NETWORK EXTERNALITY ON RETAILER AND SUPPLIER PRICING STRATEGIES FOR COMPETITIVE PRODUCTS

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1 Assocaton for Informaton Systems AIS Electronc Lbrary (AISeL) PACIS 06 Proceedngs Pacfc Asa Conference on Informaton Systems (PACIS) Summer NETWORK EXTERNALITY ON RETAILER AND SUPPLIER PRICING STRATEGIES FOR COMPETITIVE PRODUCTS Cungen Zhu Behang Unversty, Zhong Yao Behang Unversty, Jng Luan Behang Unversty, Futao Zhao Behang Unversty, Follow ths and addtonal works at: Recommended Ctaton Zhu, Cungen; Yao, Zhong; Luan, Jng; and Zhao, Futao, "NETWORK EXTERNALITY ON RETAILER AND SUPPLIER PRICING STRATEGIES FOR COMPETITIVE PRODUCTS" (06) PACIS 06 Proceedngs 46 Ths materal s brought to you by the Pacfc Asa Conference on Informaton Systems (PACIS) at AIS Electronc Lbrary (AISeL) It has been accepted for ncluson n PACIS 06 Proceedngs by an authorzed admnstrator of AIS Electronc Lbrary (AISeL) For more nformaton, please contact elbrary@asnetorg

2 NETWORK EXTERNALITY ON RETAILER AND SUPPLIER PRICING STRATEGIES FOR COMPETITIVE PRODUCTS Cungen Zhu, School of Economcs and Management, Behang Unversty, Bejng, Chna, Zhong Yao, School of Economcs and Management, Behang Unversty, Bejng, Chna, Jng Luan, School of Economcs and Management, Behang Unversty, Bejng, Chna, Futao Zhao, School of Economcs and Management, Behang Unversty, Bejng, Chna, Abstract Network externalty, whch affects the value of many hgh-tech and Internet-related products, may have a crtcal mpact on frm strateges Ths paper focuses on the strategy selecton of varous players n a channel structure We desgn a sequental game among two supplers and a retaler In the developed game and model, we provde two optonal strateges to the retaler, whereas supplers can mpact retaler strateges wth ther own prcng We found that (drect) network externalty typcally had a postve effect on frms More mportant, we conclude that when the degree of product network externalty from a weak suppler reaches a certan scale, a relatvely stable state of competton s facltated, whch s more proftable compared wth a colluson strategy Otherwse, the two supplers can stll mantan a competton relatonshp However, a colluson strategy may be more proftable than competton n the second case In ths artcle, we recommend an acquston strategy as a sustanable and reasonable colluson strategy Keywords: dgtal products, prce strategy, network externalty, competton, colluson

3 INTRODUCTION Retalers (eg, Amazon, Jngdong, Walmart, and GameStop) sell smlar products by varous brands Dfferent supplers offer these products (eg, Phone 5s and Samsung Galaxy S6) Certan dgtal and nformaton products such as cellphones, onlne games, and musc-sharng programs have network externalty In other words, consumer utlty depends on both the product tself and the number of consumers who have joned the correspondng network (Katz and Shapro 985) Network externalty s wdespread and exsts for varous nformaton sources and dgtal products (Tomak and Keskn 008) We nvestgate prcng and nteracton strateges between retalers and supplers for network externalty Prevous related studes have focused on the product verson of suppler products (Jng 007), consumer behavor (Gupta and Mela 008, L et al 04), managers aggressveness (Hahn et al 05), and sales channel selecton problems (Lu et al 05) n network externalty Prcng problems have also been researched (Bensad and Lesne 996, Cabral et al 999) However, prevous studes have rarely focused on retaler nteractons wth supplers and nteractons among supplers Specfcally, the followng topcs must be nvestgated: how supplers should manager the retaler creaton of prcng plans; how supplers affect one another; and whether supplers should engage n collaboraton For example, Amazon sells many products of the same type, such as Apple and Samsung phones, Nkon and Canon SLR cameras, and Dell and Samsung ultrabooks Dfferent supplers provde these goods We nvestgate the prcng and compettve strateges of retalers and supplers for goods smlar to these products to reach an understandng of the overall market n the context of network externalty In addton, we am to explan varous merger phenomena We modeled two supplers and one retaler n the market The two supplers offer two products wth network externalty The two supplers, wth a potental asymmetrc demand, supply products to the retaler n a local marketplace The reservaton prce of consumer ncluded ntrnsc valuaton and drect network externalty Usng ths model and a game-theoretc model, we fnd that network externalty has a postve effect on product retal and wholesale prces; the mpact s smlar on retaler and suppler proft We stll consder a possblty that the suppler wth an appealng wholesale prce can gan retaler favour through prcng Surprsngly, we dscover that when the weaker suppler has an unfavorable network externalty degree, a colluson strategy, whch s superor to a compettve strategy, may enhance profts for each suppler However, f the weaker suppler has a suffcent network externalty degree, mantanng a compettve state wth the stronger suppler may be more advantageous The remander of ths paper s organzed as follows: Secton ntroduces the lterature revew; Secton 3 presents our appled model; Secton 4 detals our analyss and the results; and fnally, Secton 5 offers a concluson LITERATURE REVIEW Prevous studes have prmarly nvestgated the two-ter customer-suppler market structure for prcng and product strateges; few studes have examned competton or cooperaton strateges among supplers For example, Baake and Boom (00) revealed that when a vertcal dfferentaton product has the characterstcs of network externalty, the qualty dfference of the products not only allevates prce competton between manufacturers but also facltates mproved compatblty for the manufacturer s creaton of products Bayer and Chan (007) found an nverse relatonshp between product prcng and the past sze of a product In other words, a greater past product scale led to a lower market prcng for the product Km (000) ndcated that when the product has network externalty, manufacturers acheve greater technologcal nnovaton In ths case, they prefer the ncompatble strategy, and are more wllng to reveal ther technology content to the market

4 Otherwse, the manufacturer wth the lower nnovaton ablty would prefer a full compatblty strategy, whch facltates further gans Numerous studes have also examned network externalty n the competton and standardzaton process (Katz and Shapro 985, Henrch 04), mplcatons of lcensng (Economdes 996), dynamc prcng and nventory management (Yang and Zhang 05), preannouncement behavor (Farrell and Saloner 986), bundlng sales (Gallaugher and Wang 00, Ghosh and Balachander 007, Prasad et al 00), and user loyalty (L et al 04) 3 MODEL SETUP We assume that two supplers and a retaler exst n the market Suppler provdes product ( or ) Products and are mperfect substtutes for each other The wholesale prce s denoted as w and w, whereas the margnal cost of each product s assumed to be 0 The retaler, whch s a monopolst, decdes the products retal prces, P and P ; the supplers as well as the retaler are proft-maxmzng frms Wthout loss of generalty, the total market potental was normalzed to n ths study In ths study, purchasng decsons of consumers are based on maxmzng consumer surplus We assume that every consumer has only one unt demand Wthout loss of generalty, we assume that the mass of the consumer s one unt n the market Each consumer offers a partcular reservaton prce for a product n the market Accordng to Prasad et al (00), the two parts of product value are called ntrnsc valuaton and drect network externalty Therefore, wth network externalty, a reservaton prce s expressed as the sum of these two parts The ntrnsc valuaton of a product s referred to as the value to a partcular consumer n the absence of any network Let Rk denote the ntrnsc valuaton of product for consumer k We assume that ( R k, R k ) s unformly dstrbuted on [0,] [0,], and that R k and R k are ndependent of each other (Nalebuff 004, Prasad et al 00) We use ths approach to represent consumer heterogenety We use R to replace R k because the mass of the consumer s one unt We represents drect network externalty utlty that consumers gan from product as nd (Padmanabhan et al 997, Economdes 000, Prasad et al 00) Parameter n represents the sze of network externalty for product Endogenous varable D s the market demand for product We thus assume that prospectve consumers know the equlbrum demand of the market Consumer reservaton prce RP for product s gven by RP R n D Thus, RP wth constrant n D RP n D The net utlty ganed by consumers from product s gven by LetV V 0; we can then derve ths as V RP P R n D P () R R m m, () where m n D P In Inequalty (), the consumer s bound to choose product, because the consumer can obtan a hgher utlty from product than from product As shown n Fgure, the gray area s consstent wth the representaton of D n Inequalty (); the remanng area s D The total market potental s one, and therefore, Assumpton 0 m m D (3) D

5 Wthout loss of generalty, here we suppose that 0 m m If we assume that m m 0, ths s the equvalent of swtchng the two products or supplers, whch does not affect the generalty of the concluson of our study In addton, when m m or m m, t s mpled that D and D 0 or D 0 and D, whch s an unfavorable scenaro Therefore, ths study nvestgates only the case of 0 m m, as shown n Fgure Consequently, the ordnate ntercept of R R m m s m m [0,] Therefore, we can formulate the demand for each product from consumers as Lemma D, D D m m, D m m After consderng Eq (3) and Fgure, D, D can be determned Ths study s based on ths premse, on whch we can consder that the two supplers are asymmetrc Because D D, we can suggest that suppler acheves a market advantage over suppler In practce, most supplers n a specfc market are often asymmetrcal, such as Apple and Samsung, Chna Moble and Chna Uncom, and Twtter and Facebook Therefore, we beleve that such a premse may receve further attenton n the future (4) Fgure Consumer s demand on the two products In ths study, the retaler and two supplers play a tmng game An ntal state before the game ncludes n and w ( or ) Accordng to ths ntal state, the retaler determnes an optmal prcng Therefore, wth ths strategy, the market has product demands D and D Accordng to the retaler s prcng strategy, the supplers are lkely to adopt varous alternatve strateges It should be emphaszed that the nteracton arses not only between the two supplers and the retaler but also between supplers and For the retaler, the purpose s to maxmze proft ( PP R, ) as max ( P, P ) ( P w ) D ( P w ) D And for suppler, the purpose s to maxmze P, P R proft ( w ), shown as max ( w) wd Then the followng conclusons can be obtaned Unless w ndcated otherwse, all proofs of ths paper are omtted due to the page lmt but avalable from authors upon request Lemma The retaler has two alternatve strateges, s and s, where s { P n, P } ; s P n, P n When the retaler chooses strategy s, the correspondng market demand s D, D 0 and the proft s R n, n w, whereas when the retaler chooses strategy s, the correspondng product demand s D, D and the proft s R n, n ( n n ) 4 ( w w )

6 Lemma 3 Suppler wants the retaler to choose polcy s We can fnd wth w andw, the proft of the retaler ncreases (weakly) wth n and n Therefore, a retaler can beneft further from the ncrease n the sze of network externalty, but wthout ncurrng the excessve addtonal cost of prce-pushng By Lemma and 3, we can also fnd that suppler benefts from a larger n and a small w, whch s n lne wth s 4 ANALYSIS We frst dentfy the factors that affect the retaler and suppler s choce of strategy Next, we nvestgate another strategy for the two supplers The results are presented n the followng Proposton When 3n n 4 w w s satsfed, the retaler chooses polcy s ; otherwse, the selected strategy s s Let R R, and3n n 4 w w Obvously, we can fnd that a larger n and a small w are supportve to polcy s From the demands of products n Lemma, we can suggest that polcy s actually mples the retaler s preference to products Retaler beneft more from a larger n and a small w f condton of s s satsfed Partcularly, under 3n n 4 w w, f possble, the retaler even want to choose D, D 0 However, because of Lemma, the ratonal retaler must choose a maxmum possble output for product, namely D D can only take a mnmum of Under the exstng condtons, suppler has a prce advantage over suppler Ths creates an ncentve when the retaler sells product, and suppler s well equpped to dvde the market demand evenly wth suppler, even f they are asymmetrc Overall, ths appears reasonable We present a dscusson on the supplers prcng Because of certan constrants nvolvng market factors such as rvals, consumer endurance or senstvty to prce, and government nterventon, to ensure the possblty of a sale, both w and w should follow an upper bound, denoted as 0 and 0 In other words, the wholesale prce cannot be excessvely hgh, even when the frm s a monopolst Our result regardng w w 3n n s acheved afterward, whch s an ndfference curve of w and w for the retaler, derved from the condton n Proposton For smplcty, we assume that t 3n n n the result Let t denote the network externalty effect, and w w t denote the wholesale prce effect The result s as follows Proposton If 3n n 0 (e, t 0 ), the retaler selects s, after whch w and when t, then w ; when t, then w t ; when t 0, then w ; Intutvely, t 0 suggests that n has reached a certan level, and that the network externalty effect benefts suppler In other words, n s suffcently hgh to facltate a retaler choce of s Because suppler has a substantally stronger motvaton to urge the retaler to choose s, a ratonal suppler does not compete wth suppler n a prce war Because suppler has a demand advantage, t can always set the hghest and optmal prce Ths s smlar to the case of Apple s market advantage wth the Phone However, for a suppler wth a weaker demand such as suppler, the case s complex When s extremely low ( 3n n ) or the wholesale prce effect regardng s postve ( t 0 ), suppler can set the hghest prce Conversely, when the wholesale prce effect regardng s negatve ( t 0 ), suppler cannot set the hghest prce because s too hgh; thus, the network externalty effect (negatve) s not strong We found that a colluson strategy cannot be reached when t 0 In other words, f the network externalty effect favors the weaker

7 suppler, competton s more effectve compared wth colluson and the two supplers only have the motvaton to mantan s Proposton 3 If 3n n 0 (e, t 0 ), when t, the retaler selects s, and w ; when t and 0 t, the retaler selects s and w, w, or the supplers adopt a colluson strategy as w t, w to have the retaler select s ; when t and t, the retaler selects s, and w, w t or the supplers employ the colluson strategy of w, w t to nfluence the retaler to select s Intutvely, t 0 suggests that n cannot reach a level at whch t 0, whereby s s unstable The network externalty effect benefts suppler When w cannot be prced too hgh (e, t ), such as n a prce war, suppler may be forced out of the market Consequently, suppler monopolzes the market at the expense of profts When t, f the wholesale prce effect of s postve (e, t 0 ), the dfference n tradeoff advantages between the two supplers s mnor Therefore, the retaler prefers s, and the supplers employ the hghest prce strategy However, f the wholesale prce effect of s negatve (e, t 0 ), the tradeoff favors suppler, whch can set the hghest prce, whereas suppler cannot When t, f suppler colludes wth suppler and employs a low-prce strategy, each suppler may generate further profts If the overall power dsparty s strong between the two frms, an acquston strategy s more proftable than s competton In summary, for the colluson strategy, the two supplers only have the motvaton to mantan s We also found that s does not have to exst wth t 0 5 CONCLUSION Although our study lacks emprcal support, t s relevant to real-world markets for varous reasons Frst, f a postve network effect exsts, a common goal among the retaler and supplers s to attempt to boost the degree of that network effect Second, for two products that are mperfect substtutes, f no sgnfcant dfference exsts n the degree of network externalty, retaler sales for the two products revealed no sgnfcant dfference, and are stable wth each other Furthermore, the supplers also retan a relatvely stable state of competton We determned that a colluson strategy was nferor to a compettve strategy n mprovng the total profts for the supplers; as n the real-world examples of Samsung and Apple cellphones, or Leca and Lnhof cameras, the weaker frm can also gan a sgnfcant market share wth an attractve network effect and a reasonable prce Thrd, f a weaker product such as product has a lower network externalty degree and an unappealng prce, t has few advantages over a stronger product For the weaker suppler n the market, t s ratonal to cooperate wth the stronger counterpart It s not uncommon for many small companes to desre acquston by larger companes Some examples nclude T-Moble USA s purchase of MetroPCS n 03, Lenovo s purchase of IBM PCD n 004, and Electronc Arts (EA) 99 purchase of Dstnctve Software whch once served Accolade, a man rval to EA and the 998 purchase of Westwood In realty, these acqustons are deal, and are smlar to a colluson strategy, whch may be more sustanable n an acquston case than n an ndependent colluson case, accordng to our analytcal results Surprsngly, for a merger strategy, the weaker product can be regarded as a low-qualty verson, whereas the stronger product s regarded as a hgh-qualty counterpart Suppler profts rely on hgh-qualty products, whereas the low-qualty product verson manly mproves the product network scale Ths s relatvely smlar to the fndngs reported by Jng (007) Future research may am to emprcally valdate the model An nvestgaton nto the socal welfare of varous frm strateges s also warranted Moreover, relaxng the premse that a consumer can buy only one product from two choces would prove frutful

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