4. platform retailing: from offline “stores within a store

52

4. Platform retailing: from offline “stores within a store” to online “marketplaces”Kinshuk Jerath and Z. John Zhang*

4.1 INTRODUCTION

The wheel of retailing spins today, but not as “new types of retailers” charge into “the market as low-status, low-margin, low-price operators” replacing mature “high-cost, high-price merchants” (Hollander 1960); it spins as various forms of pure-play online and offline retailers as well as various forms of hybrid players proliferate in the marketplace.1 Regardless of what forms they take, retailers increasingly embrace “platform retailing,” also known as “agency selling,” as a winning channel structure. This chapter is devoted to developing an understanding of the fundamentals of this channel arrangement.

Platform retailing owes its popularity today to the rapid growth of e-commerce. Retailers such as Amazon have set up online “marketplaces” or “platforms” for hundreds of categories, including books and e-books, movies, electronics, home and garden, toys, clothing, and so on. Others, such as Apple’s Appstore and Etsy, have set up specialized marketplaces for categories such as smartphone apps and handmade and vintage arts and crafts, respectively. Alibaba has use platform retailing to become the world’s biggest retailer, surpassing Walmart in 2016, with sales revenue of over $500 billion. On these platforms, manufacturers or third-party sellers can directly access end consumers without having to make investments in setting up their own retailing websites. In return, they pay a fee to the platform owners. These sellers also have the freedom to set their own prices and provide customer service, within constraints and under some monitoring. Such platforms have now commanded a significant share of the online market; for instance, Amazon’s marketplace accounts for about 95 percent of all products listed on its website, about 70 percent of unit sales and about 30 percent of revenue (the remaining percent is accounted for by products that Amazon sells on its own). Alibaba’s platform attracts over 10 million small businesses and sells to over 120 million customers per day!

In the offline world, agency selling has been a long-standing practice and it enjoys wide popularity amongst traditional brick and mortar retailers. Large department stores such as Macy’s, Nordstrom, Bloomingdale’s, and so on, for instance, allow manufacturers and other upstream sellers to set up “stores within a store” or “vendor shops,” typically limited to categories such as cosmetics, apparel, and accessories. Each manufacturer sets up its own store within a store to express the image it desires for its brand and products. The manufacturers are also given the opportunity to set the prices and make the mer-chandising decisions for their shops and often employ customer service representatives to work in these shops as well. In other words, manufacturers are given nearly complete autonomy in the stores within a store that they set up. In return, the retailer, who owns the retail space, typically charges the manufacturer a combination of a fixed fee to set up the store within a store and a percentage of the revenue that the retailer makes. This

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Platform retailing 53

unique arrangement is not new in the US, and has been especially popular with marquee brands such as Chanel, Estée Lauder, Ralph Lauren, Calvin Klein, Louis Vuitton, BCBG, Armani, Gucci, and so on. Indeed, it enjoys even greater popularity in Asian countries including China, Japan, and Korea. Jerath and Zhang (2010) provide further examples of stores within a store.

Online marketplaces and stores within a store may appear to be very different from each other, the former existing in the online world and the latter existing in the offline world. However, as may be apparent from the preceding discussion, the essential feature of both of these is the underlying key channel arrangement whereby the downstream retailer gives retailing pricing rights to the upstream seller in return for a fee. In this chapter, we focus on this common feature of these two channel arrangements in offline and online retailing and explore the factors that determine the choice of channel structures. Throughout the chapter, store within a store refers to offline platform retailing and marketplace refers to online platform retailing.

These two channel arrangements deserve close examination as they both depart from the conventional wholesale reselling model, where a retailer purchases a product from an upstream company at the wholesale price, takes ownership of the inventory, and then charges a retail price above the wholesale price to achieve its own profitability. A number of intriguing questions arise in this context. First, what motivates such a departure? To the extent that the retailer controls the channel access to end users, a related question is what incentives the retailer has to depart from the conventional channel structure and delegate pricing decisions to the upstream company. Similarly, we could further ask in this context why the upstream firm would embrace such a departure. Our answers to this set of questions will not only shed light on the practice of platform retailing or agency selling, but also offer normative guidance for such practices.

Second, retailers embrace platform retailing or agency selling to varying degrees and across online and offline retailing. In the online world, platform retailing can encompass all product categories and all transactions as in the case of Alibaba or in Apple’s Appstore. However, Amazon uses a hybrid model where it retains the traditional wholesale reselling model for a small fraction of its products on its marketplace, as discussed previously. In the offline world, department stores in the US typically limit agency selling to a small number of product categories. However, such restrictions are much more relaxed or non-existent in Asian countries as discussed in Jerath and Zhang (2010). What accounts for such variations? Our answers to this question can help to identify a number of market forces that may play a role in shaping today’s retailing industry.

To address these two sets of questions, we use a game theory model to uncover the key forces at play in platform retailing, and compare it to standard wholesale pricing contracts, to enhance our understanding of why this arrangement is gaining ground. We note that both stores within a store and online marketplaces are scenarios in which the retailer is in a position to choose the channel contracting arrangement; accordingly, in our model, we place the choice of channel arrangement in the hands of the retailer. Our key finding is that platform retailing leads to a more efficient channel than the wholesale arrangement, implying more profit for the retailer because it can extract this profit from the manufacturer using the fee. However, platform retailing also implies that the retailer loses control of the retail price and, in some cases, the manufacturer’s pricing choices can hurt the retailer; in these cases, the retailer prefers to choose the less efficient wholesale


54 Handbook of research on distribution channels

pricing arrangement to be able to keep control of the retail price. With this basic tradeoff identified, we then relate our work to the literature and discuss how service provision, sales externality, competition, and demand uncertainties all enter into the calculus of platform retailing and produce the variations we observe in practice.

This chapter is related to the rich stream of literature on the determinants of vertical channel structure (Bernheim and Whinston 1985; Bonanno and Vickers 1988; Coughlan and Wernerfelt 1989; McGuire and Staelin 1983; Moorthy 1988). Coughlan and Wernerfelt (1989) and Moorthy (1988) focus on the equilibrium channel structure when the manufacturers are the architects of the channel. Recent work in channels has been motivated by the observation that retailers are increasingly gaining greater power in the channel (Abhishek, Jerath, and Zhang 2016; Geylani, Dukes, and Srinivasan 2006; Iyer and Villas-Boas 2003; Jerath and Zhang 2010; Raju and Zhang 2005); as discussed earlier, both stores within a store and online marketplaces are scenarios in which the retailer is in a position to choose the channel structure, so this chapter can be placed into this sub-stream of the literature, which differs from various other studies that analyze contracts in channels assuming the channel structure to be exogenous (Cachon and Kok 2010; Choi 1991; Desai, Koenigsberg, and Purohit 2004; Iyer 1998; Jeuland and Shugan 1983).

The chapter is organized as follows. In Section 4.2, we develop a simple model, with a single retailer and two competing manufacturers with substitutable products, to obtain insights into the basic forces at play in platform retailing. In Section 4.3, we consider manufacturers and retailers selling product lines such that the products exert demand externalities on each other, and study the implications for platform retailing in such a setting. In Section 4.4, we briefly discuss the nascent literature on platform retailing. In Section 4.5, we conclude with a discussion.

4.2 BASIC COMPETITIVE ANALYSIS OF PLATFORM RETAILING

We develop a model of platform retailing with two competing manufacturers offering differentiated but partially substitutable products and one retailer through which these products are sold. We label the products as 1 and 2 and the demand system for the products is given by:

q1 5

111b

21

12b2 p1 1b

12b2 p2

q2 51

11 b2

112 b2 p2 1

b

12 b2 p1,

(4.1)

where qi is the quantity of product i [ {1, 2}, pi is the retail price for product i and b [ [0, 1] is the substitutability index between the two products. This demand specification corresponds to a quadratic consumer utility from consumption function U (q1, q2) 5 q1 1 q2 2

12 (q2

1 1 q22 12bq1q2) (Jerath and Zhang 2010; Raju, Sethuraman,

and Dhar 1995; Singh and Vives 1984), which clearly shows the role of b as the substitut-ability parameter – b 5 0 implies fully differentiated products and b 5 1 implies perfectly



substitutable products. As substitutability b increases, the price sensitivity for a product, given by 1

1 2 b2 , increases and the size of the total potential market, given by 21 1 b, decreases;

both are consistent with intuition (Jerath and Zhang 2010) We denote the manufacturers by M1 and M2 and the retailer by R.

We assume that the consumers accounted for in the demand system above are accessible to the manufacturers only through the retailer. This gives the retailer the power to move first in determining the channel structure. With each manufacturer, the retailer can set up either a wholesale arrangement or a platform arrangement. In the wholesale arrangement, the retailer purchases the product from the manufacturer at a per-unit wholesale price and sells it to the consumers at a marked-up retail price. In the platform arrangement, the retailer allows the manufacturer to sell directly to consumers and set retail prices, while paying the retailer a percentage of the revenue as fee. Therefore, the retailer can choose among three channel arrangements:

1. Platform-Platform (PP): platform arrangements with both manufacturers.2. Wholesale-Platform (WP): wholesale arrangement with one manufacturer and

platform arrangement with the other manufacturer. (Either one of the manufacturers can be in the wholesale or platform arrangement; we will assume, without loss of generality, that manufacturer 1 is in the wholesale arrangement.)

3. Wholesale-Wholesale (WW): wholesale arrangements with both manufacturers.

While offline platform retailing (i.e., stores within a store) and online platform retailing (i.e., marketplaces) may appear very different, the underlying economics is the same. The model that we construct captures the essential and common features of both contexts and is applicable to both contexts.

We assume, for simplicity, that the marginal cost of production for the manufacturers and the retailing cost are all zero. Next, we analyze the three channel structures in detail.

4.2.1 Platform-Platform (PP)

In this channel structure, the retailer allows both manufacturers to have the platform arrangement. Each manufacturer sets the retail price of its product on its own and the retailer charges a percentage fee to each manufacturer. In the mathematical notation, we denote the quantities of this case with the subscript p. For i [ {1, 2}, let the retail price be given by pip and the per-unit percentage fee charged by the retailer to the manufacturer be given by 0 # �ip # 1. Given this, the profits of the manufacturers and the retailer are given by:

pMip 5 (12�ip)pipqip, i [{1, 2}pRp 5 �1pp1pq1p 1 �2pp2pq2p.

(4.2)

In terms of timing, first, the retailer determines the percentage fee for both manu-facturers; next, the manufacturers decide prices under competition. Using backward induction, one can readily determine that the unique subgame-perfect equilibrium is the following:



p1p 5 p2p 51 2 b

2 2 b,

�1p 5 �2p 5 1,

q1p 5 q2p 51

2 1 b 2 b2 .

(4.3)

The retail prices and quantities sold are plotted w.r.t. b in Figures 4.1(a) and (d). We can observe the following: (1) the retailer charges a fee of 100 percent of revenue to extract the full profit of the manufacturers (assuming an outside option of zero for the manufacturers); (2) the retail prices decrease as substitutability between the products increases and reduce to zero as substitutability becomes perfect (because the manufactur-ers are setting prices in direct competition with each other); (3) the quantity first decreases and then increases in b (this is because larger b implies a smaller potential market but also lower prices due to higher competition; the former force dominates for small b and the latter force dominates for large b).

4.2.2 Wholesale-Wholesale (WW)

In this channel structure, the retailer has wholesale arrangements with both manufactur-ers, that is, it purchases products at wholesale prices from both manufacturers and then sets retail prices jointly. In the mathematical notation, we denote the quantities of this case with the subscript w. For i [ {1, 2}, let the retail price be given by piw and the wholesale price by wiw. Given this, the profits of the manufacturers and the retailer are given by:

pMiw 5 w1w qiw, i [ {1, 2}

pRw 5 (p1w 2w1w)q1w 1 ( p2w 2w2w)q2w . (4.4)

In terms of timing, first, the manufacturers simultaneously determine the wholesale prices; next, the retailer determines both retail prices. Using backward induction, one can readily determine that the unique subgame-perfect equilibrium is the following:

p1w 5 p2w 5322b

2(2 2 b) ,

w1w 5 w2w 512 b

2 2 b,

q1w 5 q2w 51

2(2 1 b 2 b2) .

(4.5)

The retail prices and quantities sold are plotted w.r.t. b in Figures 4.1(b) and (e). We can observe the following: (1) prices and quantities follow the same patterns as in the PP arrangement, but note that the retail prices are higher and the quantities are lower (because the well-known force of double marginalization is present); (2) retail prices do not go to zero even for perfect substitutability because the retailer jointly decides both


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retail prices; (3) the wholesale prices, however, reduce to zero as substitutability becomes perfect because the manufacturers are in competition.

Note that in the platform arrangement the retailer moves first to set the fee and then the manufacturer moves to set the retail price. In contrast, in the wholesale arrangement, the manufacturer moves first to set the wholesale price and then the retailer moves to set the retail price. Therefore, in the platform arrangement, the retailer has an advantage because of being the first mover. To neutralize this advantage, we can add a stage to the wholesale arrangement in which the retailer proposes to enter the arrangement with the manufacturer only if the manufacturer agrees to pay a fixed fee; essentially, using this fixed fee, the retailer can extract the full profit of each manufacturer. Adding this stage, however, does not change the key insights from our analysis so for simplicity we do not incorporate this.

4.2.3 Wholesale-Platform (WP)

In this hybrid channel structure, the retailer has a wholesale arrangement with one manufacturer and allows the other manufacturer to have the platform arrangement. In the mathematical notation, we denote the quantities of this case with the subscript h. For product 1, let the wholesale price be w1h and the retail price be p1h. For product 2, let the retail price be given by p2h and the per-unit percentage fee charged by the retailer to the manufacturer be given by 0 # �2h # 1. Given this, the profits of the manufacturers and the retailer are given by:

pM1h 5 w1hq1h

pM2h 5 (12�2h)p2hq2h

pRh 5 ( p1h 2 w1h)q1h 1 �2h p2hq2h. (4.6)

In terms of timing, first, the retailer determines the percentage fee �2h for M2; next, M1 determines the wholesale price it will charge; finally, M1 and R simultaneously decide retail prices under competition. Using backward induction, one can readily determine that the unique subgame-perfect equilibrium is the following:

p1h 53 2b 2 2b2

2(2 2b2) , p2h 54 2b 23b2

4(22b2) ,

w1h 512b

2,

�2h 5 1,

q1h 51

4(11b) , q2h 54 13b

4(11b) (2 2b2) .

(4.7)

The retail prices and quantities sold are plotted w.r.t. b in Figures 4.1(c) and (f). We can observe the following: (1) the retailer charges a fee of 100 percent of revenue to extract the full profit of manufacturer 2 (assuming an outside option of zero for the manufacturer); (2) the revenue prices reduce with b and become zero as substitutability becomes perfect; (3) the price for product 2, sold through platform retailing, is lower than the price for



product 1; (4) the quantity for product 2 is higher than the quantity for product 1; (5) as b increases, the quantity sold of product 2 may increase due to lower prices but the quantity sold of product 1 decreases, that is, the product sold through platform retailing is at an advantage. The WP arrangement is, in a sense, a compromise between the PP and the WW arrangements.

4.2.4 Retailer’s Decision for Channel Arrangement

In the first stage of the game, the retailer decides the channel arrangement based on which one of PP, WW, and WP gives it the highest profit. We can readily determine the answer to this question by comparing the profits that the retailer obtains from these channel arrangements under the respective equilibrium outcomes. These profits have been determined in the previous sections and are plotted in Figure 4.2(a).

First, note that the retailer’s profit in the PP arrangement (represented by the solid line) is highest when product substitutability is low (i.e., small b) because of channel efficiency (i.e., double marginalization is absent) but it also decreases sharply as substi-tutability increases because the manufacturers are in direct competition with each other. Second, the retailer’s profit in the WW arrangement (represented by the dotted line) is low for small b (because of double marginalization) but increases with b (because the manufacturers are in competition for wholesale prices, which go down to zero, while the retailer jointly sets retail prices and the eventual per-unit margin of the retailer increases). Third, the WP arrangement is a compromise arrangement between the PP and WW arrangements – the channel with one manufacturer is efficient while the channel with the other manufacturer has double marginalization; therefore, the retail prices go down with b but not as fast. In all, the retailer prefers the PP arrangement for small values of b (low product substitutability) due to channel efficiency, the WW arrangement for large values of b (high product substitutability) to be able to maintain high retail prices by cushioning competition, and the asymmetric WP arrangement for intermediate values of b (medium product substitutability) as a “best of both worlds” solution. The plot of the retailer’s profit under the optimal choice of channel arrangement is presented in Figure 4.2(b). Counterintuitively, if the channel arrangement is endogenously determined,

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Figure 4.2 Retailer profits in the three arrangements (PP – solid line; WP – dashed line; WW – dotted line)



the retailer’s optimal profit is non-monotonic (first decreasing, then increasing) in the product substitutability b .

Next, for the purpose of illustration, we consider other quantities of interest under the optimal channel arrangement. These include average market price, total quantity sold, manufacturer and channel profits, and consumer and social surplus, and are shown in Figure 4.3. The plots show that within a channel arrangement the quantities follow patterns that can be intuitively explained, but the retailer’s choice of optimal channel arrangement leads to “regime shifts” that produce counterintuitive patterns of variation with product substitutability. For instance, the average market price may be higher for higher product substitutability, while the total quantity sold may be lower (Figures 4.3(a) and (b), respectively). Similarly, manufacturer and channel profits may be higher for higher product substitutability (Figures 4.3(c) and (d), respectively). Finally, consumer and social surplus may be lower for higher product substitutability (Figures 4.3(e) and (f), respectively).

4.2.5 Discussion and Remarks

The preceding analysis shows that platform retailing, in which a retailer allows manu-facturers to price directly to consumers in return for a percentage fee, can indeed be advantageous for the retailer as compared to the standard wholesale pricing arrangement. The benefit of this arrangement is that the channel is efficient, as a “layer” in the channel (the retailer itself) has been removed, thus removing double marginalization; however, the disadvantage is increased competition among manufacturers who now face each other directly without any buffer in the channel. As a consequence, platform retailing is ideal for situations with low substitutability between the products of the competing manufacturers, with partial platform retailing (i.e., platform retailing for some but not all manufacturers) being optimal for intermediate degrees of substitutability.

One of our key insights is that, all else equal, retail prices will be lower in the platform arrangement as compared to the wholesale arrangement (this can be easily determined by comparing p1p and p1w). In a recent paper, Li, Chan, and Lewis (2016) analyze data from a Chinese retail department store in which the department store switches the selling arrange-ment with many of its manufacturers from the wholesale arrangement (i.e., standard resel-ling) to the platform arrangement (i.e., stores within a store). They find that, in agreement with our insight derived above, retail prices reduce after the switch to stores within a store.

Previous work has studied in detail contractual arrangements that can be used to coordinate a channel, that is, achieve the outcome that would be obtained by a centralized decision maker who maximizes the channel profit. A number of contractual instruments have been proposed, such as two-part tariffs (Moorthy 1988), quantity discounts (Jeuland and Shugan 1983), revenue or profit sharing (Cachon and Lariviere 2005), forward inte-gration by manufacturers, and so on. However, many of these contractual arrangements are difficult to implement – for instance, two-part tariffs need a large lump sum payment from the retailer to the manufacturer even before any sales have been realized, quantity discount schedules that actually coordinate a channel can be of a complicated form, revenue and profit sharing need extensive information sharing between the manufacturer and the retailer, and forward integration may be prohibitively expensive and logistically complicated for manufacturers to do.



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Figure 4.3 Equilibrium quantities under the optimal channel arrangement as chosen by the retailer. A solid line, dashed line, and dotted line imply, respectively, that the PP, WP, and WW arrangements are chosen by the retailer.



Therefore, there is reason to look beyond conventional channel coordination mecha-nisms, especially in today’s retailing environment that is more complex and more competi-tive than before because of new technologies. In this light, platform selling is an excellent option as it achieves outcomes closer to coordination than the standard wholesale pricing contract, while optimally splitting the retailing functions between the retailer (primarily managing the store- or website-level activities, payment systems, and so on) and the manu-facturer (primarily managing the brand-level activities such as pricing, merchandising, product selection, and so on). It also allows high flexibility to manufacturers to introduce and experiment with new products and ideas because there is no need to negotiate with the retailer each time such an action has to be taken. Furthermore, it prevents retailers from doing activities that may erode long-term brand value such as using too many price promotions, as manufacturers control the price and service levels for their own brands and products.

Our analysis answers a very basic question that a retailer may face: When selling prod-ucts from competing sellers, what should the channel arrangement be? We build only one parameter into the analysis, namely, the substitutability between the competing products, which represents a force that is expected to be present in most contexts. Therefore, the insights that we obtain are applicable in different contexts, including offline and online platform retailing. Nevertheless, we have made simplifying assumptions that can be revisited. We discuss a few such aspects below and argue that the insights that we obtain are robust to including these aspects into our model.

First, we have assumed away fixed and marginal costs of production as well as retailing. Including these costs leads to qualitatively the same results in terms of choice of channel arrangement with respect to product substitutability. However, the main difference is that as fixed and marginal costs increase, platform retailing becomes less attractive to the retailer. This offers an explanation for why platform retailing is found more online (in the form of a broad range of product categories sold through platform marketplaces) than offline (where a relatively narrower range of product categories is sold through stores within stores).

Second, we have assumed away service provision. Often, better service provision is considered as a key advantage of platform retailing as the manufacturer, who is typically best-informed about the products, is directly in touch with the consumers. This factor, however, still does not change the fundamental effects of substitutability that we have examined through our model and the qualitative insights continue to hold (Jerath and Zhang 2010). In certain cases, however, if service provision by the manufacturer is unobservable to the retailer, this can interact with other forms of information asymmetry and impact the choice of channel arrangement as wholesale or platform (Jiang, Jerath and Srinivasan, 2011).

Third, we assume that platform retailing involves a pure percentage fee arrangement between the manufacturer and the retailer. In reality, a fixed payment from the manu-facturer to the retailer may also be present. In other words, the fee structure involves a fixed fee simply to set up the platform arrangement and a per-unit fee for sales realized. This, again, does not change the key insights from our analysis, as the retailer can use the fixed fee to extract the full profit of the manufacturer from the platform arrangement (Jerath and Zhang 2010), while the pricing decisions of the manufacturer will not be affected. In fact, a combination of fixed fee and per-unit fee would achieve the same



qualitative outcomes. In a scenario with demand uncertainty but risk neutral agents, the same insights would hold. In a scenario with demand uncertainty but risk averse agents, the percentage fee will help with risk sharing while a fixed fee alone cannot achieve that.

While the factors considered above do not change our results qualitatively, there are other factors that are of practical importance and do influence the channel structure decision. In the next section, we discuss some such factors.

4.3 IMPACT OF EXTERNALITIES IN PLATFORM RETAILING

In the analysis in Section 4.2, we assumed the existence of two competing products, one produced by each manufacturer. There may be cases, however, when manufactur-ers or retailers may be selling other products as well. These other products may exert externalities on the focal product(s), for example, through the demand system, such that all players will make decisions for the focal products considering implications for the full product line. In this section, we consider such scenarios and study the implications of externalities on the choice of channel arrangement between platform retailing and wholesale selling.

4.3.1 Impact of Manufacturer Externalities on Platform Retailing

Consider a case with a manufacturer selling one product to a retailer where the retailer decides on the channel arrangement for selling this product. In addition, the manufacturer sells a second poduct, not sold through this retailer, but whose demand is influenced by the demand for the first product. These demand externalities will influence the manufacturer’s decisions and, in turn, the retailer’s choice of channel arrangement.

We can formalize the above using the following model. Suppose there is one manu-facturer and one retailer. The focal product is labeled as product 1 and has the demand system

q1 5 1 2 p1. (4.8)

The manufacturer sells a second product, labeled as product 2. The demand for this product is assumed to be

q2 5 11 t # q1, (4.9)

where t is a parameter between 21 and 1. If t [ [ 21, 0), then high sales for product 1 lead to lower sales for product 2, that is, there is a negative externality from product 1 to product 2. This may be the case of substitutable products, such as clothing – if a consumer purchases one shirt from a manufacturer, the demand for a second shirt from the manufacturer is lower. If t [ (0, 1], then high sales for product 1 lead to higher sales for product 2, that is, there is a positive externality from product 1 to product 2. This may be the case of complementary products, such as sound tracks for music sold online and concert sales for the same songs. If t 5 0, then the two products exert no influence on each other. The retailer’s profit is only from product 1, while the manufacturer’s profit is



from both products 1 and 2. The retail price of product 1, p1, is endogenously determined but the retail price of product 2 is exogenously fixed to be 1 (this is done for simplicity and allowing this price to be endogenous does not qualitatively change any insights). We assume that marginal costs of production and retailing are zero. In this scenario, we study the retailer’s choice of channel arrangement.

4.3.1.1 Platform retailingFirst, we consider platform retailing and denote this case by the subscript p. Therefore, the demand system is given by the following:

q1p 5 1 2 p1p (4.10) q2p 5 1 1 t # q1p.

Assume that the retailer charges a percentage �p of the per-unit revenue as a fee to the manufacturer. Then the retailer’s and manufacturer’s total profits are given by:

pRp 5 �pp1pq1p

pMp 5 (1 2�p)p1pq1p 1 1 # q2p . (4.11)

In the first stage, the retailer sets the platform fee �p and in the second stage the manufacturer sets the retail price. Solving for the subgame-perfect solution, the optimal retail price, given the fee, is:

p1p 5

12 t2 �p

2(12�p). (4.12)

One can see that this price is dependent on t. If t is positive and increases in magnitude, then the retail price decreases. This is because a larger t implies that higher sales of product 1 will lead to higher sales of product 2, and higher sales of product 1 are achieved through a lower price of product 1. If t is negative and increases in magnitude, then the retail price increases. This is because a larger t implies that higher sales of product 1 will lead to lower sales of product 2, and the manufacturer has the incentive to lower the sales of product 1 by increasing its price.

Accounting for the above, the optimal fee of the retailer is given by:

�p 5 1 2t2

#3 3"3"t4(t2 1 27) 2 27t21#3 "3"t4(t2 127) 2 9t2

32/3 (4.13)

This expression is difficult to interpret so we plot it in Figure 4.4. The plot shows an interesting trend – the fee is highest (at 100 percent) for t 5 0 and reduces as the magnitude of t increases on both sides of zero. The reasoning for this is subtle. For negative t, the manufacturer wants to keep sales of product 1 low and the retailer has to offer an incentive to the manufacturer to sell more in this channel; therefore the retailer keeps the percentage fee low. As t increases from 21 to zero, this effect reduces so the fee



increases. For positive t, the manufacturer wants to keep its price low to motivate more sales of product 2, and this effect is stronger for larger t. To counter this and to motivate the manufacturer to not reduce prices by as much, the retailer reduces the fee so that the manufacturer keeps a larger portion of the revenue of product 1.

4.3.1.2 Wholesale sellingWe now consider standard wholesale selling and denote this case by the subscript w. Therefore, the demand system is given by the following:

q1w 5 1 2 p1w

q2w 5 1 1 t # q1w . (4.14)

Assume that the manufacturer charges a per-unit wholesale price w1w to the retailer. Then the retailer’s and manufacturer’s total profits are given by:

pRw 5 (p1w 2 w1w)q1w

pMw 5 w1wq1w 1 1 # q2w . (4.15)

In the first stage, the manufacturer sets the wholesale price and in the second stage the retailer sets the retail price. Solving for the subgame-perfect solution, the optimal retail and wholesale prices are:

p1w 53 2 t

4 (4.16) w1w 5

1 2 t

2.

We can see that as t increases from 21 to 1 the wholesale price decreases because the manu-facturer wants to keep the retail price low to induce more demand for product 1 so that more demand can be motivated for product 2; concomitantly, the retail price also decreases.

0.5 1.0–1.0 –0.5

0.2

0.4

0.6

0.8

1.0

fa

t

Figure 4.4 Impact of externality t on the platform fee charged by the retailer



4.3.2 Channel Choice

We now compare the retailer’s choice of channel arrangement as a function of the exter-nality parameter t. In Figure 4.5(a) we plot the profits and in Figure 4.5(b) we plot the optimal profit. We can see that the retailer chooses the platform arrangement for negative and small positive t, and the wholelsale arrangement for positive and large enough t. The reasoning is as follows. The platform arrangement is more efficient and leads to higher channel profit which the retailer can extract using the platform fee, so the retailer has an incentive to use the platform arrangement. However, the platform arrangement gives retail pricing power fully to the manufacturer. When t is large enough, the manufacturer has the incentive to reduce the retail price significantly to increase sales of product 1 and motivate high demand for product 2. In this case, the retailer’s revenue, which is a percentage of the revenue through product 1, reduces. Therefore, the retailer prefers to switch to the wholesale arrangement in which it keeps control of the retail price and can prevent it from going too low. In Figure 4.6(a) we plot this retail price under the optimal

0.5 1.0

0.05

0.10

0.15

0.20

0.25

t0.5 1.0–1.0 –0.5 –1.0 –0.5

0.05

0.10

0.15

0.20

0.25

t

(a) Profits in different arrangements (b) Profit in optimal (maximum profit) arrangement

Figure 4.5 Retailer profits in the two arrangements (platform – solid line; wholesale – dashed line)

0.4

0.6

0.8

1.0

t t

(a) Retail price of product 1 (b) Manufacturer profit from both products

0.5 1.0–1.0 –0.5

1.0

1.1

1.2

1.3

1.4

1.5

0.5 1.0–1.0 –0.5

Figure 4.6 Quantities of interest under the optimal channel arrangement (platform – solid line; whole-sale – dashed line)



channel arrangement. In Figure 4.6(b) we plot the manufacturer profit under the optimal channel arrangement; not that this is non-monotonic in t.

In short, the platform arrangement offers channel efficiency but this comes at the cost of control on retail price, and the retailer wants to keep control of the latter for a large enough positive externality for the manufacturer.

4.3.3 Impact of Retailer Externalities in Platform Retailing

Similar to the case of the manufacturer selling multiple products, we can have the case of the retailer selling multiple products that exert externalities on each other. Consider such a case with a manufacturer selling one product to a retailer where the retailer decides on the channel arrangement for selling this product. In addition, the retailer sells a second poduct, not produced by this manufacturer, but whose demand is influenced by the demand for the first product.

We can formalize the above using the following one manufacturer and one retailer. The focal product is labeled as product 1 and has the demand system

q1 5 1 2 p1. (4.17)

The retailer sells a second product, labeled as product 2. The demand for this product is assumed to be

q2 5 1 1 x # q1, (4.18)

where x is a parameter between 21 and 1. If x [ [2 1, 0), then high sales for product 1 lead to lower sales for product 2, that is, there is a negative externality from product 1 to product 2. This may be the case of substitutable products, such as clothing – if a consumer purchases one shirt from a retailer, the demand for a second shirt being sold by the retailer but produced by a different manufacturer is lower. If t [ (0, 1], then high sales for product 1 lead to higher sales for product 2, that is, there is a positive externality from product 1 to product 2. This may be the case of complementary products, such as e-books and e-readers. If t 5 0, then the two products exert no influence on each other. The manufacturer’s profit is only from product 1, while the retailer’s profit is from both products 1 and 2. The retail price of product 1, p1, is endogenously determined but the retail price of product 2 is exogenously fixed to be 1. We assume that marginal costs of production and retailing are zero. In this scenario, we study the retailer’s choice of channel arrangement.

4.3.3.1 Platform retailingFirst, we consider platform retailing and denote this case by the subscript p.Therefore, the demand system is given by the following:

q1p 5 1 2 p1p

q2p 5 1 1 x # q1p. (4.19)

Assume that the retailer charges a percentage �p of the per-unit revenue as a fee to the manufacturer. Then the retailer’s and manufacturer’s total profits are given by:



pRp 5 �pp1pq1p 1 1 # q2p

pMp 5 (1 2 �p)p1pq1p . (4.20)

In the first stage, the retailer sets the platform fee �p and in the second stage the manufacturer sets the retail price. Solving for the subgame-perfect solution, the optimal retail price and fee are given by:

p1p 5

12

�p 5 1.

We see that since the retailer has no control over the retail price in this case, the manufac-turer sets the retail price independent of x, though the retailer would not have done so. In other words, the retailer gives up control over the retail price of product 1, and fails to internalize the externality between products 1 and 2.

4.3.3.2 Wholesale sellingWe now consider standard wholesale selling and denote this case by the subscript w.Therefore, the demand system is given by the following:

q1w 5 1 2 p1w

q2w 5 1 1 x # q1w. (4.22)

Assume that the manufacturer charges a per-unit wholesale price w1w to the retailer. Then the retailer’s and manufacturer’s total profits are given by:

pRw 5 (p1w 2w1w)q1w 1 1 # q2w

pMw 5 w1wq1w. (4.23)

In the first stage, the manufacturer sets the wholesale price and in the second stage the retailer sets the retail price. Solving for the subgame-perfect solution, the optimal retail and wholesale prices are:

p1w 53 2 x

4 (4.24) w1w 5

1 1 x

2.

We can see that as x increases from 21 to 1 the retail price decreases because the retailer wants to motivate higher sales for product 1 to motivate higher sales for product 2. However, this implies that the manufacturer’s profit reduces, because it comes only from product 1, and anticipating this it increases wholesale price as x increases.

4.3.4 Channel Choice

We now compare the retailer’s choice of channel arrangement as a function of the externality parameter x. In Figure 4.7(a) we plot the profits and in Figure 4.7(b) we plot the optimal profit. We can see that the retailer chooses the wholesale arrangement for x below a threshold value (which is negative) and the platform arrangement for x above this



value. (Note that this pattern is, loosely speaking, the reverse of the channel choice pattern in Subsection 4.3.1 in which the wholesale arrangement is chosen by the retailer only for a positive and large enough t.) As discussed before, the platform arrangement is more efficient and leads to low prices and higher channel profit which the retailer can extract using the platform fee, so the retailer has an incentive to use the platform arrangement. However, the platform arrangement gives retail pricing power fully to the manufacturer. When x is negative and large enough in magnitude, the retailer has an incentive to keep the retail price of product 1 high to limit sales of product 1 and therefore limit the negative effect on the sales of product 2. To achieve this, the retailer needs to keep control of the retail price, and for this reason is chooses the wholesale arrangement over the otherwise more efficient platform arrangement. In Figure 4.8(a) we plot this retail price under the

0.8

1.0

1.2

1.4

1.6

1.8

z

0.8

1.0

1.2

1.4

1.6

1.8

z

(a) Profits in different arrangements (b) Profit in optimal (maximum profit)arrangement

0.50.0 1.0–1.0 –0.5 0.50.0 1.0–1.0 –0.5

Figure 4.7 Retailer profits from both products in the two arrangements (platform – solid line; whole-sale – dashed line)

0.5

0.6

0.7

0.8

0.9

1.0

(a) Retail price of product 1

0.01

0.02

0.03

0.04

(b) Manufacturer profit

z

0.50.0 1.0–1.0 –0.5z

0.50.0 1.0–1.0 –0.5

Figure 4.8 Quantities of interest under the optimal channel arrangement (platform – solid line; whole-sale – dashed line)



optimal channel arrangement. In Figure 4.8(b) we plot the manufacturer profit under the optimal channel arrangement; not that this is non-monotonic in x.

In short, the platform arrangement offers channel efficiency but this comes at the cost of control on retail price, and the retailer wants to keep control of the latter when sales of product 1 significantly hurt sales of product 2. Gaudin and White (2014) and Abhishek, Jerath, and Zhang (2016) use a similar externality explanation to explain the changes in prices after Apple introduced the platform model to sell e-books in competition primarily with Amazon.

4.4 ADDITIONAL PERSPECTIVES

There is a nascent literature analyzing platform retailing in offline and online settings. In this section, we briefly discuss relevant papers from this literature to provide other prevailing perspectives on platform retailing.

4.4.1 Retail Competition

In the offline setting, platform retailing typically takes the form of “stores within a store,” as discussed in previous sections. Jerath and Zhang (2010) analyze this arrangement assuming that fixed rather than percentage fees are charged by the retailer to the manufac-turer. They model retail competition and find that stores within stores are advantageous in markets with high competition among retail stores.2 This is because by setting up its stores within multiple retail stores, a manufacturer can reduce the impact of inter-store competition as it is a common agent setting retail prices across all of these stores. Stated differently, stores within stores serve as a collusion device for multiple competing retailers by outsoucing the pricing decision to common manufacturers. Such a price increase effect was observed when Apple, which sold the e-reader iPad, adopted platform retailing with publishers of e-books (Cote 2013, p. 92; De los Santos and Wildenbeest 2015). Johnson (2013) and Gaudin and White (2014) build theoretical models capturing similar intuitions to explain price increase in platform retailing in the context of online markets. Johnson (2015) and Abhishek, Jerath, and Zhang (2016) analyze the practice of using (most-favored nation) clauses along with platform arrangements in a multiple manufacturers setting and show that the MFN clause leads to a competition reduction effect (by limiting the space of competitive response), in turn leading to higher prices.

4.4.2 Unobservability of Actions and Asymmetric Information

In the online setting, a number of papers analyze online marketplaces (sometimes called retail platforms). In some of these marketplaces, in addition to allowing third-party sellers to sell products, the retailer also sells certain products itself. For instance, Amazon.com sells products itself and also allows third parties to sell on its platform for a platform fee; in contrast, Etsy.com follows only a platform retailing model. As reported in Jiang, Jerath, and Srinivasan (2011) and Zhu and Liu (2014), platform owners that also sell themselves have been observed to start selling some of the products that third-party sellers sell successfully. Jiang, Jerath, and Srinivasan (2011) conduct a theoretical analysis



of this situation and show that this threat of being replaced by the platform owner leads to third-party sellers trying to under-sell their products to escape detection as a good product worth replacing. This introduces an inefficiency into the platform arrangement which can, in turn, have implications for the channel arrangement choice by reducing the attractiveness of the platform arrangement.

4.4.3 Information About Consumer Base

Hagiu and Wright (2015) develop a theoretical model to understand the role of informa-tion about the consumer base held by the platform owner and the sellers (e.g., regard-ing marketing activities). They conclude that whether the platform or the wholesale arrangement is preferred depends on whether the upstream suppliers / manufacturers or the platform owner/retailer have more information relevant to the optimal tailoring of marketing activities for each specific product.

4.4.4 Two-sided Markets

A number of papers study platforms using a two-sided market paradigm in which agents on the two sides of the market (e.g., sellers and buyers) derive utility from being matched with each other by the platform. Examples of this include matching sellers and consum-ers on a retailing platform such as Etsy, men and women on a dating platform such as eHarmony, drivers and riders on a platform such as Uber, hosts and guests on AirBnB, and so on. The platform, as the intermediary, has to make strategic decisions regarding how to grow both sides jointly, how much to charge them, how to match individual players on the two sides, and so on. This conceptualization of platforms is different from ours and also focuses on different questions, and we do not go into details here. The interested reader may consult the following papers (among others): Rochet and Tirole (2003; 2006), Halaburda (2010), Weyl (2010), Hagiu and Jullien (2011).

4.5 CONCLUSIONS

Platform retailing has become increasingly pervasive in offline as well as online retailing in the form of stores within a store and marketplaces, respectively. In this chapter, we argue that while these two arrangements may appear different (and, to some extent, have certain important differences), the basic economics underlying them both is essentially identical. Platform retailing, or agency selling as it is sometimes known, involves a retailer giving near autonomy (in terms of transferring pricing rights) to an upstream seller in its retail space in return for a fee. We show that a key benefit of platform retailing is channel efficiency. This efficiency gain is the key to coordinating a distribution channel.

In a conventional dyadic channel, the double marginalization problem is known to prevent channel members from achieving the maximum channel profitability. One of the remedies is for the upstream company to integrate forward. Such a solution, as we have pointed out earlier, is infeasible for most manufacturers with a limited product line or market reach. In this context, platform retailing or agency selling provides a low cost, low capital requirement way for the upstream company to integrate forward and to achieve



channel coordination. This perhaps explains the resurgence of platform retailing and stores within a store in today’s retailing landscape. To the extent that setting up a store within a store in the physical world is still much costlier than setting up a store in the online marketplace, it is perhaps not so surprising that online platform retailing is more all-encompassing in terms of product categories and market reach than offline stores within a store.

However, in a competitive manufacturers context, as we have shown, neither platform retailing nor stores within a store can perfectly coordinate a channel, although channel efficiency can still improve. With upstream companies competing for end users, the retailer who sets its own prices serves as a cushion against direct price competition, as has been shown in McGuire and Staelin (1983), Bernheim and Whinston (1985), and Bonanno and Vickers (1988). This means that platform retailing or agency selling can remove this cushion and intensify inter-brand competition to the detriment of all channel members. In such a case, the retailer prefers the wholesale reselling arrangement, even though it is less efficient, because it gives the retailer control over the retail prices. The retailer wants to retain the control to reduce inter-brand competition.

This conclusion does not mean, however, that competition always hinders platform retailing or agency selling, as competition at the retail level takes place along multiple dimensions. The retailer under the wholesale reselling format may be able to reduce inter-brand competition inside a store or a marketplace, but such a format will encourage inter-store or inter-marketplace competition as an offline store or an online marketplace tries to build its own customer base. Such competition has clearly beset the retailing industry in recent years, especially as online and offline retailers compete for the same customers. In this context, the “showrooming” effect ensues, where a customer may go to a full-service store, make the product selection, but purchase online at a lower price. “Laser shopping” also occurs in this context, where a customer free-rides on the product information provided by an online retailer in making a product choice, but purchases offline for immediate possession of the product. Online platform retailing, combined with offline stores within a store, can be an antidote for both “showrooming” and “laser shop-ping.” This is because when an upstream company faces end users directly in the market, it will not pit its own products in one store or platform against those in another store or platform, thus reducing inter-store and inter-platform competition. Most importantly, regardless of where a consumer makes a purchase, the manufacturer always internalizes the service and information provision as long as the customer purchases the firm’s prod-uct. For these two reasons, online platform retailing, in conjunction with stores within a store, can be a key to channel integration across online and offline retailing.

Besides product substitutability and inter-store or inter-marketplace competition, there are also some obvious benefits associated with platform retailing and agency selling to make this channel structure the choice of retailers and manufactures. The manufacturer sets the prices, provides consumer service, does the product selection and merchandising and conducts experimentation with new offerings, all activities that it can do more effectively than the retailer. The retailer manages the store level (or website level) infrastructure and logistics to ensure an environment in which multiple manufacturers can coexist and seamlessly conduct business. Furthermore, inventory never changes hands from the manufacturer to the retailer which reduces not only logistical challenges (and obviates return contracts) but also reduces the financial requirements of the retailer



as it never has to purchase inventory. The service provision by the manufacturer for its own brand rather than by the retailer for the manufacturer’s brand also leads to improved incentive alignment for service provision effort. Using a variable per-unit fee leads to risk sharing between the manufacturer and the retailer which, if they are risk averse, leads to higher chances of them entering into the channel arrangement itself. Moreover, manufacturers are able to get in touch directly with consumers and obtain a better pulse on the consumer, which leads to better long-term management including better products being developed.

Many other not so obvious factors, which we have touched upon in this chapter, also explain the variations in the extent to which retailers embrace platform retailing or agency selling. As fixed and marginal costs of production as well as retailing increase, platform retailing is less desirable for a retailer, which explains why platform retailing is more prevalent online. The effectiveness of service provision is another factor that can tip the balance of a retailer’s decision to embrace platform retailing or stores within a store. A retailer’s decision can also be affected by upstream or downstream externalities, as we have shown in this chapter. As in the case of inter-brand and inter-store or inter-platform com-petition, a retailer may want to retain the control over pricing through wholesale reselling to control competition as well as upstream and downstream externalities. Furthermore, asymmetrical information in a distribution channel can also affect a retailer’s choice of the channel structure.

In conclusion, our analysis has shown that platform retailing has many advantages and as more and more offline and online retailers recognize them, it could very well be the channel structure of the future.

NOTES

* The authors thank Miklos Sarvary for useful comments.1. Currently in the US, offline retailing comprises approximately 92.2 percent of total retail sales and online

retailing comprises the rest (7.8 percent) (US Census Report 2016). While offline retailing comprises the bulk of retailing activity, online retailing is important because it is growing at a much faster annual rate of approximately 15.2 percent compared to offline retailing’s annual growth rate of about 1.2 percent (US Census Report 2016).

2. They also model inter-manufacturer competition and find, as we do, that stores within stores are advanta-geous in categories with low product substitutability.

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4. platform retailing: from offline “stores within a store

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