Implications of product substitutability in a distribution channel

Abstract This paper examines the effect of product substitutability on the equilibrium profits in a distribution channel of two symmetric manufacturers selling substitutable products to consumers through a nonexclusive retailer. Conventional wisdom suggests that when the products are more substitutable, the retailer will be better off while the manufacturers will be worse off, owing to the dominance of the competition effect of substitutability. In this work, we identify the hitherto neglected demand effect of substitutability and show that the relative strength between the competition and demand effects is the key to this result. As the products become more substitutable, the upstream competition does intensify, but vitally, the demand may expand. We show that the interests of the retailer and manufacturers can be aligned in terms of product substitutability, depending on both the demand and supply factors. Surprisingly, the conventional result can even be completely reversed such that the manufacturers benefit from a certain level of substitutability for some demand patterns. Assuming linear demand, we further isolate the important role of the bargaining power balance and the alternative of agency selling format in moderating the competition effect. For example, as the retailer gains more bargaining power, the (negative) demand effect can overshadow the (positive) competition effect such that a higher degree of substitutability can actually hurt the retailer. Our findings provide valuable implications for persuasive advertising and category management.