Strategic Benefits of Referral Services

Internet referral services, hosted either by independent third-party infomediaries or by manufacturers serve as ``lead-generators'' in electronic marketplaces, directing consumer traffic to particular retailers. The conventional wisdom on Internet referral services is that they are valuable to consumers because they can be used to compare prices and get binding price quotes from retailers. Less clear is the role of such referral services for the manufacturers and the retailers. In addition, a manufacturer's entry into the online referral business has implications for pricing, allocation of channel profits and retail competition. In a model of price dispersion, we investigate the competitive implications of these institutions on retailer prices and their impact on channel structures and distribution of profits. Models that analyze firm conduct in distribution channels (Jeuland and Shugan, 1983; Moorthy, 1987) typically do not consider third-party infomediaries. In a paper closely related to ours, Chen, Iyer and Padmanabhan (2002) examine how an infomediary affects the market competition between retailers. However they do not consider the impact of an upstream manufacturer's referral services on the behavior of downstream players.We consider a model with a distribution channel consisting of a manufacturer, an infomediary, and two retailers. We focus, in particular, on the response of the manufacturer to the presence of an infomediary. Consumers are heterogenous both in their valuations and in search behavior, so that price dispersion exists in equilibrium. Price dispersion has been extensively studied, both theoretically (Varian, 1980, and Narasimhan, 1988, for example) and empirically. Brynjolfsson and Smith (2000) and Clemons, Hann and Hitt (2002) find that price dispersion continues to exist on the Internet.In our model, the online sales environment results in lower customer acquisition costs. However, it also offers retailers less information about a consumer's willingness to pay. In the offline channel, consumers physically walk into stores, and retailers are able to determine willingness to pay, via a costly negotiation process. This enables them to discriminate offline between high and low valuation consumers. Online, they lose this ability to discriminate.In an industry such as the auto industry, purchases are infrequent, with significant time gaps. In such a setting, it is reasonable to think of consumer preferences changing from one purchase to the next, and hence of a lack of availability of information online. If purchases were more frequent (e.g., books or CDs), one can think of more information being available online rather than offline, providing an even stronger reason to divert traffic online. The impact of online consumer information on retailer pricing strategies has been studied by Ghose, et al (2002) and Aron, Sunderarajan and Vishwanathan (2001), among others.We find that, first, the establishment of manufacturer referral services leads to an increase in channel profits and a reallocation of some of the increased surplus, through the franchise fee, to the manufacturer. The impetus to increased profits comes from both retailers' ability to price discriminate between informed and uninformed consumers, and by the lowering of acquisition costs due to diversion of traffic from the offline to the online channel. Thus the strategic decision by the manufacturer to adopt an online referral service affects both channel profits achievable and the allocation of profits among channel members.Second, a higher offline customer acquisition cost (incurred by retailers) is beneficial to the infomediary, but detrimental for the manufacturer. Conversely, increasing heterogeneity in consumer valuations hurts the infomediary, but benefits the manufacturer. Higher profits for the non-enrolled translate into higher franchise fees for the manufacturer, while the smaller difference in profits between retailers results in lower referral fees for the infomediary.Third, online prices are lower than offline prices for the retailer enrolled with the infomediary. The referral service is essentially used as a price discrimination mechanism, to distinguish between uninformed and informed consumers. We also how that in equilibrium, with or without the introduction of the manufacturer referral service, the retailer associated with the infomediary, has higher expected sales and gross profits. Further, the sales of each retailer remain the same even after the introduction of the manufacturer referral service.Fourth, some of the online cost savings are transferred to the consumer, leading to an overall increase in consumer welfare. This happens both through heightened price competition and an increase in the segment of consumers which observe the largest set of prices.Finally, our model provides some insights into the closing efficiency of such referral services. Since a referral request is not a costless process, a significant parameter which all players need to keep in mind is the average closing ratio of this mechanism. Our results are in accordance with empirical evidence. We also discuss some possible extensions to our model and how they would not change the qualitative nature of our main results.This paper, therefore, offers a different viewpoint on how manufacturers can increase profits by diverting traffic into online channels. In the auto industry, manufacturers cannot directly sell to consumers. However, they can extract higher profits from the channel by increasing their franchise fee. This provides them with an incentive to reduce the acquisition costs in the channel. The tradeoff is that, since consumer purchases in this industry are infrequent, little information about consumers is available online. Offline, a retailer is able to infer a consumer's willingness to pay. We show that, for a wide range of parameters, the cost savings dominate any losses due to absence of online information. Further, in the presence of competition from a third party infomediary, a manufacturer can use a referral website as a device to regain some control over the channel.