Product diversion by vertically differentiated firms

Retail sellers authorized to sell a branded product may divert some units to an unauthorized dealer thus enabling the dealer to become a direct competitor. Because these sellers vary in quality, it is often unclear what type of seller is more motivated to participate in diversion. We develop an analytical model to demonstrate how vertically differentiated sellers make diversion decisions responding to an unauthorized dealer under unique circumstances not considered by previous research. The model demonstrates that when diversion occurs, the low‐quality seller can actually earn a greater profit than the high‐quality seller. Furthermore, a higher quality differential can lead to an overall profit loss for the high‐quality seller when both sellers divert. The sellers will divert products to the competing dealer if and only if they are sufficiently similar to each other. The low‐quality seller has an incentive to divert more units in general, and is motivated to divert alone when the quality differential is not too high. Additionally, changes in vertical differentiation have nonmonotonic effects on the sellers. Overall, the results establish seller vertical differentiation as a new key variable in analyzing product diversion and demonstrate its unique consequences for the authorized sellers and the unauthorized dealer.