a brand nor to a retailer (S).
Whether to promote a high priced brand is based on the relative ratio of the customers the retailer
has to fight for (M), relative to the guaranteed customers (MR). In contrast, the decision to
promote a low priced brand is based on the relative ratio of the customers the retailer has to fight
for (M+S), relative to the guaranteed customers (MR+R). The main insight of the paper is that
M M +S
the retailer has the incentive to promote the higher priced brand when > .
MR MR + R
Thus the decision to pass-through a trade deal for the retailer is based on both the extent
of retailer and brand loyalty. Interestingly, retailer loyalty has the opposite effect of brand
loyalty. Greater brand loyalty allows greater pass-through, while greater retailer loyalty reduces
pass-through. Note that these results about how brand loyalty affects pass-through are critically
dependent on retail competition. If there were no retail competition, then brand loyalty will not
lead to greater pass-through, because the retailer will find the brand loyal customer to be captive
and only the price sensitive customer needs to be wooed by price promotions.
Kumar, Rajiv and Jeuland (2001) suggest that information asymmetry between customers
and firms might be a reason for low pass-through. In a model where customers differ in their
valuations and have search costs to find the lowest price, they argue that retailers will pass-
through a trade promotion only probabilistically in a mixed strategy equilibrium. This is because
in any given week, the consumer may not know if a better price may be available at another
retailer who may pass-through the trade promotion. The authors show that manufacturers can
increase pass-through by advertising to consumers their trade promotions. This relationship
between asymmetry and pass-through is consistent with the findings in Busse, Silva-Risso and
Zettelmeyer (2006), who show that pass-through increases when asymmetric information is
reduced in the context of trade promotions versus consumer promotions in the car market.
Another suggestion about how to improve pass-through is provided in Gerstner and Hess
(1991, 1995). They show that manufacturers can use consumer rebates (pull promotion), targeted

10
towards the low valuation segment, in combination with trade promotions (push promotions) to
improve pass-through. Consumer promotions increase the low valuation segment’s willingness
to pay. This encourages retailers to participate in trade promotions and serve this segment. Also,
consumers are better off with retail price reductions motivated by trade promotions than with
large consumer rebates alone. With only consumer rebates, the retailer increases the retail price
by the value of the rebate so that the consumer has to pay a higher price in addition to the
transaction cost of using the rebate.
3.3 Empirical Results on Pass-through
Empirical research on pass-through has mostly been on grocery markets, because of the
availability of data. Theoretical models show that pass-through is affected by retail competition.
But for groceries, even though there is retail competition at the basket level (Bell, Ho and Tang
1998; Gauri, Sudhir and Talukdar 2007), retail competition is not as strong at the individual
product level (Walters and Mackenzie 1988). Hence a significant body of empirical research on
pass-through has assumed a monopoly retailer.
Based on research in Chevalier and Curhan (1976), Curhan and Kopp (1987/88), Walters
(1989) and Blattberg and Neslin (1990), Blattberg, Breisch and Fox (1995) conclude that the
finding, “pass-through rates are less than 100%”, is an empirical generalization. However,
Armstrong (1991), Walters (1989) and Besanko, Dube and Gupta (2005) find that pass-through
rates can be greater than 100% for certain products. While Armstrong and Walters use a
multiplicative functional form for demand (which, as we discussed earlier, leads to greater than
100% pass-through), Besanko et al. estimate a reduced-form regression for pass-through across
products in several categories without making any assumptions about the functional form of
demand or retailers’ objectives (category or brand profit maximization). For a single store chain,
they find that pass-through rates are greater than 100% for 14% of the products. In most
categories, brands with larger market shares get greater pass-through, suggesting the effect of
differences in manufacturers’ bargaining power on pass-through. Pass-through rates are also
found to be greater in markets with older and more ethnic populations and in markets with larger
households and greater home values. This may be an evidence for the findings of Lal and Villas-
Boas (1998) if consumers in these markets have low retailer loyalty.
Does retail competition affect pass-through? Besanko et al., find that distance from the
competitor does not affect pass-through. While one possible interpretation of this result is that

11
retail competition has no impact on pass-through, the more likely explanation is that retailers of
the same store chain do not adjust their prices across stores because of practical difficulties of
having different specials at different stores. In fact, Besanko et al. find that only 2% of their pass-
through variations can be explained by price zones. But the result that brands with greater market
shares have greater pass-through offer indirect support for the role of retail competition. If
market shares are correlated with strong brand loyalty, then the result that brands with stronger
market share get greater pass-through suggests that retailers do consider retail competition when
deciding on pass-through (See the discussion on Lal and Villas-Boas, 1998). Alternatively, this
could be because the retail chain is weaker on the brands with the larger market share (Moorthy
2005). Additional research needs to resolve these alternative reasons for the empirical results.
How do retailer objectives affect pass-through? The retailer objective affects the
magnitudes of own and cross pass-through, and, in case of a logit demand specification, even the
sign of the cross pass-through. Sudhir (2001) shows that, without retail competition, the cross
pass-through is negative for category profit maximization and positive for brand profit
maximization. He finds that category profit maximization by the retailer fits the price data better
than brand profit maximization for the analyzed categories. Basuroy et al. (2001) evaluate how
pricing behavior changed when a retailer shifted from a brand management to a category
management behavior. They find that retail pricing in terms of own and cross pass-through
changed in a manner predicted by the theory, suggesting that a manufacturer should take into
account the retailer’s price setting rules when setting optimal wholesale prices.
A retailer could strategically vary its pricing strategy over high and regular demand
periods. Chevalier et al., (2003) show that retail margins for specific goods fall during peak
demand periods for that good. Meza and Sudhir (2006) account for the differences in levels of
demand and price sensitivity between regular and high demand periods and show that pass-
through varies over the year and the average measures of pass-through for the entire year may be
misleading. They use two categories: tuna, which has peak demand during Lent, and beer, which
has peak demand during holiday and major sports weekends, to study differences in pass-through
between high and low demand periods. They find an interesting difference between the two
categories. Tuna’s peak demand is not correlated with peak purchases in other complementary
categories. Hence, while a tuna promotion can draw customers into the store, it does not provide
much spillover benefits. In contrast, peak beer demand is correlated with peak purchases in

12
complementary high margin categories such as snacks. Hence the benefit of passing through
promotions is greater for beer than for tuna during peak periods and accordingly pass-through is
greater for beer than for tuna during peak demand. Further, they find that retailers follow a
narrow but deep pass-through strategy (only pass-through for the most popular size/brand “pull
items”) in regular periods, but a broad but shallow pass-through strategy (lower but similar pass-
through for all items) in peak periods.
With respect to cross pass-through, Besanko, Dube and Gupta (2005) find that about two-
thirds of the cross pass-through effects are statistically different from zero. Slightly more than a
third of these effects are negative, while slightly less than a third of these effects are positive.
However, McAlister (2007) shows that these significant effects do not exist once we account for
the high correlation in prices (0.9) across the stores in the data. Essentially, she argues that these
significant effects are an artifact of the additional degrees of freedom due to using repeated price
observations at the zone level (that do not vary independently over time). Hence further research
is required on cross pass-through effects. One possibility as to why the cross pass-through effects
are insignificant could be because extant pass-through research has not included prices from
competing retailers in the model (as argued by Moorthy 2005). Future research needs to study
cross pass-through effects in greater detail.
Busse, Silva-Risso and Zettelmeyer (2006) show support for the information asymmetry
effect on pass-through in the car market and may be considered indirect support for the findings
of Kumar, Rajiv and Jeuland (2001). They show that consumers obtain about 70-90% of the
value of a consumer rebate, while they get only about 30-40% of a dealer promotion. As the
authors acknowledge, the result is also consistent with a prospect theory argument. When
consumers see a consumer promotion, the reference price shifts downwards, but with a trade
promotion, the consumer is unaware of the price discount and the reference price is not affected.
This differential effect on consumers’ reference prices may explain the differences in pass-
through. Future research needs to separate the role of consumer reference point effects and
information asymmetry on pass-through.
3.4. Future Research
In practice, price discrimination and demand and cost changes both affect wholesale
prices. The extant analytical literature on pass-through has studied these cases separately, but it
would be worthwhile to see how the predictions might change when both of these effects coexist

13
as in real markets. This can help create better hypotheses of pass-through in future research. In
terms of empirical research, structural models that simultaneously develop both the demand side
and the supply side (e.g., Villas-Boas and Zhao, 2005), could potentially incorporate
heterogeneity in consumers’ price sensitivity or brand and retailer loyalty, and thus tie in the
price discrimination motive along with cost changes on the supply side. As we discuss in a
subsequent section, a structural model to this effect would not only enable us to test some of the
theoretical predictions but would also allow us to perform counterfactual simulations to
understand channel member reactions and their impacts under different scenarios.
There are a number of issues that are important to address in empirical research on pass-
through. Some issues are: (1) How does retail competition affect pass-through? (2) How does
demand specification (brand/retailer loyalty; functional forms etc.) affect pass-through? (3) How
does pass-through behavior vary across categories? (4) How does pass-through change over
time? (5) How is pass-through measured? (6) How does pass-through behavior differ across
types of trade promotions?
Moorthy (2005) and Lal and Villas-Boas (1998) have shown how pass-through is
critically dependent on the extent of retail competition. Empirical research on pass-through has
mostly assumed that retail competition is not strong at the individual product level (Walters and
Mackenzie 1988). Further, data from multiple competing retailers is hard to obtain. Hence,
empirical evidence for the effects of competition is scarce. However, there could be variations in
shopping behavior, across categories within consumers’ shopping basket. For example, a
consumer might buy her produce from the same retailer always but might search across retailers
for best prices on paper goods. Such category-based consumer shopping behavior would be
critical for a retailer whose objective is to maximize profits across categories. The issue of share-
of-wallet across retailers and its influence on pass-through, for different categories and different
retail formats, has not been sufficiently explored. Such analysis would of course require a rich
data set that has information on consumer behavior at a disaggregate level and across retail
chains and retail formats. Future research needs to closely investigate the implications of retail
competition either directly, by acquiring data across competing retailers, or indirectly, by
appropriately approximating retail competition in terms of geographical locations of consumers
and retail stores of the same or different formats in the market.

14
 For retail competition it is important to consider the differences in retail formats. On the
cost side or the supply side, this is important because manufacturers could use non-linear pricing
contracts (as we discuss in the next section) which could result in different marginal costs for
different retailers and hence, different pass-through behaviors. In addition, manufacturers could
time trade deals synchronously or asynchronously to different retailers which has different
implications for pass-through (Moorthy, 2005). Also, as we have seen, pass-through varies over
regular and peak demand periods. The extant literature on pass-through has assumed that the
manufacturer and the retailer marginal costs are independent of order quantities and order
frequencies. If the operating costs of the manufacturer and the retailer are misaligned, or if they
are different for different retailers (as may be the case for supermarkets versus club stores), it
could have implications for pass-through when demand varies over time.
On the demand side, brand and retailer loyalty and competition could vary across store
formats. For example, consumers who tend to visit supermarkets may be less price sensitive, and
more retailer or brand loyal, whereas consumers who frequent discount stores or Club stores
could be more price sensitive, and less retailer and brand loyal. There could be such idiosyncratic
differences in consumers across retail formats because of the different assortment of products in
different store formats or because of their different pricing policies (e.g., small pack sizes versus
bulk quantities and Hi-Lo versus EDLP). This could have some interesting implications for the
nature of competition between different formats and the resulting pass-through behavior across
retail formats and brands. Further, retailer and brand loyalty may differ over time as infrequent
customers enter markets in peak periods. Systematic research needs to be done across store
formats and time to test some of the existing theories and to present managers with descriptive
insights about pass-through. For instance, most store chains have a loyalty program. Analysis of
store loyalty card data, in conjunction with the overall sales data, could be used to test some of
the conclusions in Lal and Villas-Boas (1998).
As the analytical literature has shown, results on pass-through are conditional on the
demand functional forms. Hence, adopting specific structural models in empirical research could
impose specific constraints on possible pass-through rates. A systematic investigation of which
functional forms are supported in the pricing and pass-through data in a given setting can be
useful to understand which models should be used for decision support systems for setting
wholesale and retail prices.

15
 Pass-through has been measured in many ways. Much of the theoretical literature has
∂pi
focused on the comparative static to study pass-through (e.g., Tyagi 1999), while others
∂wi
have looked at the proportion of trade deals passed through (Kumar et al. 2001). In the context of
forward buying and consumer stockpiling, one may need a different definition of pass-through
such as the fraction of the total discount that gets passed through to the consumer. Meza and
Sudhir (2006) show that using the weighted average wholesale price (rather than the true current
promotional price) gets us closer to a true estimate of pass-through in the presence of forward
buying and stockpiling than the actual prices. Testing this using data on true marginal wholesale
price and actual shipping data as in Abraham and Lodish (1987) and Blattberg and Levin (1987)
would be useful validation of extant research using readily available weighted average wholesale
price.
Lal, Little and Villas-Boas (1996) study forward buying, merchandising and trade deals
in a single retailer context. They find that while such forward buying reduces pass-through for
manufacturers, it is beneficial for manufacturers because it reduces competition among them.
Future research should look at how these effects manifest in terms of pass-through when there is
retail competition.
Pass-through research has mostly been on grocery markets. It is obvious that there are
interesting issues in the context of durable goods, services, industrial buying situations etc. As
discussed earlier, Busse et al. (2006) is an exception. Bruce, Desai and Staelin (2005) note that
that secondary markets matter with durable goods. They find that trade promotions can mitigate
the double marginalization problem better for manufacturers of more durable goods. In their
model, retailers do not compete with each other. Hence, how these results translate in markets
with retail competition needs to be investigated.
Much research on pass-through is based on off-invoices, with unconditional wholesale
price reductions. Gomez, McLaughlin and Rao (2007) study different types of trade deals. They
find that only 25.9% of discounts are off-invoices. Scan-backs and accruals (31%) are negotiated
with retailers; these require retailers to attain a quantity level to get the allowance. Scanbacks and
accruals may therefore be considered similar to a quantity discount in terms of our discussion of
pricing contracts below. Billbacks (3.1%) are similar to scanbacks, but based on items that are
purchased, not sold and therefore leaves open the option for forward buying. A systematic

16
investigation of how pass-through changes when different pricing contracts are used would be
very useful areas of research.

4. Optimal Pricing Contracts

Manufacturers (or upstream firms) can decide the pricing contract they offer to the
retailer (or downstream firm). Researchers have evaluated a number of pricing contracts such as
linear wholesale price, quantity discounts, two part-tariffs and resale price maintenance.
Typically, the upstream manufacturer structures the pricing contract in a way that is most
profitable for it. When the upstream firm does not have the power (for example with large
retailers), either the downstream player will set the terms of pricing contract or it may be an
outcome of bargaining negotiations.
4.1 Linear Wholesale Prices
The simplest and most common pricing contract is the linear wholesale price. This leads
to the familiar double marginalization problem discussed in the illustrative example of Section 2.
The double marginalization problem results in lower total channel profits (the size of the pie)
than what it could have been under channel coordination. A long stream of literature on channels
of distribution has emphasized on pricing contracts where the double marginalization problem
can be minimized and the channel can be coordinated3. We discuss these contracts below.
4.2 Quantity Discounts and Two Part Tariffs
Quantity discounts and two-part tariffs can coordinate the channel. With quantity
discounts, the per-unit costs to the retailer fall with quantity purchases. Jeuland and Shugan
(1983) show that quantity discounts can be used as a means by which a manufacturer can
coordinate the channel in a bilateral monopoly setting.
Moorthy (1987) argues that the Jeuland-Shugan quantity-discount coordination requires
only that the retailer’s marginal cost equal the marginal revenue at the channel’s optimal
quantity; its value at quantities other than the channel’s optimal quantity can be almost anything.
This leeway in choosing the retailer’s effective marginal cost away from the channels’ optimal
quantity leads to a variety of potential pricing schemes (e.g., two-part tariff) that can also be
optimal. In a two-part tariff, the retailer makes a fixed payment and pays a per-unit charge for the

3
Channel coordination can also be brought about by non-pricing mechanisms. For a simple bilateral monopoly case,
Shugan (1985) shows that implicit understandings between channel members can be a partial substitute for formal
agreements. Also see Fugate et al., (2006) for a discussion on the different types of coordination mechanisms.

17
product. The fixed fee and the per-unit charge are set such that the sales volume and total profit
of the channel members is the same as when maximizing total channel profit. For instance, in the
bilateral monopoly model discussed in Section 2, the manufacturer can set the wholesale price
(w) equal to his marginal cost (c) and then extract the retailer’s profit completely with a fixed
fee. This will maximize total channel profit and also help the manufacturer maximize his profit.
Researchers have shown that two-part tariffs can be optimal in a wide range of market
scenarios such as (1) when retailers have to provide non-contractible services as with franchising
services with potential for moral hazard as in Lal (1990); (2) when retailers have to complement
the product with another input and then sell a composite output (Vernon and Graham 1971); (3)
when retailers carry a product line (Villas-Boas 1998); (4) when there is demand uncertainty
(e.g., Rey and Tirole 1986); (5) when manufacturers and retailers have private information (e.g.,
Desai and Srinivasan 1995; Tirole 1988, p.176).
Iyer and Villas-Boas (2003) however argue that two-part tariffs are not optimal if the
product is not completely specifiable. They show that in a model of bargaining between
manufacturers and retailers when products are not completely specifiable and demand is
uncertain (as is typical in almost all channel models, they also assume retail actions are
unobservable), two-part tariffs will not be a part of the market contract even in a simple one
manufacturer-one retailer channel. This is because the fixed fee in the two-part tariff does not
affect the opportunistic behavior on the part of the manufacturer and, therefore, will not be
accepted by the retailer. In their bargaining model, a linear wholesale price contract emerges as
the equilibrium outcome. They also note that empirically the use of two-part tariffs is
considerably small, despite prior findings in the theoretical literature about optimality of two-part
tariffs in a broad range of settings4.
When else might a two-part tariff or a quantity discount not work? Ingene and Parry
(1995a, 1995b, 1998, 2000) have studied the case of a manufacturer, setting a wholesale price
schedule for it’s retailers who differ in their demand and cost structures. They show that when
these non-identical retailers compete on price, channel coordination can still be achieved with an
appropriately specified quantity discount schedule but not with a simple two-part tariff. A
quantity discount scheduled can be designed such that, the effective marginal cost is different for

4
Through a laboratory experiment, Ho and Zhang (2007) show that, with a reference-dependent utility function,
retailers perceive the up-front fixed fee in a two-part tariff as a loss, and the subsequent sales proceeds as a gain.
Hence if retailers are loss averse, a two-part tariff may not be able to coordinate the channel.

18
different retailers, and is equal to their marginal revenue, given their differences. In contrast, a
two-part tariff offers each retailer the same per-unit charge. Since the Robinson-Patman Act does
not allow manufacturers to discriminate between different retailers by charging retailer-specific
wholesale prices, a menu of two-part tariffs, where retailers can select whichever tariff they
want, can overcome this legal problem, and also coordinate the channel. Interestingly, the
authors show that, from the perspective of a profit-maximizing manufacturer, a non-coordinating
“Sophisticated Stackelberg” two-part tariff, that simultaneously optimizes the per-unit fee and
the fixed fee, in light of the difference in retailers’ fixed costs, may be preferred over channel
coordination. The optimal pricing policy is dependent on (1) the retailers’ fixed costs, (2) the
relative size of the retailers, and (3) the degree of retail competition.
Models in marketing typically assume the manufacturer and retailer marginal costs as
constant and fixed. There is a literature at the interface of marketing and operations that
addresses optimal pricing contracts when it affects retailer operating costs. When the operating
costs of the retailer and the manufacturer are a function of the order quantities, the manufacturer
needs to motivate the retailer to choose both retail prices and order quantities that will
simultaneously maximize the retailer’s profit and the joint profit of the retailer and the
manufacturer (Weng 1995). A simple quantity discount cannot achieve this and the manufacturer
will have to use a fixed franchise fee in combination with the quantity discount. When a supplier
caters to multiple non-identical retailers, Chen, Federgruen and Zheng (2001) show that the
same optimum level of channel wide profits, as in a centralized system, can be achieved in a
decentralized system, but only if coordination is achieved via a unique wholesale pricing policy
– a periodically charged fixed fees, and a discount pricing scheme under which the discount
given to a retailer is the sum of three discount components based on the retailer’s (i) annual sales
volume, (ii) order quantity, and (iii) order frequency.
4.3 Resale Price Maintenance (RPM)
RPM is a method of vertical control where the upstream firm dictates pricing policies at
subsequent stages of the distribution channel. By setting a price ceiling (maximum RPM) the
upstream firm can control the retailer’s margin, so that it can eliminate the double
marginalization problem and reduce the retail price. Setting a price floor (minimum RPM) can
also achieve channel coordination by reducing price competition among retailers and diverting

19
competition into non-price dimensions such as service (Telser, 1960; Mathewson and Winter,
1984; Iyer, 1998) or product quality (Marvel and McCafferty, 1984)5.
The issue of RPM is pertinent in cases of demand uncertainty, information asymmetry,
and moral hazard – (1) When retailers have private information about an uncertain state of the
demand (Gal-Or, 1991); (2) Both the upstream and downstream firms make a non-price choice
(e.g., advertising, sales effort, etc.) subject to moral hazard – double or two-sided moral hazard
(Romano, 1994); and (3) When the manufacturer faces uncertain demand (Butz, 1997).
Iyer (1998) examines a channel with two symmetric retailers engaging in price and non-
price competition (e.g., provision of product information, after-sales service, etc.). Consumers
are heterogeneous in their locations (as in the spatial models of horizontal differentiation) and in
their willingness to pay for retail services (as in the models of vertical differentiation). When the
diversity in willingness to pay is relatively greater than locational differentiation, neither quantity
discounts nor a menu of two-part tariffs are sufficient to coordinate the channel. A complicated
menu of contractual mechanisms is necessary that can induce retail differentiation so that all
retailers don’t compete only for consumers with low willingness to pay (by engaging in price
competition) or only for consumers with high willingness to pay (by engaging in non-price
competition). An example of such a menu is one consisting of retail price restraints linked to
particular wholesale prices and fixed fees.
In general, RPM restricts the resellers’ freedom to set prices. Minimum RPM can be
anticompetitive by acting as a monitoring or an enforcing mechanism that facilitates collusion of
an upstream or downstream cartel or by facilitating third degree price discrimination by a
monopolistic manufacturer (Gilligan, 1986). Although maximum RPM is traditionally viewed as
reducing retail price,6 it could reduce consumer welfare by reducing the number of retailers
(Perry and Groff, 1985) or facilitate manufacturer opportunism, where in, it may drive prices
down enough so that the retailers almost fail and then the manufacturer may exploit such
retailers (Blair and Lafontaine, 1999). Hence, both forms of RPM are viewed unfavorably by the
U.S. Supreme Court.

5
On a different note, Perry and Porter (1990), show that minimum RPM can result in excessive retail service or
induce new entry because of the reduced price competition.
6
When manufacturer can set both a franchise fee and a wholesale price, Perry and Besanko (1991) show that the
traditional view that maximum RPM will lower retail prices and that minimum RPM will raise retail prices may be
reversed.

20
 Since 1911, and until recently, either form of RPM was per se illegal under Section 1 of
the Sherman Antitrust Act. This meant that a violation of Section 1 had been established once the
government or private plaintiff proved that the defendant manufacturer had implemented an
explicit or implicit plan to maintain a resale price. However, the last few years have seen legal
cases where a price maintenance agreement between an upstream supplier and a downstream
distributor is judged on its unique circumstances. In its State Oil Company, Petitioner V. Barkat
U. Khan and Khan & Associates, Inc. decision of 1997, the Court returned the antitrust treatment
of maximum RPM to the rule of reason so that now a defendant manufacturer can defend itself
by demonstrating that, in its case, maximum RPM has pro-competitive effects which benefit the
consumers (Roszkowski, 1999). More recently, in June 2007, the Supreme Court’s decision in
the Leegin Creative Leather Products Inc. V. PSKS Inc. established that courts should also
evaluate minimum RPM according to the rule of reason7.
4.4 Slotting Allowances
Unlike fixed fees that retailers pay to manufacturers in two-part tariffs, slotting
allowances are payments made by manufacturers to retailers. It includes a wide assortment of
fixed transfers from manufacturers to retailers that are not linked to quantities sold. These have
been variously called pay to stay fees, failure fees, premium shelf-placement fees, share of shelf-
space fees etc.
Sullivan (1997) argues that as cost of developing new products fall, more new products
are supplied; slotting allowances emerge as a means by which to ration shelf space efficiently to
the most profitable products. Another argument often used is that when shelf space is a scarce
resource, slotting allowances serve to shift the risk of failure from the retailers to the
manufacturer. This risk shifting becomes particularly important in the presence of private
information about the success of the product in the hands of the manufacturer. Lariviere and
Padmanabhan (1997) and Desai (2000) argue that slotting allowances are means by which
manufacturers signal to retailers their private information about the quality of their products.
Desai (2000) shows that slotting allowances can be pro-competitive as it serves to enhance
retailer participation because it reduces the demand uncertainty of retailers and increases their
profitability. But Shaffer (1991) argued that slotting allowances are anti-competitive because
they reduce retail competition and increase prices.

7
Source: Knowledge@Wharton, August 08, 2007.

21
 While Shaffer assumes that manufacturers are in a perfectly competitive market and
therefore have no power and the retailer sets the terms of trade, in Desai’s model, the
manufacturer sets the terms of trade. In both models, wholesale prices are higher in the presence
of slotting allowances. But with manufacturers setting the terms of trade and using slotting
allowances as a signaling device, the likelihood of slotting allowances falls when there is greater
market potential (as understood by both manufacturers and retailers). This is because retailers
find it worthwhile to participate in the market even without slotting allowances, when the market
is profitable. However, when the retailer seeks to exercise power, the retailer can extract the
manufacturers’ entire surplus through slotting allowances. Then slotting allowances should
increase with market potential.8
In terms of empirical research, Bloom et al. (2000) and Wilkie et al. (2002) use surveys
of manufacturers and retailers to identify key reasons for why slotting allowances are used.
However the results are inconclusive because retailers and manufacturers have somewhat
opposing views. Rao and Mahi (2003) survey manufacturers and retailers about each transaction
they were involved in. They find that slotting allowances increases with greater retailer power,
but acknowledge that the results may be due to their inability to control for manufacturer-retailer
power at the level of each transaction due to pooling transactions across a wide range of
manufacturers and retailers.
Sudhir and Rao (2006) use a database of all new products offered to a particular retailer,
some of which received slotting allowances and others that did not. By using such a universe of
accepted and non-accepted products, they are able to control for any potential issues of selection
involved in only using accepted products. They also had internal ratings data of retailer buyers
about the potential of success. This data enabled them to study which of the rationales are
supported in their data, by sidestepping the common problems of selection and levels of
information asymmetry for any new product. Broadly, Sudhir and Rao find support for the
efficiency rationales: opportunity costs, information asymmetry, signaling and retail
participation. They do not find support for the retail power and retail competition mitigation
(with an anti-competitive rationale) hypotheses.

8
Chu (1992) develops a screening model where retailers use slotting allowances to screen new products for their
potential. Again with this model where retailer has power, slotting allowances increase with the potential of the
product.

22
 Israelevich (2004) shows evidence based on a policy analysis using a structural model
that slotting allowances (pay to fees) serves to put products on retailer shelves that may not be
profitable purely through the revenues it generates for the retailer; thus slotting allowances may
serve to increase consumer variety. The question of whether other better products that could be
more in demand by consumers are being pushed out from the shelves due to slotting fees is yet to
be resolved.
Slotting allowances for existing products may also be given to enhance retailer
participation in activities like in-store service or merchandising. These allowances may be called
display allowances or advertising allowances and may fall under the broad rubric of slotting
allowances. Kim and Staelin (1999) show that with greater store substitutability, manufacturers
will “freely” give retailers side payments to increase merchandising. If a retailer passes through a
greater portion of these side payments to the consumer then the manufacturer increases the side
payment to this retailer. In addition, the competing retailers will react by lowering their retail
margin, and thus, regular retail price. The authors present comparative static results for how
changes in consumer sensitivity to pricing and promotional activities affect prices, side
payments, and both retailer and manufacturer profits.
4.5 Future Research
As we have seen, manufacturers might use any of the several possible pricing schemes or
they could even use a combination of pricing schemes. Future research needs to address (1) What
are the implications of different pricing contracts for pass-through? (2) How does retail
competition, manufacturer competition and the overall channel structure influence the choice of
pricing contract? (3) What combination of pricing schemes might be used under what market
situations?
Different pricing schemes would have different implications for how pass-through is
defined and measured. Specifically, when wholesale prices are not observed, the researcher
should be wary that with a non-linear pricing scheme, the marginal cost could be different for
different retailers which could, in turn, result in different pass-through behaviors across
competing retailers. Also, researchers should be cautious about using directly observed
wholesale prices if, say, side-payments or slotting allowances, which are not observed by the
researcher, change the effective wholesale price for the retailer. Inferring pass-through behavior

23
through a structural model that tests different hypothesis on the contracting and pricing
relationships between manufacturers and retailers could be one potential solution.
It would be interesting to see if retailers’ pass-through behavior might influence the
pricing contract set by manufacturers. While the causality between the pricing contract and the
pass-through behavior may be difficult to tease out, it is nonetheless interesting to explore this
issue. For instance, it is known that pass-through behavior changes between regular and peak
demand periods. What terms might a manufacturer want to incorporate in the pricing contract
(e.g., RPM) to guard itself against these variations? How might a manufacturer want to set the
contract differently when retailers’ objective is brand profit maximization versus when retailers’
objective is category profit maximization?
Heterogeneity among retailers (Ingene and Parry, 2000), and the relative bargaining
power of manufacturers and retailers (Iyer and Villas-Boas, 2003; Shaffer, 1991; Desai 2000)
have implications for the terms of the pricing contract. Different retail formats (Supermarkets
versus Discount stores or Club stores) carry different assortment of products and attract different
kinds of consumers and hence face very different demand structures. Hence, the bargaining
power of a retailer may not only depend on the extent of retail competition in the market but also
on the store format. Future research should analyze pricing contracts in the context of differences
in demand structures and bargaining power of competing retailer formats9.
Chen (2003) studies the situation where an upstream supplier uses two-part tariffs for its
downstream retailers which include a dominant retailer and competitive fringe retailers. The
dominant retailer is more efficient at a large scale of operation (i.e., it has a cost advantage). In
order to offset the reduction in profits caused by the rise in the dominant retailer’s power, the
manufacturer seeks to boost the fringe retailers’ sales by lowering wholesale prices to them. This
in turn leads to greater retail competition and lower prices. Dukes et al., (2006) consider a
bilateral bargaining situation of competing manufacturers and competing multi-product retailers.
In this setting, manufacturers raise prices to the weaker retailer in order to boost sales through
the more efficient retailer which is also more profitable. This in turn reduces retailer competition
and raises retail prices. Manufacturers’ increased bargaining power over the weaker retailer
allows them to accrue, in part, the additional extracted consumer surplus. These findings need to

9
One source of retail power has been the emergence of store brands. We refer the reader to the companion chapter
on store brands in this handbook for a survey of issues relating to store brands.

24
be empirically tested in view of their implications for pass-through behavior of dominant versus
weak retailers, with and without manufacturer competition.
Both, Chen (2003) and Dukes et al., (2006) assume that the manufacturers can charge
different prices to the powerful and weak retailers, but, as pointed out earlier, manufacturers
could instead use menu pricing schemes to overcome the limitations imposed by the Robinson-
Patman Act. While the Robinson-Patman Act does not allow a manufacturer to discriminate
between retailers, different manufacturers might offer different contracts to the same retailer.
Hence, with regards to upstream competition, it would be interesting to understand when
competing manufacturers might offer different pricing contracts or pricing schemes to their
retailers. For example, would a national brand and a local brand always offer the same pricing
scheme to a retailer? If not then when might they differ?
Future research should investigate how different channel structures influence pricing
contracts. For instance, as will be discussed in the next section, the presence of a direct channel
that is owned by the manufacturer (a partially integrated channel) could strain the manufacturer-
retailer relationship. What is the optimal pricing contract under such a scenario? Also a
distribution channel could evolve over time because of mergers or because manufacturers and
retailers enter or exit the market. This would change the extent of competition upstream or
downstream and also the demand for individual retailers. How should the pricing contract be
designed to adjust for such potential changes in the channel structure?
Iyer and Villas-Boas (2003) note that empirically the use of two-part tariffs is
considerably small despite findings in the theoretical literature about optimality of two-part
tariffs. While bargaining between the channel members could be a possible reason, an alternate
reason could be that the “real” world settings are far more complex, and as the findings of Chen
et al. (2001) and Iyer (1998) suggest, manufacturers might be using more complicated pricing
schemes. Future research thus needs to better incorporate the characteristics of channel members,
characteristics of the product, and consumer behavior, in analyzing the issue of setting a
wholesale pricing contract, while allowing for the use of a combination of different pricing
schemes.

5. Channel Structure

25
 The channel structure is a long-term decision where managers decide on the structure of
the distribution channel given the market characteristics. Managers can decide whether to have
an integrated channel (sell directly to the consumer) or a decentralized channel (use
intermediaries like retailers, dealers, etc.) or a combination of both – a partially integrated
channel (e.g., use a direct online channel and also traditional retailers). For a channel with
intermediaries, managers can not only decide the number of players at each level but they can
also choose among different options like exclusive dealers (EDs), exclusive territories (ETs), and
independent profit maximizing retailers. While making such a decision, managers need to take
into account the optimal pricing strategy that can be implemented in the resulting channel
structure, given the market characteristics (e.g., competition, demand uncertainty, power
structure)
5.1 Vertical Integration and Decentralization
In the illustrative model of section 2, we found that Vertical Integration (VI) can solve
the double marginalization problem and the associated pricing inefficiency from an independent
retailer. (Jeuland and Shugan, 1983). VI can lower retail prices for other channel structures as
well – upstream monopolists selling through multiple downstream monopolists (Romano, 1987),
a duopoly channel structure with exclusive dealers (McGuire and Staelin, 1983; Coughlan,
1985), and a “Full Channel” structure with two competing manufacturers both selling through
both competing retailers (Trivedi, 1998)10.
Although, VI can internalize the double marginalization problem, when the retail market
is highly competitive (as a result of, say, high product substitutability11), manufacturers may be
better off if they can shield themselves from the competitive environment by inserting privately-
owned profit maximizers (retailers) between themselves and the ultimate retail markets
(McGuire and Staelin, 1983; Coughlan, 1985; Lin, 1988)12. This is because marketing
middlemen soften manufacturer competition as the effect of a price change by a manufacturer on
final retail demand is weakened by the intermediary. Other channel restraints such as exclusive
dealing (Trivedi, 1998) and exclusive territories (Rey and Stiglitz, 1995) can also reduce
manufacturer competition.

10
The integrated structure has two manufacturers selling directly to consumers.
11
Product substitutability is defined as the ratio of the rate of change of quantity with respect to the competitor’s
price to the rate of change of quantity with respect to own price.
12
They all find conditions under which decentralization is a Nash equilibrium strategy of manufacturers.

26
 Moorthy (1988) showed that retail competition is not necessary for decentralization to be
a Nash equilibrium. What is critical is the nature of coupling between demand dependence and
strategic dependence. The author shows that decentralization is a Nash equilibrium only if one of
the following (mutually exclusive) conditions are satisfied: (1) the manufacturers’ products are
demand substitutes at the retail level and strategic complements at the manufacturer or retailer
levels (2) the manufacturers’ products are demand complements at the retail level and strategic
substitutes at the manufacturer or retailer levels.
In general, with pure price competition, a mixed channel structure where one firm
vertically integrates while another decentralizes is not an equilibrium. However, when retailers
engage in price and non-price competition (e.g., provision of product information, after-sales
service, etc.), Iyer (1998) shows that a mixed channel structure can be an equilibrium in markets
with weak brand loyalty. Although, the decentralized retailer will charge higher prices than that
chosen by the vertically integrated firm, adopting a high-end service position helps the retailer to
differentiate and support the higher price. Hence the corresponding manufacturer’s incentive to
decentralize is reinforced in equilibrium.
We already discussed that demand functional form and manufacturer-retailer interactions
affect pass-through. Choi (1991) and Trivedi (1998) analyze the effect of demand functional
forms and manufacturer-relationship on channel structure. The two papers find a rich set of
results on how channel structure decisions are affected by functional form and manufacturer-
retailer interactions.
The channel structure may also evolve over time with the entry of new players into the
market. Tyagi (1999b) shows demand conditions where, contrary to conventional wisdom, entry
of a new downstream firm lowers the downstream-market output and increases the consumer
price. This is because the upstream firms gain bargaining power with downstream entry, raising
their wholesale price and this effect can overcome the competitive effect of entry. But he also
shows that for a class of widely used demand functions – linear, constant elasticity and a variety
of convex and concave demand functions, the supplier’s optimal price is invariant to the
entry/exit of downstream firms. Similarly, Corbett and Karmarkar (2001) model competition and
entry into different levels of a multiple tier serial channel structure with a price-sensitive linear
deterministic demand and find that price per unit, in a tier, falls with the number of entrants in
any upstream tier, but is unchanged with the number of entrants in a downstream tier.

27
 Desai et al., (2004) discuss the role of the intermediary in the context of durable goods.
There are two issues with durable goods: (1) the presence of secondary market competition and
(2) the Coase problem, where the manufacturer’s inability to commit to a future price, causes
consumers to wait and the market to fail. Desai et al. show that by pre-committing to the retailer
to a two-part contract that covers both periods, the manufacturer can solve both problems. With
pre-committed wholesale prices, the channel can replicate the sales schedule under consumer-
pricing commitment. Interestingly, in this contract, the manufacturer charges a wholesale price
above marginal cost in both periods and earns higher profits by selling through a retailer than by
selling the product directly to the consumers.
5.2 Partial Integration
Manufacturers may also consider Partial Integration (PI) – taking over part of the
downstream industry – as a channel design strategy. The popular argument for this strategy is the
manufacturer’s incentive to raise rivals’ (independent retailers’) costs. Romano (1987) considers
the case when an upstream monopolist services two downstream monopolists. Through PI, the
upstream monopolist can not only (partially) eradicate the pricing inefficiency associated with
successive monopolies, but also practice implicit price discrimination towards the non-integrated
downstream firm. Hastings and Gilbert (2005) focus on the 1997 acquisition by Tosco of
Unocol’s West Coast refining and retail assets. They empirically examine the reaction of Tosco’s
wholesale prices in 13 metropolitan areas to differential increases in competition with
independent retailers resulting from the merger. The upstream firms (refineries) have market
power and the downstream products (gasoline from different refineries) are strategic
complements. The authors find that an increase in the degree of integration is associated with
higher wholesale prices to competing retailers.
The emergence of the Internet as a sales channel has brought the issue of partial forward
integration again into focus in recent years. The growth of Internet has made it very easy for
manufacturers to directly connect with the final consumer through an online store (Direct
channel). While the direct channel reduces the manufacturer’s dependence on retailers and
eliminates pricing inefficiencies due to double marginalization, it is also likely to steal customers
from retailers. This might strain the manufacturer-retailer relationship and may cause retailers to
react in a way that adversely affects the manufacturer. It has been shown that firms can control
the competition between the online channel and the traditional retailers by controlling the

28
amount of information made available on the online channel (Balasubramanian, 1998;
Zettelmeyer, 2000; Brynjolfsson and Smith (2000)).
The online channel, however, may not always be detrimental for the non-integrated
retailers. Chiang et al., (2003) analyze the price-setting game between a direct channel of a
manufacturer and its independent retailer. They find that depending on consumers’ acceptance of
direct channel purchases, (for low acceptance) the introduction of the direct channel may be
accompanied by a wholesale price reduction (as a result of low direct channel prices).
Kumar and Ruan (2006) consider the case when a retailer carries products of competing
manufacturers and maximizes category profits. Consumers in the market are one of two types –
they are either brand loyal or store loyal. In addition to the retail price, the retailer is also allowed
to set the level of merchandising support, which impacts the demand for the manufacturer’s
product. They find conditions under which a manufacturer may get higher margins from brand-
loyal customers online, and then offer higher margins to the retailer to get better merchandising
support and a greater share of the store loyal consumers. Thus under certain conditions, the
online channel not only serves to increase the level of retail support and manufacturer’s profits
but it may also increase retailer’s profits.
5.3 Future Research
The literature on channel structure in marketing has typically assumed that consumer
demand is deterministic. However, the operations literature typically highlights the variability in
consumer demand. Small levels of consumer demand variability, is amplified across a channel
and leads to the well-known “bullwhip effect” and harms channel efficiency (Lee et al., 1997).
Thus a decentralization decision may depend on demand variability, which is typically abstracted
away from in the traditional channel structure literature in marketing. It is critical to understand
the tradeoffs when designing channels in the presence of demand uncertainty,
retailer/manufacturer moral hazard, etc.
While there has been a large volume of theoretical research on issues of channel
structure, the volume of empirical research on this issue has been very limited. This is partly
because channel structure decisions tend to be long-term and therefore researchers cannot get
variation in the data. The emergence of the Internet has provided opportunities to study the effect
of a change in channel structure and empirical researchers should take advantage of this natural
variation in the data.

29
6. Structural Econometric Models of Pricing in a Channel
In this section, we discuss the emerging literature on structural econometric models of
channels. We begin by discussing an illustrative structural econometric model of channels. In
recent years, a number of papers have used the structural econometric framework to model the
marketing channel. Such models serve to (1) describe manufacturer-retailer interactions that best
describe the market and (2) perform policy analysis in markets where a channel intermediary
needs to be modeled. We discuss these two types of models in turn.
6.1 An Illustrative Structural Empirical Model of Channels
We will illustrate a basic structural econometric model of the channel using a logit
demand model to highlight the key aspects of developing a structural econometric model of the
marketing channel.
Demand
Consider a market where households can choose between two brands (sold by two
different manufacturers) denoted by i = 1, 2 and a no purchase option denoted by i = 0. The
utility for a brand i to household h in period t is given by
U hit = β0i + X it β − αpit + ξit + ε hit , i = 1,2.
(1)
= δit + ε hit , i = 1,2.
where Xit is a vector of observable (to the firm and the econometrician) attributes and marketing
variables (for e.g., display and feature activity for the brand) and pit is the retail price. β 0 i is the
intrinsic preference of consumers for brand i, and ξ it is the unobservable (to the econometrician,
but observable to the firm and the consumer) component of utility. This term captures the
variation in consumer preferences for brands across time that is induced by manufacturer
advertising and consumer promotions. ε hit is household h’s idiosyncratic component of utility
which is unobserved by the firm and is assumed to be independent and identically distributed as
a Type I extreme value distribution across consumers. This assumption leads us to the familiar
multinomial logit model of demand. Denote the deterministic part of the utility that is observed
by the firm by the term δ it and normalizing the deterministic component of utility for no
purchase ( δ 0t ) to zero, we have the familiar equation for market share for the brand
exp(δ it )
sit = 2
, i = 0,1, 2 . (2)
1 + ∑ exp(δ kt )
k =1

30
It is therefore easy to see that
ln( sit / s0t ) = δ it = β 0i + X it β − α pit + ξit , i = 1, 2 .

This equation serves as the demand side estimation equation. The term ξ it serves as the
error term in the estimation equation. It can capture the effects of manufacturer advertising and
consumer promotions and other unobserved demand shocks that are not explicitly modeled.

The Supply (or Channel) model

Assume that the two manufacturers set wholesale prices and the retailer then sets retail
prices to maximize its category profits in period t. Then the retailer’s objective function is given
by:
Π Rt = ( p1t − w1t ) s1t M t + ( p2t − w2t ) s2t M t

where p1t and p2t are the retail prices of products 1 and 2, w1t and w2t are the wholesale prices of
products 1 and 2 set by the manufacturers and s1t and s2t are the shares of products 1 and 2
defined in the demand model (note that s0t = 1 − s1t − s2t is the share of the outside good) and Mt
is the size of the market. The t subscript refers to the period t.
The first order conditions for the retailer are given by
∂Π Rt ⎡ ∂s ⎤ ⎡ ∂s ⎤
= sit + ( p1t − w1t ) ⎢ 1t ⎥ + ( p2t − w2t ) ⎢ 2t ⎥ = 0 , i = 1, 2 .
∂pit ⎣ ∂pit ⎦ ⎣ ∂pit ⎦
Taking the derivatives of market share with respect to prices, we have
⎛ ∂s1t ∂s2t ⎞
⎜ ∂p1t ⎟
∂st ⎜ ∂p1t − s (1 − s1t )
⎟ = α ⎛⎜ 1t
s1t s2t ⎞
= ⎟. (3)
∂pt ⎜ ∂s1t ∂s2t ⎟ ⎝ s1t s2t − s2t (1 − s2t ) ⎠
⎜ ⎟
⎝ ∂p2t ∂p2t ⎠

Solving the first order conditions, we get the formula for retail prices that is written in
matrix form.

1 ⎛p ⎞ ⎛w ⎞
pt = wt + where pt = ⎜ 1t ⎟ and wt = ⎜ 1t ⎟ (4)
α (1 − s1t − s2t ) ⎝ p2t ⎠ ⎝ w2t ⎠
If the wholesale prices can be observed, the equation above can serve as the supply side
equation for the retailer. One could potentially capture unobservable retailer costs as an error on
the supply equation.

31
 Alternatively one may wish to actually write out an equation to describe the wholesale
prices, in order to structurally model the wholesale price choices. In that case, one will write out
the manufacturers’ pricing model. To illustrate different types of manufacturer pricing behavior,
consider the two alternatives of (1) tacit collusion and (2) Bertrand competition. The objective
function of manufacturer i selling brand i in period t is given by
Π Mit = ( wit − cit ) sit M t + θ ( w jt − c jt ) s jt M t − Fit , i = 1, 2; j ≠ i .

where wit is the wholesale price for brand i that the manufacturer charges the retailer and

cit is the marginal cost of brand i. Fit is the fixed cost to the manufacturer (it can include costs

that are not related to the marginal sales of the brand; for e.g., slotting allowances). Note that

θ = 1 for the case of tacit collusion and θ = 0 for the case of Bertrand competition. Let the

marginal cost of brand i be cit = γ i + ωit , where γ i is the brand specific marginal cost, and ωit is

the brand specific unobservable marginal cost at time t. Note that ωit is unobservable to the

researcher, but observable to the manufacturers.

The first order conditions for the manufacturer are given by

∂Π itM ⎡ ∂ s ∂ p1t ∂ sit ∂ p2t ⎤

= sit + ( wit − cit ) ⎢ it + ⎥+
∂ wit ⎣ ∂ p1t ∂ wit ∂ p2t ∂ wit ⎦
, i = 1, 2; j ≠ i .
⎡ ∂ s jt ∂ p1t ∂ s jt ∂ p2t ⎤
θ ( w jt − c jt ) ⎢ + ⎥=0
⎣ ∂ p1t ∂ wit ∂ p2t ∂ wit ⎦

⎡⎛ ∂ p ∂ st ⎞ ⎤
st + ⎢⎜ t ⎟ .* Θ ⎥ ( wt − ct ) = 0
⎣⎝ ∂ wt ∂ pt ⎠ ⎦

⎛ 1 1⎞ ⎛ 1 0⎞
where Θ = ⎜ ⎟ for tacit collusion and Θ = ⎜ ⎟ for Bertrand competition. The .* operator
⎝ 1 1⎠ ⎝ 0 1⎠

denotes element by element multiplication of a matrix.

We can thus solve for the wholesale prices as

32
 −1
⎡⎛ ∂ p ∂ st ⎞ ⎤
wt = ct + ⎢⎜ − t ⎟ .* Θ ⎥ st (5)
⎣⎝ ∂ wt ∂ pt ⎠ ⎦

−1
⎡⎛ ∂ p ∂ st ⎞ ⎤
where the term ⎢⎜ − t ⎟ .* Θ ⎥ st is the vector of margins that manufacturers choose for
⎣⎝ ∂ wt ∂ pt ⎠ ⎦

their brands. The retailer’s reactions to manufacturers’ wholesale prices are obtained by taking

the derivatives of the retail prices in (4). It can be shown that (see Sudhir (2001) for the proof)

⎛ ∂p1t ∂p2t ⎞
⎜ ∂w1t ⎟ ⎛1 − s1t − s1t ⎞
∂pt ⎜ ∂w1t ⎟=⎜
= ⎟
∂wt ⎜ ∂p1t ∂p2t ⎟ ⎝ − s2t 1 − s2t ⎠
⎜ ⎟
⎝ ∂w2t ∂w2t ⎠

If we observe wholesale prices and retailer prices, we can model the supply side by fitting
both equations. However, typically, wholesale prices are not observed and most researchers in
marketing substitute the wholesale price equation into the retail pricing equation and fit the
following retailer pricing equation to the data.
−1
⎡⎛ ∂ p ∂ st ⎞ ⎤ 1
pt = ct + ⎢⎜ − t ⎟ .* Θ ⎥ st + . (6)
N ⎢⎝ ∂ wt ∂ pt ⎠ ⎥ α (1 − s1t − s2t )
⎣
Manufacturer Cost    ⎦
 

Wholesale Margin Retail Margin

 

Wholesale Price (w )
t
There are some key aspects that should be highlighted in the derivation of the structural
econometrics models. First the demand side error is incorporated into the supply side equations
through the observed market shares. Note that in contrast to the game-theoretic models of
Section 2.1, where the retailer and wholesale pricing equations are characterized completely in
terms of the primitive demand and cost parameters, the pricing equations here (4 and 5) are
characterized in terms of the observable market shares. The advantage of incorporating observed
market shares is that demand side errors (which are observable to the consumers and firms) are
allowed to affect prices. In this sense, the structural econometric specification acknowledges that
econometric errors have structural meaning and are accounted for in the specification.
In summary, a standard structural econometric model of channels is a simultaneous-
equation model with demand and supply pricing equations (could be one equation for

33
manufacturer and retailer each or combined into one), both specified in terms of behavioral
primitives. The demand equation relates quantity purchased to retail price, product
characteristics, and unobserved demand determinants. While many types of demand models can
be used, the random coefficients logit model remains the most popular because of its flexibility
in capturing substitution patterns, while still providing closed form solutions that do not require
integration for individual level choice probabilities (See Dube et al. 2002 for discussion). The
supply equation relates prices to a mark-up and to observed and unobserved cost determinants.
The structural econometric model can be used to either infer the consumers’ and firms’ decision
rules from observable retail price-quantity pairs. It can also be used to perform policy
simulations on how the equilibrium will evolve in response to actions by firms.
6.2 Descriptive models of Channels
Sudhir (2001) demonstrated how to construct a structural econometric model of the
channel under alternative assumptions of manufacturer-retailer interaction. In his analysis of
competition among manufacturers selling through a single retailer, he finds that the manufacturer
Stackelberg model of vertical interactions fits the data better than the Vertical Nash Model. He
also finds that the category profit maximization objectives fit the data better than brand profit
maximization objective. He finds that the logit model fits the data better than a constant elasticity
multiplicative model of demand, suggesting that even though multiplicative models fit the data
well, they are less useful in retail decision support systems, because the implied markups are less
consistent with the data.
Berto Villas-Boas (2007) expands the analysis to vertical interactions between multiple
manufacturers and multiple retailers using a general random coefficients logit model. She finds
that wholesale prices are close to marginal cost, but retailers have pricing power in the market.
This could be consistent with either retail power or nonlinear pricing contracts. Bonnet and
Dubois (2006) explicitly model nonlinear contracts involving two-part tariffs and resale price
maintenance and find that manufacturers use two-part tariffs with RPM13. Unlike Berto Villas
Boas, they find that retailers price at marginal cost.
Berto Villas-Boas and Bonnet and Dubois do not observe wholesale prices. Using a
conjectural variations framework, Kadiyali, Chintagunta and Vilcassim (2000) take advantage of
the fact that wholesale prices can be observed in their data and estimate the extent of channel

13
They study the market of bottled water in France.

34
power. Their findings suggest that channel participants deviate from the prices predicted by
“standard” games such as Manufacturer/Retailer Stackelberg and Vertical Nash and retailers
have power in that they obtain the larger share of channel profits. While this is consistent with a
two-part tariff, they find that neither manufacturers nor retailers charge zero markups. Similar to
Kadiyali et al., Meza and Sudhir (2007) estimate both a retail and wholesale price equation, but
explicitly look for departures from the short-term profit maximizing prices predicted by the
standard models. They find that retailers strategically deviate from short-term profit maximizing
retail prices to support their store brands, but manufacturer margins are consistent with a
Manufacturer-Stackelberg model. Again both manufacturers and retailers have non-zero
markups.
There appears to be a discrepancy in extant research: when wholesale prices are
observed, Kadiyali et al. and Meza and Sudhir observe positive markups by manufacturers and
retailers; when wholesale prices are not observed, Berto Villas-Boas and Bonnet and Dubois find
evidence of zero markup for either manufacturer or retailer. While the differences may be
artifacts of the specific markets studied, the differences in inference of markups when wholesale
prices are not observed should be explored systematically in future work.
In contrast to the above analysis using aggregate data, Villas-Boas and Zhao (2005) use
household level data in a particular local market to evaluate the degree of manufacturer
competition, retailer-manufacturer interactions, and retailer product category pricing in the
ketchup market in a certain city using household level data. Che, Sudhir and Seetharaman (2007)
also use individual data to model manufacturer and retailer behavior in the presence of consumer
state dependence. Given the dynamics involved, they study the extent to which firms are forward
looking in their pricing behavior. They find that firms are boundedly rational in that they look
only one period ahead when setting prices.
6.3 Policy Analysis within a Channel Setting
Several papers have also applied the structural econometric framework of channels in
performing policy simulations on a wide range of marketing mix questions. These analyses have
addressed product, pricing, promotions and channel issues.
Goldfarb, Lu and Moorthy (2007) use the structural econometric channel framework to
measured brand equity. They estimate a demand model and then assess how prices and profits
will change within a competitive setting in the presence of a channel when a brand loses its

35
intangible equity (as represented by the relative value of the intercept with respect to a base
brand such as the store brand).
Israelevich (2004) addresses the issue of product variety and the role of slotting fees
within a distribution channel. As discussed earlier, he finds that slotting fees have served to
enhance the available product variety at a retailer, because the policy analysis indicates that
retailers do not find all products to be intrinsically profitable. This result suggesting two-part
tariffs, where manufacturers are offering retailers allowances, is different from the pricing
strategies suggested in the analysis of Berto Villas-Boas and Bonnet and Dubois. Clearly more
research on the types of pricing contracts used for different types of products is required.
Besanko, Dube and Gupta (2003) study optimal targeted pricing on behalf of
manufacturers in the presence of retailer, using aggregate data within a competitive setting.
Pancras and Sudhir (2007) study the optimal marketing strategies of a customer data
intermediary, who needs to consider the value of its target pricing services to manufacturers in
the presence of a retailer who sets retail prices. Hartmann and Nair (2007) estimate a demand
system for tied good (razors and razor blades) when consumers shop across stores of different
retail formats. Consumers buy razors disproportionately at grocery and drug stores, but the razor
blades at club stores. As cross-elasticities between the two products is moderated by the retail
channel, a policy analysis requires modeling the retail channel behavior. Chu, Chintagunta and
Vilcassim (2007) study the pricing behavior in the PC market and are able to assess the value of
different distribution channels. They perform a variety of policy analysis on how dropping a
distribution channel will affect firms. They also investigate the effect of the HP-Compaq merger
using their estimates.
6.4 Future Research
In summary the structural models of channels literature have been able to map game
theoretic models to the data to both, provide descriptions of the equilibrium interactions in the
market, and to perform policy analysis. As we pointed out earlier, there are some discrepancies
in the inferences of power within the channel depending on whether wholesale prices are
observed or not. Further, there has been limited research on describing channel behavior in the
presence of nonlinear contracts, because fixed transfers are typically not observed. More
empirical research is needed in describing channel behavior in such markets.

36
 While much extant research has focused on pricing as the key variable, future research
should address other strategic variables such as manufacturer advertising and push versus pull
promotions. Also current methodologies can deal with continuous strategic variables like price,
but new methodologies need to endogenize discrete decisions such as the retailer’s decision to
carry a product, introduce a new store brand etc. This would be in contrast to Israelevich’s model
where he takes product acceptance decisions as exogenous. Such models can shed additional
insights about aspects such as how pricing contracts such as slotting allowances and trade deals
affect product attractiveness and the decision to carry the product. Such advances not only
require modeling advances, but also additional data on retailer product acceptance and rejection
decisions (e.g., Sudhir and Rao 2006) that would help us to learn about market behavior.
Far more challenging would be to model asymmetric information among channel
members and how this may affect pricing contracts within a channel. This would require us to
have access to a variety of contracts entered to by a firm under alternative levels of information
asymmetry. Such data however are hard to obtain. But detailed data from a particular retailer
(manufacturer) about the pricing contracts it enters with different manufacturers (retailers) can be
very useful in developing appropriate methodologies and obtaining insights on how channel
members arrive at pricing contracts.
Overall, the ratio of empirical to theoretical research on pricing across channels is low.
This situation is being remedied as more data on both consumer choices across channels and
retailer pricing become available and new empirical tools for analyzing retailer behavior are
being developed. We hope these tools will provide greater insights about consumer behavior
across channels, channel structure and relationships, and the behavior of channel participants in
the near future.

7. Conclusion
This paper surveyed the analytical and structural econometric literature on pricing in a
channel. We described the analytical literature on channels in terms of the time horizons of
decision making: pass-through, pricing contracts and channel structure. We described the
econometric literature in terms of its two major applications: description and policy analysis. The
paper also discussed gaps in the literature in each of the areas and offered suggestions for future
research.

37
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 Table 1: Features Modeled in Selected Papers on Channels
Papers Market Manufacturers Retailers Pricing Contract Model Characteristics
Characteristics Monopoly/ Monopoly/ Linear Pricing(LP); Demand Model: Linear(L)/
Deterministic Competition(M/C); Competition (M/C); 2-Part Tariff (TT)/ Nonlinear(NL)
/Uncertain Demand Observed/Hidden Single/multiple (SP/MP); Qty Discount(QD)/ Logit/Exponential/General;
(DD/UD)); Action (O/H) Observed/Hidden Action RPM/ Manufacturer/Retailer
(Durable/Nondurabl Non-price Action (O/H) Slotting Allow(SA) Stackelberg/Vertical Nash
e(D/ND)/ (NP) Non-price Action (NP) (MS/RS/VN)
Non-specifiable(NS)
Jeuland and Shugan (1983) DD, ND M, O M, SP, O LP, QD L, MS
McGuire and Staelin (1983) DD, ND C, O C, SP, O LP L, MS
Coughlan (1985) DD, ND C, O C, SP, O LP L, Concave, Convex, MS
Choi (1991) DD, ND C, O (C, SP); (M, MP), O LP L, NL, MS, RS, N
Trivedi (1998) DD, ND C, O C, MP, O LP L, MS, RS, N
Desai et al. (2004) DD, D M, O M. SP, O TT L, MS
Iyer (1998) DD, ND M, O C, NP
Moorthy (1987) DD, ND M, O M, SP, O TT L, MS
Ingene and Parry (1998) DD, ND M, O C, non-identical, SP, O TT L, MS
Iyer and Villas-Boas (2003) UD, NS M, O M, SP, H TT, Bargaining NL
Romano (1994) DD, ND M, H, NP M, SP, H, NP RPM NL, N
Lal (1990) DD ND C, O M, MP, O LP, TD L, N
Gerstner and Hess (1995) DD, ND M, O M, SP, O LP, Manufacturer 2 segments of high and low
Rebates/Coupons valuation, MS
Lal and Villas-Boas (1998) DD, ND C, O C, MP, O LP, TD 4 segments, MS
Bruce et al. (2005) DD, D C, O C, SP, O LP, TD 2 segments of high and low
valuation, MS
Moorthy (2005) DD, ND C, O C, MP, O LP, TD General, MS
Tyagi (1999) DD, ND M, O M, SP, O LP, TD L, Concave, Convex, MS
Sudhir and Rao (2006) DD, ND C, O M, MP, O SA L
Shaffer (1991) DD, ND C, O C, MP, O LP, SA, RPM General, MS
Kim and Staelin (1999) DD, ND C, O C, MP, O, NP LP, SA L, MS
Chen (2003) DD, ND M, O C, SP, One dominant TT General, MS
retailer, O
Dukes et al. (2006) DD, ND C, O C, MP, O Bargaining L
Chiang et al. (2003) DD, ND M, O, Direct M, SP, O LP L, MS
channel
Kumar and Ruan (2006) DD, ND C, O, Direct M, MP, O, NP LP 2 segments of store/brand
channel loyal, L, MS
Purohit (1997) DD, D M, O C, SP, O LP Rent vs Buy, MS

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 Table 2: Summary of Pass-through Results in the Literature
Vertical Implications for own-
Market Retailer Implications for cross-brand pass-
brand pass-through
Paper
Structure
Demand Model Strategic
Objective through ( ∂Pi / ∂w j )
Interaction ( ∂Pj / ∂w j )
Besanko, Gupta, Multiple Homogeneous Vertical Nash Maximize • Equal to 1 • Equal to 0
and Jain (1998) Manufacturers logit category
Single Retailer profits
Tyagi (1999) Single Linear; Concave; Manufacturer Maximize • Greater or less than • Not applicable (only one product)
Manufacturer Convex Stackelberg profits (only 100% depending on
Single Retailer one product) demand model
Sudhir (2001) Multiple Homogeneous Manufacturer Maximize • Between 0 and 1 • Between 0 and -1
Manufacturers logit Stackelberg category • Inversely • Magnitude is directly proportional
Single Retailer profits proportional to own to promoting brand share sj
share sj • Unrelated to si
Homogeneous Manufacturer Maximize • Positive • Positive
logit (two brands Stackelberg brand profits • Inversely related to • Magnitude is directly proportional
+ outside good) own share sj to promoting brand share sj
• Directly related to si
Shugan and Multiple General linear Not specified Maximize • Between 0 and 1 • 0 if cross-price effects in demand
Desiraju (2001) Manufacturers, category • Does not vary with are equal
Single Retailer profits share • Positive or negative, depending on
direction of asymmetry in cross-
price effects in demand
• In a product pair cross-brand pass-
through rates have opposite signs
Moorthy (2005) Two Linear Demand Manufacturer Maximize • Between 0 and 1 w/o • Positive with retail competition
Manufacturers Hotelling-like Stackelberg category retail competition • Without retail competition, brand
and Two model profits asymmetry needed for cross-pass-
Retailers through, positive for stronger
brand and negative for weaker
brand

Two Nested Logit Manufacturer Maximize • Positive • Negative cross pass-through w/o
Manufacturers Stackelberg category retail competition
and Two profits • Can be greater or less than 100%
Retailers depending on demand model

44