PLATFORM OR WHOLESALE: DIFFERENT EFFECTS

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1 PLTFOM O WHOLESLE: DIFFEENT EFFECTS ON ETILES OF ONLINE PODUCT EVIEWS Completed esearch Paper Young Kwark The Unversty of Texas at Dallas chardson, Texas 758 youngk8@utdallas.edu Janqng Chen The Unversty of Texas at Dallas chardson, Texas 758 chenjq@utdallas.edu Srnvasan aghunathan The Unversty of Texas at Dallas chardson, Texas 758 sraghu@utdallas.edu bstract We study the effect of onlne product revews on an onlne retaler under tradtonal wholesale-scheme and emergent platform-scheme when retaler carres two substtutable products produced by dfferent manufacturers. Products dffer n both qualtes and fts to consumers' needs. evews provde nformaton for consumers to mtgate uncertanty about product s qualty and ft to consumers' needs. We fnd that qualty nformaton homogenzes consumers' utlty dfferences between products and ncreases upstream competton, whch drves down wholesale prces and always benefts retaler under wholesale-scheme whereas lowers manufacturers' revenues and hurts the retaler under platform-scheme. Ft nformaton heterogenzes consumers' estmated fts to products and softens upstream competton, whch pushes up wholesale prces and hurts the retaler under wholesale-scheme, whereas ncreases manufacturers' revenues and benefts the retaler under platform-scheme. We demonstrate qualty and ft nformaton play very dfferent roles n changng upstream competton, and whether retaler benefts from revews crtcally depends on ts prcng scheme choce. Keywords: Onlne Product evews, Prcng Schemes, Competton Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 1

2 Economcs and Value of IS Introducton Wth the ubquty of the Internet and the evdent advantage wth E-Commerce, onlne retalng has been contnuously growng for the past few years. Forrest esearch (1 reported that onlne retal sales reached $ bllon n 11 and accounted for 7 percent of overall retal sales n the U.S. Two unque features assocated wth onlne retalng platform have been well documented (bhshek et al. 1; rchak et al. 11; Clemons et al. 6; Duan et al. 8; Zhu and Zhang 8: the practce of dfferent prcng schemes and the effect of product revews on consumers' purchase decsons. For example, mazon uses both wholesale scheme and platform scheme. In wholesale scheme, mazon purchases products from manufacturer and then resells them to consumers. In platform scheme, mazon lets others sell ther products on ts platform drectly to consumers, and mazon charges a commsson fee for each sale. Meanwhle, on the mazon platform, product revews are readly avalable, whch provde addtonal nformaton to consumers about products' qualtes and ther fts to consumers needs beyond standard product descrptons. In ths paper, we study how onlne product revews affect retalers n platform and wholesale schemes. oth wholesale scheme and platform scheme have long been used n onlne retalng. Wholesale scheme, also known as resellng on the Internet, s the tradtonal practce, an extenson of the practce of off-lne retalng to onlne retalng. Platform scheme s a relatvely new practce but the number of products sold under ths scheme s sgnfcantly hgher than that under wholesale scheme. For nstance, mazon uses wholesale scheme for only 7% of the more than two mllon products n the Electroncs category and the remanng 93% are sold under platform scheme (Jang et al. 11. On the other hand, mazon sells 64 of the top 1 bestsellers n the electroncs category. In addton to mazon, other onlne retalng companes have been also usng platform scheme. For example, lce.com and Etsy.com provde platforms for other sellers to sell on ther platforms for a fee. The recent law suts and debates about wholesale scheme versus platform scheme (also called agency prcng n sellng e-books has brought the choce of prcng schemes to the attentons of practtoners, government, and academa. nother mportant feature assocated wth onlne retalng s the popularty and prevalence of onlne product revews. Many consumers read onlne product revews for ther purchase decsons (Delotte and Touche 8; Cone 1. Consumer surveys report the strong nfluence of onlne product revews on consumers' purchase decsons. ccordng to Delotte and Touche (8, 43% of surveyed consumers were renforced of ther orgnal purchase ntenton by revews and bought the product orgnally ntended for, whereas 43% of consumers changed ther opnons about whch product to buy and 9% of consumers even abandoned ther purchase after readng the product revews. These data suggest the consumers' relance on the others' assessments of products, embedded n the product revews, as well as ther own assessments of products n evaluatng competng products and makng purchase decsons. To address the queston of how onlne product revews affect retalers n platform and wholesale schemes, we develop a game theoretc model n whch a retaler ether drectly sells two substtutable products produced by dfferent manufacturers or provdes a platform for the manufacturers to sell ther products. The sellng party can exert effort to ncrease the traffc to the platform and boost the demands. The products dffer n both ther qualtes and the fts to consumers' needs. Whle all consumers value hgh qualty rather than low qualty, dfferent consumers have dfferent needs, wth some consumers percevng one product more sutable than the other product whle others percevng the opposte way. Each consumer has her own assessment of the qualty of each product and ts ft to her need. The onlne product revews provde addtonal nformaton n both the qualty and ft dmensons. We dstngush the case n whch the qualty dmenson plays a domnant role n determnng consumers' perceved utlty dfferences between the two products, and the case n whch the ft dmenson plays an mportant role such that the ft s crtcal for some consumers. We call the former the qualty-domnates-ft case and the latter the ft-domnates-qualty case. We use the scenaro wthout product revews as the benchmark and study the effect of onlne product revews on the competton between the two manufacturers and ultmately on the retaler under the two prcng schemes. We show the effect of revews vares across two dfferent schemes and the effect also depends on whch dmenson plays a domnant role. We fnd the nformaton n the qualty dmenson and ft dmenson conveyed by the onlne product revews have very dfferent effects on the competton. For the qualty dmenson, we show that revews Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

3 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews reduce the heterogenety between consumers' perceved qualty dfferences by combnng the revew dfference wth consumers' prvate assessment, whch ncreases the competton between the two manufacturers. We call ths reduced heterogenety resultng from the revews varance-reducng effect. In addton, revews shft the mean perceved qualty dfference n favor of the product wth favorable revews. We call ths mean-shftng effect. Under platform scheme, the retaler takes a fracton of manufacturers' revenues. On the one hand, the ntensfed competton resultng from the varancereducng effect tends to drve down the retal prces as well as manufacturers' total revenue. On the other hand, the mean-shftng effect makes the two products market potentals asymmetrc by shftng one product's demand to the other s. ecause the consumers shfted to the product wth favorable revews purchase at a hgher prce than the prce they would have pad for the other product, the revenue ncrease n the product wth favorable revews outweghs the revenue decrease n the product wth unfavorable revews. s a result, the mean-shftng effect tends to ncrease the total revenue generated by the two products. Whether the retaler benefts from the revews depends on the tradeoff between the varancereducng effect and mean-shftng effect. If the revews are mld such that the varance-reducng effect domnates the mean-shftng effect, the retaler s hurt by the revews; Otherwse, the retaler benefts. Under wholesale scheme, n a sharp contrast, the retaler always benefts from the revews. Ths s because the varance-reducng effect ncreases the upstream competton between the two manufacturers and drves the wholesale prces down, whch gves the retaler more room to explot the market because the retaler can lower the retal prces to ncrease demand whle ncreasng the proft margns. In addton, the mean-shftng effect contnues to play a postve role n ncreasng the total revenue from the two products. Furthermore, wth the postve effect on ts revenue from the varance-reducng and mean-shftng effects, the retaler has more ncentve to boost ts traffc, whch amplfes the beneft from the ncreased upstream competton by the revews. s a result, unlke under platform scheme, the retaler always benefts from the revews under wholesale scheme. In contrast, for the ft dmenson, onlne product revews enable consumers to better understand the products fts to ther needs. We demonstrate that consumers are dfferentated further from each other n ther perceved fts because of the revews, snce consumers have dfferent needs and they learn better about the products' fts to ther needs wth the addtonal product nformaton conveyed by the revews. We call ths ncreased heterogenety resultng from the revews varance-ncreasng effect, whch softens the competton between the two manufacturers. Under platform scheme, the reduced competton from the varance-ncreasng effect tends to ncrease each manufacturer's revenue. The mean-shftng effect smlarly shfts the demand from one product to the other and ncreases the total revenue from the two products because of the prce asymmetry. In addton, wth the beneft from the varance-ncreasng effect and mean-shftng effect, the ncrease n the traffc-boostng effort from the manufacturer wth favorable revews offsets the possble decrease n the effort from the manufacturer wth unfavorable revews, and the total effort level s hgher wth revews. s a result, the retaler always benefts from the revews, because the retaler shares the manufacturers revenues. Under wholesale scheme, n contrast, the retaler may be hurt by the revews, because the softened upstream competton resultng from the varancencreasng effect tends to drve up the wholesale prces, whch gves the retaler dsadvantage n resellng. On the other hand, the mean-shftng effect contnues to be benefcal to the retaler. Whether the retaler benefts from the revews depends on the tradeoff between the varance-ncreasng effect and meanshftng effect. If the revews are mld such that the varance-ncreasng effect domnates the meanshftng effect, the retaler s hurt by the revews; Otherwse, the retaler benefts. Stated more generally, our man result s that when onlne product revews mtgate consumers' uncertanty about qualty and ft dmensons of perceved utlty dfference between competng products, the retaler's prcng schemes are crtcal n understandng the effect of revews on retalers va the change n the upstream competton. We show that such revews' effect vares dependng on whch knds of nformaton from revews play a domnant role. More mportantly, revews' effect on the retaler vares dependng on whether the retaler provdes platform or sells drectly. In partcular, we fnd that (1 n the qualty-domnates-ft case, the retaler always makes more proft n the presence of revews under wholesale scheme, whereas, under platform scheme, the retaler may be hurt by the revews; ( n the ftdomnates-qualty case, the retaler always makes more proft n the presence of revews under platform scheme, whereas, under wholesale scheme, the retaler may hurt by the revews. In addton, we can also show that dependng on the context and revew characterstcs, the retaler can be better off under one scheme wthout revews but be better off under the other scheme wth revews; n other words, the Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 3

4 Economcs and Value of IS avalablty of the revews can change the retaler's optmal choce of the prcng scheme from one to the other. Our study relates to the exstng analytcal work that models product revews as nformaton to enable consumers to dentfy products matchng ther needs (Chen and Xe 8 or estmate ther true utltes more accurately (L et al 11; Sun 11. Many of these models focus on how the nature of a product n ther market appeal (e.g., mass or nche products affects revew outcome (e.g., postve or negatve, and n turn how the revews affect consumers wllngness-to-pay and thus the product demand. They typcally consder the effect of revews on sellers n a context of drect sellng from sellers to consumers. We dffer n that we consder a two-level channel structure wth a retaler that ether provdes platform competng manufacturers sell ther products or sells drectly to consumers and consumers facng two dmensonal uncertanty about a product---both the product qualty and the ft to ther needs. Shaffer and Zettelmeyer ( analyzes the effects of nformaton provson on the profts of channel members when the nformaton s suppled by thrd partes. In ther model, all consumers have the same product nformaton, addtonal nformaton has the same qualtatve mpact (postve or negatve on every consumer, and sellers have perfect knowledge of all product nformaton. In our settng, we consder that consumers have prvate estmates of the products' qualtes and fts to ther needs, and onlne product revews provde publc and common addtonal nformaton about qualty and prvate and dosyncratc addtonal nformaton about ft to consumers. In addton, we focus on the effect of revews on retalers under dfferent prcng schemes. nother related stream of research s the recent studes on platform provson n onlne retalng (Jang et al. 11; bhshek et al. 1. For nstance, bhshek et al. (1 studes the retalers strateges over settng platform n the context that competng retalers have both tradtonal and onlne channels. Dfferently, we focus on the effect of onlne product revews on onlne retalers that sells substtutable products, and show the effect vares dependng on the retaler's prcng scheme choce (wholesale scheme versus platform scheme and the type of nformaton conveyed by the revews (n the qualty dmenson versus n the ft dmenson. Model We consder a retaler that carres two products, and, produced by dfferent manufacturers, and uses one of two prcng schemes---wholesale scheme and platform scheme. Under wholesale scheme, the manufacturers sell ther products to the retaler and the retaler resells them to consumers. Under platform scheme, the manufacturers sell ther products drectly to consumers on the retaler's platform, and the retaler charges a commsson fee for each sale. Products and are mperfect substtutes. We call the manufacturer that produces product ( manufacturer (. The margnal producton cost for each product s assumed to be zero. We use Hotellng s horzontal dfferentaton model to capture consumer preference (Hotellng 199. We assume that products and are located at postons and 1 of a lne of length 1 (.e., at the two ends of the lne, respectvely. contnuum of consumers wth unt mass are unformly dstrbuted along the lne, and each consumer has a unt demand. Consumer utlty for a product s her perceved qualty of the product net the dsutlty from the ms-ft between the product and her need measured by the dstance between the product's and her locatons on the lne. We assume that the consumer s dsutlty per unt dstance s t, and thus for the consumer located at λ, her dsutlty for product s λt and dsutlty for product s (1 λt. Therefore, f we denote the perceved qualty dfference between products and as δ, a consumer located at poston λ perceves utlty dfference between products and equal to δ + (1 λt (1 Consumers are uncertan about both product qualty and the msft. The uncertanty n the msft s modeled as that consumers know the locatons of the two products but are not sure about ther own locatons. In the absence of onlne product revews, based on the product descrpton and other nformaton sources, each consumer has her own assessments of the qualty dfference between the two products and of her locaton. We denote a consumer s own assessment of the qualty dfference as x C, and assume that x C satsfes unform dstrbuton over [-ε,ε]. For the ft dmenson, a consumer's assessment s that she s located at y wth probablty β C and can be anywhere on the lne equally wth probablty (1-β C. 4 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

5 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews Dfferent consumers perceve dfferent y, and we assume that consumers assessments are unbased such that y satsfes the unform dstrbuton as n the true dstrbuton of consumers. Onlne product revews provde publc nformaton about the products, and consumers use ths nformaton n addton to ther own assessments to evaluate the products. We denote as x the perceved qualty dfference n the two products revealed by the onlne product revews. In the presence of onlne product revews, consumers combne x C and x to form ther judgment of the qualty dfference between the two products. For the ft dmenson, wth the addtonal nformaton provded by onlne product revews, consumers know better about the ft. In partcular, a consumer's updated assessment s that she s located at y wth probablty β and can be anywhere on the lne equally wth probablty (1-β, where (β > β C. consumer's updated perceved locaton can be dfferent from or the same as the perceved locaton n the absence of revews. egardless of the revew avalablty, we denote α (α + as a consumer's prce senstvty of each product that measures the margnal decrease n the demand of each product from a margnal ncrease n the prces of both products. y modelng the prce senstvty of α, we mplctly model that consumers may have outsde optons and only consumers wth surplus above some threshold purchase such that the market s not always covered. 1 We call the demand for each product from the above descrbed consumers wth unt mass base demand, whch s denoted as D, {,}. We assume that the party that sells products to consumers can make an effort to ncrease the traffc to the retaler's ste such that the demand for each product can be boosted. The sellng party's effort can be, for example, advertsng on sponsored search. If we denote the effort as θ, {,}, we assume the demand for each product s ( D = D 1+ η θ + θ ( where η measures the effectveness of the effort, and θ s the effort ntated by the retaler for product under wholesale scheme or ntated by manufacturer under platform scheme. Notce that traffcboostng effort ntated for one product also ncreases the demand for the other product, because under ether scheme, the traffc goes to the retaler's platform whch lsts both products. The cost of the effort θ s assumed to be θ. The sequence of events under each prcng scheme s as follows. Under platform scheme, n stage 1, the retaler sets the commsson rate k for each sale, whch s the percentage of the revenue that the retaler charges for each sale. In stage, manufacturers determne ther effort levels. In stage 3, the manufacturers set retal prces p smultaneously. In stage 4, consumers evaluate the dfference of product utlty, and make ther purchase decsons. Under wholesale scheme, n stage 1, the retaler determnes the effort level for each product. In stage, manufacturers set wholesale prces w smultaneously. In stage 3, the retaler sets retal prces p. In stage 4, consumers make ther purchase decsons by evaluatng dfference of product utlty. We use the scenaro wthout revews as the benchmark to analyze the effect of revews n next secton. In the scenaro wth revews, revews are observed by consumers, the manufacturers, and the retaler before they make ther decsons. Consumers' own estmates about product qualty dfference and ther locatons are ther prvate nformaton. ll players are rsk neutral, and all other model parameters are common knowledge. Effect of Onlne Product evews In ths secton, we frst derve each product s demand as a functon of the two products retal prces and onlne product revew nformaton. We then analyze the effects of onlne product revews on the 1 Techncally, we assume α > to ensure an nteror soluton for retal prces n equlbrum. The man nsghts about how onlne revews affect upstream competton retan the same wthout ths assumpton (such that the whole market s covered. Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 5

6 Economcs and Value of IS competton between the two manufacturers and the retaler under both platform scheme and wholesale scheme. We start wth consumer decson makng n stage 4 of the game, whch are the same under the two prcng schemes. For the qualty dmenson, wthout product revews, a consumer's perceved qualty dfference s x C ; that s, δ = x C n Equaton (1. Wth onlne product revews, a consumer has two sources of nformaton, x C and x, to estmate δ. s shown by ates and Granger (1969 usng the mnmum varance estmaton, the consumer's expected qualty dfference δ becomes rxc + (1 r, where r [,1], depends on the relatve precsons of the two nformaton sources, and the weght on the product revews, (1- r, s hgh when the precson of the product revew nformaton s hgh. For the ft dmenson, a consumer who perceves her locatng at y wth probablty β has expected locaton βy+(1-β/, and n the scenaro wthout product revews β = β C and n the scenaro wth revews β = β. ltogether, we can formulate perceved utlty dfference n Equaton (1 for both scenaros unformly as 1 β V = [ γ xc + (1 γ ] + 1 β y + t n whch {γ,β} {{1, β C },{r, β }} wth γ = 1 and β = β C for the scenaro wthout revews and γ = r and β = β for the scenaro wth revews. Consumers' net utlty dfferences from the two products also depend on the prces. Consumers derve hgher net utlty from product f and only f the utlty dfference V n Equaton (3 s greater than the prce dfference (p - p. We thus formulate the net utlty dfference as γ x + (1 γ x + 1 y βt p p (4 [ ] ( ( C where (1-yβt s from the smplfcaton of the term on ft dmenson n Equaton (3. Clearly, besdes consumers own assessments, the product revews also affect consumers' perceved net utlty dfferences between the two products by changng γ and β. We focus our analyss on the cases n whch onlne product revews play a mld or moderate role n changng the competton between the two manufacturers such that n equlbrum two manufacturers are comparably compettve. The extreme case n whch the addtonal dfference revealed by onlne product revews s so dramatc such that one manufacturer has a domnant advantage n the market s not consdered n ths study. We next dstngush two cases: (1 Qualty-Domnates-Ft case: n whch the qualty dmenson domnates the ft dmenson such that even the consumer who has the lowest ft wth a product may derve hgher net utlty from the product than from the other when her perceved qualty dfference s strongly favorable toward the product. ( Ft-Domnates-Qualty case: n whch the ft dmenson domnates the qualty dmenson for some consumers such that those consumers always derve hgher net utlty from the product that offers a better ft, regardless of the perceved qualty dfference. (3 (a Qualty-Domnates-Ft case (b Ft-Domnates-Qualty case Fgure 1. Compettve Cases In qualty-domnates-ft case, as llustrated n Fgure 1(a, for any consumer who perceves herself beng located at y, y [,1], by Equaton (4, f her perceved qualty dfference s hgher than [( p p (1 γ (1 y βt] / γ, she derves hgher net utlty from product ; otherwse, she derves hgher utlty from product. Therefore, we can formulate the demand for each product as 6 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

7 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews D dxdy p p p x p [ ] 1 ε = p (1 (1 = (1 p γ x y βt α γ α γ ε γε p (1 (1 1 p γ x y βt γ = α = [ (1 ] ε + γ α D dxdy p p p x p ε γε where the ntegral n product s demand measures the consumers who derve hgher net utltes from product than from the other product, and αp measures the consumers who leave for outsde optons, {,}. In ft-domnates-qualty case, consumers who perceve a strong ft wth product always derve hgher net utlty from product, and consumers who perceve a strong ft wth product always derve hgher net utlty from product, regardless of the perceved qualty dfference. s llustrated n Fgure 1(b, we can denote the former consumer group as those located at [, y ] and the latter as those located at [y,1] along the lne. The consumers who perceve beng located between y and y may derve hgher net utlty from product or from product, dependng on ther perceved qualty dfferences. The margnal consumer y (y s the one who derves the same net utlty from the two products when percevng the largest qualty dfference aganst product (; that s, when xc = ε ( x C = ε. y Equaton (4, we have 1 1 y = [ (1 x t ( p p ] and y = [ (1 x t ( p p ] t γε + γ + β β βt γε + γ + β (6 We then can formulate the base demand for each product n ft-domnates-qualty case as y y ε D = dy p (1 (1 = [ (1 ] p γ x y β + t y dxdy α p p p γ x α p γ ε βt (7 p p (1 γ x (1 y βt y D = γ dxdy dy α p = [ p p (1 γ ] α p y + + ε ε y βt From Equatons (5 and (7, we notce that frms' demands are n a lnear form n both cases. Moreover, each frm's demands n both cases take the same structure except the coeffcents of the terms n the brackets (.e., 1/(γε n qualty-domnates-ft case versus 1/(βt n ft-domnates-qualty case. s a result, combnng the relatonshp between the base demand and the efforts n Equaton (, we can unformly characterze the demand as follows: D = + (1 γ + α p + p 1+ η θ + θ τ τ τ ( [ ] D = (1 γ + α p + p ( 1+ η [ θ + θ ] τ τ τ where τ {γε, βt} wth τ = γε for qualty-domnates-ft case and τ = βt for ft-domnates-qualty case. Ths expresson evdently demonstrates that the assumptons that we mpose on consumers' true and perceved preferences and dstrbuton of consumers perceved qualty dfference are equvalent to the assumptons on lnear demand functons, whch have been commonly used n the lterature (e.g., Cho We focus our analyss wthn the same qualty-domnates-ft or ft-domnates-qualty category. The onlne product revews affect the competton between the two manufacturers va changng the parameters of the above demand functons. To exclude trval cases, we assume that the market potental szes are postve. We next analyze the effects of onlne product revews under platform scheme and then analyze the effects under wholesale scheme. Effect of Onlne Product evews under Platform Scheme Usng backward nducton, we next derve the equlbrum retal prces, the commsson rate charged by the retaler, and the retaler's proft. In stage 3 of the game, the manufacturers maxmze ther profts gven ther effort levels and the commsson rate k pre-announced by the retaler by choosng the optmal prces; that s, π = ( 1 k p D θ (9 max p (5 (8 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 7

8 Economcs and Value of IS where {,} and D s specfed n Equaton (8. y the frst-order condtons, we can derve the manufacturers optmal prces. In stage of the game, the manufacturers maxmze ther proft by choosng ther effort levels; that s, maxπ = ( 1 k p D θ = ( 1 k p D 1+ η ( θ + θ θ (1 θ where the second equalty s by Equaton (. Solvng the frst-order condtons, we can derve the manufacturers' optmal effort levels as functons of the commsson rate. In stage 1 of the game, antcpatng the retal prces set by manufacturers and ther effort levels, the retaler maxmzes ts proft by choosng the commsson rate k; that s, maxπ = k ( p D + p D = k ( p D + p D 1+ η ( θ + θ (11 k ased on the frst-order condtons, we can derve the retaler's optmal commsson rate. The retaler's equlbrum proft can be derved by substtutng the optmal commsson rate, optmal effort levels, and optmal retal prces to the retaler s proft functon. We summarze the equlbrum outcome n the followng lemma. Lemma 1: Under platform scheme, the equlbrum retal prces, commsson rate, and the retaler's proft are as follows. (a etal prces: (b Commsson rate: τ (1 γ p = + and p ατ ατ τ (1 γ = ατ ατ τ (1 + 4 ατ (3 + 4 ατ + (1 + ατ (3 4 (1 (1 4 x k = τ + ατ + γ + ατ η (1 + ατ τ (3 + 4 ατ + (1 γ (1+ 4 ατ x η (c etaler's Proft: τ (1 4 ατ (3 4 ατ (1 ατ τ (3 4 ατ (1 4 ατ (1 γ x η π = τ (1 + 4 ατ (3 + 4 ατ η where τ {γε, βt} and {γ,β} {{1,β C },{r,β }} wth τ =γε for qualty-domnates-ft case and τ=βt for ftdomnates-qualty case and n each case wth {γ,β}={1,β C } for the scenaro wthout revews and {γ,β}={r,β } for the scenaro wth revews. Qualty-Domnates-Ft Case under Platform Scheme Wthout loss of generalty, we consder x ; that s, the onlne product revews are n favor of manufacturer. The followng proposton summarzes the effects of product revews, n whch we use the regular notatons (e.g., π for the scenaro wthout revews and use the notatons wth hats (e.g., ˆ π for the scenaro wth revews. We follow the same conventon when comng to smlar comparson later. Proposton 1: Under platform scheme, n the qualty-domnates-ft case, n the presence of onlne product revews wth x : (a Product 's retal prce s lower (.e., p > p ˆ ; Product 's s lower (.e., p > p ˆ f and only f ε (3 + 4 αrε < (15 (1 + 4 αε (1 + 4 αrε (b etaler's commsson rate k s hgher (.e., k < k ˆ and retaler's proft s lower (.e., π > ˆ π f and only f rε (3 + 4 αrε [ 1+ α(1 + r ε ] < (16 (1 (1 4 (1 (1 4 r + αε + αrε + αrε In the symmetrc case wth x =, the condtons n Inequaltes (15 and (16 are apparently satsfed and thus we have the followng corollary. Corollary 1: Under platform scheme, n the presence of the symmetrc product revews (.e., x =, the retal prces lower; the retaler's commsson rate s hgher and retaler's proft s lower. (1 (13 (14 8 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

9 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews The ntuton for the symmetrc case s as follows. In the scenaro wthout product revews, each consumer's perceved qualty dfference s from her own prvate assessment. In the scenaro wth revews, the consumer combnes her own assessment wth the qualty dfference assessment revealed by the onlne product revews. ecause the qualty dfference revealed by the revews s publc and common to all consumers, the presence of product revews reduce the heterogenety of consumers' perceved qualty dfference and thus reduces the heterogenety of ther perceved utlty dfferences. Fgure (a llustrates the effect of the onlne product revews on the perceved utlty dfferences n ths symmetrc case. ecause consumers put some weght on the common component---perceved qualty dfference revealed by the revews---n evaluatng the utlty dfferences, the span of ther evaluatons s reduced and thus the varance of ther evaluatons s reduced because of the product revews. We call ths effect varancereducng effect. (a Varance-educng Effect (x = (b Mean-Shftng Effect(x =1 Fgure. Effect of Onlne Product evews n Qualty-Domnates-Ft Case (r =.4, ε =3, t =., β C =.5, and β =.6 The reduced heterogenety n consumers perceved utlty dfferences between the two products makes the two products more substtutable overall and makes consumers more prce senstve to a specfc product, and thus t ncreases the competton between the two manufacturers. The ncreased substtutablty and competton can also be seen from the demand functons. In ths symmetrc case, the base demand functons n Equaton (5 can be rewrtten as D = 1/ α p ( p p / ( γε, where {, } = {, }. Note that the coeffcent of the prce dfference term (.e., 1/(γε n the case measures the substtutablty between the two products: the larger the coeffcent s, the more substtutable the two products are. The effect of onlne product revews on the demand functon s that t reduces γ from 1 to r (where γ <1, and thus t ncreases the substtutablty between the two products. The ncreased competton between the two manufacturers drves ther retal prces down as well as the revenue from the base demands. Notce that from Equaton (1, the margnal beneft of the traffc-boostng effort for manufacturer s (1 k p D η. (The margnal cost s θ and thus the optmal effort level s (1 k p D η /. Clearly, both the commsson rate and the revenue from the base demand affect manufacturers' ncentves to exert effort. Gven any commsson rate k, the decreased revenue from the base demand resultng from the ncreased competton by the product revews makes manufacturers have less ncentve to exert effort to boost traffc. s a result of the decreased efforts and the decreased revenue from the base demand, the retaler's revenue s always lower under the same commsson rate. Therefore, n equlbrum, the retaler's optmal revenue (by choosng ts optmal commsson rate s reduced by onlne product revews. The retaler charges a hgher commsson rate n the presence of the revews, because, wth the decreased revenue from the base demand, the margnal beneft of the traffc-boostng effort s less senstve to the commsson rate. In the general case n Proposton 1, the onlne product revews have asymmetrc effect on each manufacturer. The favorable qualty nformaton toward product revealed by the revews (.e., x > unformly changes each consumer's perceved qualty dfference between the two products favorably toward product. s a result, n the presence of the favorable revews toward product, on average consumers' perceved qualty dfferences and thus ther perceved utlty dfferences between the two products are favorable for product. We call ths effect mean-shftng effect. Fgure (b llustrates such Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 9

10 Economcs and Value of IS an effect. Wth favorable revews for product, consumers are more lkely to have a hgher utlty from product. s a result, the mean of ther perceved utlty dfferences s shfted toward the rght-hand sde and s changed favorably for product. In the demand functons outlned n Equaton (5, the mean shftng s reflected n the shftng from product s potental market sze to product s such that, compared to the symmetrc case, manufacturer s potental market sze ncreases (from 1/ to [1/+(1- rx /(γε] and manufacturer s decreases (from 1/ to [1/-(1-rx /(γε]. Manufacturer may suffer from the reduced potental market sze resultng from unfavorable revews, n addton to ncreased competton resultng from the varance-reducng effect as n the symmetrc case. s a result, the retal prce for product s reduced. For manufacturer, the favorable revews have postve effect on ts retal prce because of the boosted appeal n the market, whereas the ncreased competton resultng from the varance-reducng effect has a negatve effect. Whether the manufacturer ncreases ts retaler prce depends on the relatve strength of the two effects, and more favorable revews make the postve effect more sgnfcant, whch n turn nduces manufacturer to charge a hgher retal prce. Inequalty (15 pnponts the condton showng that only f the revews are favorable enough, the retal prce for product become hgher n the presence of revews. lthough t hurts by the varance-reducng effect, the retaler may beneft from the mean-shftng effect. The beneft from the mean-shftng effect mght come from two sources. Frst, the mean-shftng effect makes the base demands asymmetrc n terms of ther potental market szes, whch may ncrease the total revenue generated from the base demands, compared to the symmetrc case. For example, shftng the potental demand from product to product, per se, allows manufacturer to charge a hgher retal prce for product and receve a hgher realzed demand, at the cost of a lower retal prce wth a lower realzed demand for product. Notce the gan from the ncreased prce and ncreased demand for product outweghs the loss from the decreased prce and decreased demand for product, because the changes n both the prce and demand are more sgnfcant for product than product due to s domnance n the market potental. Therefore, the ncrease of the degree of the asymmetry n the market potentals can ncrease the total revenue generated from the base demand. When the revews are hghly favorable to one product, the total revenue generated from the base demand could be hgher that the total revenue n the benchmark case, despte the varance-reducng effect. Second, when the revews are hghly favorable to manufacturer, the ncreased proft from the base demand for product can nduce manufacturer to exert consderably hgh effort, whch can compensate the effort reducton of manufacturer. s a result, the total effort level s even hgher, compared to the no-revew scenaro. Inequalty (16 essentally shows that the retaler can beneft from the revews f the revews are hghly favorable to one product over the other. The change n the equlbrum commsson rate s n the opposte drecton of the change n the retaler's revenue because of the smlar reason as n the symmetrc case. When the total revenue from the base demands s lower, the total effort level (whch s (1 k( p D + p D η /, by the frst-order condton of Equaton (1 s less senstve to the commsson rate, and, as a result, the retaler tends to charge a hgher commsson rate n equlbrum. Ft-Domnates-Qualty Case under Platform Scheme Proposton : Under platform scheme, n the ft-domnates-qualty case, n the presence of onlne product revews wth x : (a Product 's retal prce s hgher (.e., x p < p ˆ ; Product 's s hgher (.e., p < p ˆ f and only f t( β β (3 + 4 αβ t C < (1 r (1 + 4 αβt (1 + 4 αβct (b etaler's commsson rate k s lower (.e., k > k ˆ and retaler's proft s hgher (.e., π < ˆ π. In the symmetrc case wth x =, the condton n Inequalty (17 s satsfed because β >β C and we thus have the followng corollary. Corollary : Under platform scheme, n the presence of the symmetrc product revews (.e., x =, the retal prces are hgher; the retaler's commsson rate s lower and retaler's proft s hgher. (17 1 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

11 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews The ntuton for the symmetrc case s as follows. In the ft dmenson consumers have dfferent preferences and onlne product revews provde more nformaton for them to further calbrate ther own fts. Wth the addtonal nformaton, consumers become less uncertan about the products' fts to ther needs (from wth probablty β C to wth probablty β for some degree of the ft. The reduced uncertanty thus makes consumers more heterogeneous n terms of ther perceved fts, whch tends to ncrease the heterogenety n consumers' perceved utlty dfferences. Fgure 3(a llustrates the effect of the onlne product revews on the perceved utlty dfferences n ths symmetrc case. Contrary to the effect n the qualty dmenson, the nformaton provded by the product revews n the ft dmenson tends to ncrease the varance of consumers' perceved utlty dfferences. We call ths effect varance-ncreasng effect. (a Varance-Increasng Effect(x = (b Mean-Shftng Effect(x =1 Fgure 3. Effect of Onlne Product evews n Ft-Domnates-Qualty Case (r =.6, ε =1, t = 3, β C =.7, and β =.9 The ncreased heterogenety n consumers' perceved utlty dfferences between the two products makes the two products less substtutable overall and makes consumers less prce senstve to a specfc product, and thus t softens the competton between the two manufacturers. The decreased substtutablty and competton can also be seen from the demand functons. In ths symmetrc case, the demand functons n Equaton (7 can be rewrtten as D = 1/ α p ( p p / ( βt, where {, } = {, }. s dscussed prevously, the larger the coeffcent of the prce dfference term (.e., 1/(βt n the case s, the more substtutable the two products are. The effect of onlne product revews on the demand functon s that t ncreases β from β C to β and thus t decreases the substtutablty between the two products. The softenng of the competton between the two manufacturers ncreases ther retal prces as well as the revenue from the base demands. s n the qualty-domnates-ft case, by Equatons (1, the margnal beneft of the traffc-boostng effort s (1 k p D η, the proporton of the revenue from the base demand that each manufacturer receves. Wth the ncreased revenue from the base demand resultng from the ncreased competton by the product revews, manufacturers have more ncentve to exert effort to boost traffc. s a result of the ncreased revenue from the base demand and the manufacturers' ncreased ncentves to exert effort, the total revenue generated n the market s hgher, and so s the retaler's revenue because the retaler takes an (optmal proporton of the total revenue. Notce that the retaler's proporton, or the commsson rate, n ths case s lower, because, wth the ncreased revenue from the base demand, the margnal beneft of the traffc-boostng effort s more senstve to the commsson rate. In other words, beng aware of the ncreased revenue from the base demand, the retaler stmulates manufacturers traffc-boostng efforts by reducng the commsson rate that the retaler charges. s a result, the total revenue from the market s boosted, and the retaler's revenue s also boosted although t charges a lower commsson rate. In the general case as prescrbed n Proposton, the onlne product revews have asymmetrc effect on each manufacturer. s n the qualty-domnates-ft case and as llustrated n Fgure 3(b, the meanshftng effect contnues to exst (.e., x >. In the demand functons outlned n Equaton (8, the mean shftng s reflected n an ncrease n manufacturer s potental market sze (from 1/ to [1/+(1- rx /(β t] and a decrease n manufacturer s (from 1/ to [1/-(1-rx /(β t]. Manufacturer benefts from the favorable revews and the resultng ncreased potental market sze, n addton to softened competton resultng from the varance-ncreasng effect as n the symmetrc case. s a result, because of the revews, manufacturer ncrease ts retal prce, ts revenue from the base demand s hgher, and t has Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 11

12 Economcs and Value of IS more ncentve to boost the traffc. For manufacturer, the unfavorable revews have a negatve effect on ts retal prce because of the reduced appeal n the market, whereas the softened competton resultng from the varance-ncreasng effect, as n the symmetrc case, has a postve effect. Whether the manufacturer ncreases ts retal prce depends on the relatve strength of the two effects. When unfavorable revews are mld, the softened competton effect domnates, whch nduces manufacturer to charge a hgher prce compared to the no-revews scenaro. Inequalty (17 descrbes such a condton. In the presence of asymmetrc revews, as n the qualty-domnates-ft case, retaler benefts from the mean-shftng effect. s before, the mean-shftng effect makes the potental market szes asymmetrc n the base demand, whch ncreases the total revenue from the base demands. Wth the ncreased total revenue from the base demand, the total effort level s also enhanced. In addton to the mean-shftng effect, the retaler also benefts from the varance-ncreasng effect, as dscussed n the symmetrc case. s a result of the both postve effects, the retaler's proft s hgher n the presence of the revews, although t charges a lower commsson rate. Effect of Onlne Product evews under Wholesale Scheme Smlarly, usng backward nducton, we can derve the equlbrum wholesale prce, retal prces, and the retaler's proft under wholesale scheme. Manufacturers objectve functons are w D, {,}, and the retaler s objectve functon s ( p w D + ( p w D θ θ = ( p w D + ( p w D 1 + η ( θ + θ θ θ (18 In stage 3 of the game, the retaler maxmzes ts proft gven ts effort level and wholesale prces by choosng the optmal retal prce for each product. In stage, the manufacturers maxmze ther profts by choosng ther optmal wholesale prces. In stage 1, the retaler maxmzes ts proft by choosng the effort level for each product. We summarze the equlbrum outcome n the followng lemma. Lemma : Under wholesale scheme, the equlbrum wholesale prces, retal prces, and the retaler's proft are as follows. (a Wholesale prces: τ (1 γ τ (1 γ w = + and w = ατ ατ ατ ατ (b etal prces: ατ (5 + 6 ατ (1 γ ατ (5 + 6 ατ (1 γ p = + and p = 4 α (1 + 4 ατ 4(1 + ατ (3 + 4 ατ 4 α (1 + 4 ατ 4(1 + ατ (3 + 4 ατ (c etaler's Proft: 4 x x (1+ ατ τ (1 ατ (3 4 ατ α(1 γ (1 4 ατ (1 ατ τ (1 ατ (3 4 ατ α(1 γ (1 4 ατ η π = ατ (1 + ατ (1 + 4 ατ (3 + 4 ατ 18 α τ (1 + ατ (1+ 4 ατ (3 + 4 ατ where τ {γε, βt} and {γ,β} {{1,β C }, {r,β }} wth τ=γε for qualty-domnates-ft case and τ=βt for ftdomnates-qualty case and n each case wth {γ,β}={1,β C } for the scenaro wthout revews and {γ,β}={r,β } for the scenaro wth revews. Qualty-Domnates-Ft Case under Wholesale Scheme Proposton 3: Under wholesale scheme, n the qualty-domnates-ft case, n the presence of onlne product revews wth x : (a Product s wholesale prce s lower (.e., x w > w ˆ ; Product s s lower (.e., w > w ˆ f and only f ε (3 + 4 αrε < (1 + 4 αε (1 + 4 αrε (b Product 's retal prce s lower and the retaler's proft s hgher (.e., 's retal prce s lower (.e., p > p ˆ f and only f x ε (1 + αrε (3 + 4 αrε < (1 + 4 αε (1 + 4 αrε (5 + 6 αrε (19 ( (1 ( p > p ˆ and π < ˆ π ; Product (3 1 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1

13 Kwark et. al. / Platform or wholesale: Effect of Onlne Product evews In the symmetrc case wth x =, the condtons n Inequaltes ( and (3 are apparently satsfed and thus we have the followng corollary. Corollary 3: Under wholesale scheme, n the presence of the symmetrc product revews (.e., x =, both the wholesale prces and retal prces are lower, and retaler's proft s hgher. The ntuton of the effect of revews on upstream competton for the symmetrc case s smlar to the case under platform scheme. s llustrated n the analyss under platform scheme, revews have a varance-reducng effect, whch makes the two products more substtutable overall and ncreases the competton between the two manufacturers. The ncreased competton drves ther wholesale prces down. s a result, the retaler benefts from the ncreased competton between the two manufacturers, and the benefts are two-fold. Frst, wth the lower wholesale prces, the retaler can lower ts retal prces to ncrease the base demand for each product whle ncreasng ts proft margn from each sale at the same tme. Therefore, the proft derved from the base demands ncreases because of the ncreased competton between the upstream manufacturers. Second, wth the ncreased proft from the base demand, the retaler has more ncentve to boost the traffc, whch further benefts the retaler's total proft. In the general case (.e., x > as prescrbed n Proposton 3, the mean-shftng effect, as llustrated n the analyss under platform scheme, also plays a role n the equlbrum outcome. Manufacturer hurts by the unfavorable revews, n addton to the ncreased competton because of the varance-reducng effect. Therefore, manufacturer charges a lower wholesale prce, whch n turn nduces the retaler to charge a lower retal prce for product. For manufacturer, the favorable revews have postve effect on ts wholesale prce, whereas the ncreased competton resultng from the varance-reducng effect has a negatve effect. Inequalty ( shows that when the postve revews are mld, the varance-reducng effect domnates the mean-shftng effect, and thus the wholesale prce for product s lower because of the revews. The change n the wholesale prce, together wth the change n the base demand for product because of the favorable revews, changes the retal prce of product n a smlar fashon, as characterzed by Inequalty (3. The retaler benefts from the revew from three sources. Frst, as n symmetrc case, the varancereducng effect ntensfes the upstream competton, whch, per se, reduces the wholesale prces and thus ncreases the retaler's revenue from base demands. Second, as llustrated prevously, the mean-shftng effect makes the downstream demand asymmetrc n terms of ther potental market szes, whch engenders more room for the retaler to explot ts market and benefts the retaler. oth the varancereducng effect and mean-shftng effect ncrease the retaler's proft from the base demand. Thrd, as n the symmetrc case, wth the ncreased proft from the base demand, the retaler has more ncentve to boost the traffc and boost the demand, whch benefts the retaler. In other words, the possblty of boostng the traffc enables the retaler to beneft from the revews even more. Ft-Domnates-Qualty Case under Wholesale Scheme Proposton 4: Under wholesale scheme, n the ft-domnates-qualty case, n the presence of onlne product revews wth x : (a Product s wholesale prce s hgher (.e., (b Product s retal prce s hgher (.e., x x w < w ˆ ; Product s s hgher (.e., w < w ˆ f and only f t( β β (3 + 4 αβ t C < (1 r (1 + 4 αβt (1 + 4 αβct p < p ˆ ; Product s s hgher (.e., p < p ˆ f and only f t( β β (1 + αβ t(3 + 4 αβ t C < (1 r (1 + 4 αβct (1 + 4 αβt (5 + 6 αβt (c etaler's proft s lower (.e., π > ˆ π f and only f 4t ( β βc β ( 1+ tαβ ( 3 + 4tαβ 1 3t t C ( 3 8t x < + αβ + αβ + αβ (6 (1 γ ( 1 + 4tαβ C ( 1 + tαβ ( 1 + 4tαβ In the symmetrc case wth x =, the condtons n Inequaltes (4, (5, and (6 are all satsfed because β > β C and we thus have the followng corollary. (4 (5 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1 13

14 Economcs and Value of IS Corollary 4: Under wholesale scheme, n the presence of the symmetrc product revews (.e., x =, both the wholesale prces and retal prces are hgher, and the retaler's proft s lower. The ntuton of the effect of revews on upstream competton for the symmetrc case s smlar to the case under platform scheme. s llustrated n the analyss under platform scheme, the onlne product revews have a varance-ncreasng effect, whch makes the two products less substtutable overall and makes consumers less prce senstve to a specfc product, and thus t softens the competton between the two manufacturers. The softened competton between the two manufacturers ncreases ther wholesale prces. The ncreased wholesale prces nduce the retaler to ncrease ts retal prces, whch decreases the base demand for each product. Meanwhle, the ncreased wholesale prces leave the retaler wth lower proft margn from each sale. s a result, the retaler earns less proft from the base demands because of onlne product revews. Furthermore, wth the decreased proft from the base demands, the retaler has less ncentve to boost ts traffc, whch, n addton to drect loss n the proft from base demands, hurts the retaler's proft. In the general case (.e., x > as prescrbed n Proposton 4, the onlne product revews have asymmetrc effect on each manufacturer, and the mean-shftng effect, as llustrated n prevous secton, also plays a role n the equlbrum outcome. Manufacturer benefts from the favorable revews, n addton to the softened competton because of the varance-ncreasng effect. Therefore, manufacturer charges a hgher wholesale prce, whch n turn nduces the retaler to charge a hgher retal prce for product. For manufacturer, the unfavorable revews have negatve effect on ts wholesale prce, whereas the softened competton resultng from the varance-ncreasng effect has a postve effect. Inequalty (4 shows that when the postve revews are mld, the varance-ncreasng effect domnates the mean-shftng effect, and thus the wholesale prce for product s hgher because of the revews. The change n the wholesale prce, together wth the change n the base demand for product because of the unfavorable revews, changes the retal prce of product n a smlar fashon, as characterzed by Inequalty (5. The retaler s affected by the onlne product revews through both the varance-ncreasng effect and mean-shftng effect. Frst, as n symmetrc case, the varance-ncreasng effect softens the upstream competton, whch, per se, ncreases the wholesale prces and thus decreases the retaler's revenue from base demands. Second, as llustrated n prevous secton, the mean-shftng effect makes the downstream demand asymmetrc n terms of ther potental market szes, whch engenders more room for the retaler to explot ts market and benefts the retaler. Whether the retaler can beneft from the revews depends on the balance betweeen the varance-ncreasng effect and the mean-shftng effect. When the revews are mld and the mean-shftng effect s lmted, the varance-ncreasng effect domnates the mean-shftng effect, whch hurts the retaler's proft from the base demands. Furthermore, when the retaler's proft from the base demands s lower, the retaler has less ncentve to nvest on the traffc-boostng effect, whch amplfes the decrease n the revenue. Inequalty (6 characterzes such a case. Concluson We examne the effect of onlne product revews n a channel structure wth a retaler sellng two substtutable products. The retaler may use wholesale scheme and sell products by tself, or use platform scheme and let manufacturers sell drectly to consumers. We consder that consumers face uncertanty n both the product qualty and fts to ther needs, and product revews provde addtonal nformaton and reduce ther uncertantes. We dentfy the qualty-domnates-ft case n whch the qualty dmenson plays a domnant role n determnng consumers' perceved utlty dfferences of the competng products and the ft-domnates-qualty case n whch the ft dmenson plays a more mportant role. We show the effect of the revews on an onlne retaler can be opposte dependng on whch dmenson plays a domnant role and whch prcng scheme the retaler uses. We fnd, n qualty-domnates-ft case, onlne product revews homogenze consumers' perceved utlty dfferences between the two products and ncrease the competton between the manufacturers. Under platform scheme, the retaler hurts by revews unless the revews are strongly favorable to one product aganst the other, whereas, under wholesale scheme, the retaler always benefts from revews. In contrast, n ft-domnates-qualty case, onlne product revews heterogenze consumers' estmated fts to the products and soften the competton between the manufacturers. Under platform scheme, the retaler always benefts from revews, whereas, under 14 Thrty Thrd Internatonal Conference on Informaton Systems, Orlando 1