Competitive stocking and coordination in a multiple-channel distribution system

In this paper, we study a multiple-channel distribution system in which a manufacturer sells its product through an independent retailer as well as through his wholly-owned channel. The manufacturer and the retailer stock the product solely to satisfy the final customer demand of their respective channels. We focus on the stocking levels of the manufacturer's wholly-owned channel and the retail channel. We assume that each channel has a local stochastic demand, but that the products are substitutable, which means there will be spill-over customers in the event that one channel runs out of stock. We explore the channel inefficiencies induced by the presence of simultaneous vertical competition (double-marginalization) and horizontal competition (substitutability). We show that there is an overall tendency for both channels to overstock due to substitution, which intensifies under increasing substitution rates. Increasing double-marginalization, on the other hand, intensifies the tendency to overstock in the manufacturer's wholly-owned channel, but induces the retail channel to understock. We find that supply chain losses are least under moderate levels of double-marginalization and or substitution. We also investigate coordination mechanisms, and show that most of the well-known, simple contracts fail to achieve coordination in this setting. An exception to this is an appropriately designed penalty contract which can indeed coordinate the supply chain, but is hard to implement. In search of practically more appealing coordination mechanisms, we design a novel two-part compensation-commission contract, whose terms depend on the retail channel sales.