Vertical product line extension when online retailers serve as mom-and-pop stores’ suppliers

We consider a new-retail supply chain in which an online retailer sells a high-quality product through a local (offline) store. Besides participating in this online-to-offline business, the local store also sells its own product of low quality. We investigate the optimal quality decision in product line extension when a new product is launched along with the two pre-existing products. To understand how the role of the new-product introducer affects the outcome, we consider three cases where the new product is introduced either by the online retailer, or by the local store, or by a centralized firm formed by them. In the centralized case, it is always optimal for the centralized firm to introduce a new product of quality different from that of the existing ones as it can flexibly adjust prices to better segment the market. By contrast, in the decentralized cases, the new-product introducer may choose to replace the existing product of the counterparty with its own new product. Furthermore, when both parties have the same cost efficiency, the local store may introduce a new product with quality close to the high-quality product to squeeze the market share of the high-quality product, whereas the online retailer may meticulously position the new product to facilitate finer market segmentation. We also find that the online retailer and the local store may sometimes choose the same quality level for the new product. Lastly, even when it is not directly involved in the new product introduction, the local store’s inveterate efficiency has a significant impact on the online retailer’s product positioning.