The Effect of Probabilistic Selling on Channel Dynamics in Supply Chains

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Scott Fay, Syracuse University and Shahryar Gheibi, Siena College

Manufacturing and Service Operations Management (forthcoming)

One sentence summary:
We find that Probabilistic Selling can improve channel performance by mitigating the demand distortion caused by double marginalization, but that PS is less likely to arise in decentralized channels relative to centralized ones despite this additional potential benefit.

Research Questions:
(1)  Is the advantage of Probabilistic Selling (PS) larger in a decentralized channel or a centralized one? Does channel conflict expand or diminish the market conditions for which an opaque good is viable?

(2)  How does the retailer’s ability to offer an opaque good alter its channel power relative to that of the manufacturer? 

(3)   How does upstream competition between manufacturers influence the impact of PS on the allocation of profit across channel members and on the retailer’s incentive to adopt PS?

What we know:
Prior to this paper, we knew that PS (selling an randomly chosen product in additional to standard, transparent products) could be profitable because it facilitates price discrimination on the basis of how strongly consumers prefer one product over another one. However, our paper considers how PS impacts the interactions between channel members, e.g.., manufacturers and retailers. We find that PS increases channel efficiency and shifts channel profit towards the manufacturers.

Several novel findings include:

1. When consumers are rational, even if the products have different wholesale prices, it is optimal for the retailer to construct the opaque product so that consumers receive each product with equal probability.

2. Channel conflict between manufacturers and retailers can undermine the introduction of opaque goods even though the potential increase in total channel profit arising from the introduction of an opaque good is greater when there is channel conflict.

3. The retailer’s ability to adopt PS can make it optimal for the manufacturer to sell a product for less than it costs to produce. 

4. Competition between manufacturers can reduce the likelihood that the retailer will adopt PS. 

5. The mutual benefit manufacturers obtain from sales of an opaque good creates a form of coopetition in which, interestingly, a manufacturer’s profit can increase when its rival’s production cost decreases.

Implications for Practice:
First, our paper encourages manufacturers to be proactive participants in the offering of opaque goods. A manufacturer should be especially supportive of retailers who use several of the manufacturer’s products to construct an opaque good. Such support could facilitate adoption of PS by a larger range of retail settings than is currently observed. For example, manufacturer brands such as New Balance, Hanes, Crest, and General Electric currently offer multiple versions of shoes, undergarments, toothpaste, and refrigerators, respectively. Lowering the wholesale price of one or more models would encourage their retailers (e.g., Kohl’s, Target, Best Buy, Walmart, and Lowe’s) to introduce opaque goods on their e-commerce sites in these product categories, thus boosting the manufacturers’ sales of all models, including those whose wholesale prices have not been reduced. 

Second, we find that a manufacturer may still benefit from a retailer offering opaque goods even if the retailer combines its product with that of a rival manufacturer. This is because a retailer has an incentive to split demand for the opaque product equally across the two products. Such balanced assignments relax price rivalry, thus allowing manufacturers to increase unit sales while still maintaining substantial profit margins. This result is especially noteworthy because it may help assuage some manufacturers who are reluctant to support retailers’ offerings of opaque goods due to concerns about potential dilution of brand image and/or the necessity to discount wholesale prices.

Third, retailers will obtain the largest gains from PS if they construct opaque goods by using similar goods that are produced by competing manufacturers, e.g., Lowe’s could offer an opaque medium-size refrigerator if it combines the stainless-steel top-freezer refrigerators from GE and Whirlpool with 17.5 cu-ft and 17.6 cu-ft capacities, respectively.

Fourth, even if current wholesale prices are not sufficiently low to make it profitable to offer an opaque good, the retailer may benefit from investing in the capability to offer opaque goods. This is because, once this capability is acquired, the manufacturers of sufficiently substitutable products will have an incentive to lower their wholesale prices so as to entice the retailer to adopt PS. Such a preemptive investment by the retailer, as long as the PS technology is not too expensive, can lead to a win-win-win outcome in which all supply chain members earn higher profit and consumers also benefit from introduction of an opaque good.

Implications for Research:
The current paper demonstrates that channel interactions can dramatically impact the viability of PS. Thus, one would expect future research to examine more complex channel structures. For example, in contrast to our model which assumes consumers buy from a single retailer who procures at most two products from either one or two manufacturers, future research should examine competition between retailers, especially when manufacturers can choose which retailer(s) to utilize and retailers have more than two products to select from when constructing an opaque good.

Full Citation:
Scott Fay and Shahryar Gheibi. 2023, “The Effect of Probabilistic Selling on Channel Dynamics.” Manufacturing & Service Operations Management (forthcoming).

Problem definition: Probabilistic Selling (PS) is a business model whereby, in addition to selling transparent products, a firm sells an opaque good, which is unknown to buyers until after purchase. We examine how PS affects retailer-manufacturer interactions in markets for physical goods and how upstream competition impacts channel members’ incentives to facilitate PS.

Methodology/results: Using a Hotelling-based model of a multi-product retailer, we find that a retailer maximizes its profit by assigning equal probability to each product even when the products have different wholesale prices. We also find that PS mitigates the inefficiencies caused by the double-marginalization problem. Although the potential benefit from PS is greater for a decentralized channel than for a centralized one, the market conditions for which PS arises are more narrow for a decentralized channel. Furthermore, PS shifts channel power toward the manufacturer. However, it is possible for a win-win-win outcome to arise in which the manufacturer, retailer, and consumers benefit from PS. As expected, upstream competition shifts channel profit towards the retailer. However, competition also has surprising effects: It shrinks, rather than expands, the viability of PS and makes it possible for each manufacturer to benefit from its rival’s cost reduction.

Managerial implications:A manufacturer should induce the retailer to offer an opaque good if its production costs are sufficiently low and the products are sufficiently close substitutes. It is optimal for the manufacturer to increase (decrease) its wholesale prices in response to the retailer’s ability to offer opaque goods if product differentiation is low (modest). Setting a wholesale price below cost sometimes maximizes a manufacturer’s profit. Furthermore, a retailer can achieve a strategic advantage by using products from multiple manufacturers to construct opaque goods. However, the retailer’s ability to leverage this advantage is curtailed because its use of equal-probability assignments relaxes competition between manufacturers.

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