ARTICLE IN PRESS

Int. J. Production Economics 125 (2010) 84–95

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Int. J. Production Economics

journal homepage: www.elsevier.com/locate/ijpe

Channel selection and pricing in the presence of retail-captive consumers

Moutaz Khouja a,, Sungjune Park a, Gangshu (George) Cai b
a
Business Information Systems and Operations Management Department, The Belk College of Business, The University of North Carolina at Charlotte, 9201 University City Blvd.,
Charlotte, NC 28223, USA
b
Department of Management, College of Business Administration, Kansas State University, Manhattan, KS 66506, USA

a r t i c l e in f o a b s t r a c t

Article history: We analyze channel selection and price setting of a manufacturer who has several distribution options
Received 23 March 2009 which include selling through (1) a direct channel, (2) a manufacturer-owned retail channel, and/or (3)
Accepted 9 January 2010 an independent retail channel. The manufacturer can use any combination of these options. We divide
Available online 18 January 2010
consumers into two segments: (1) a retail-captive segment whose consumers do not use the direct
Keywords: channel and (2) a hybrid segment whose consumers may use either channel. Hybrid segment
Pricing consumers are heterogeneous in their channel preference. We identify the relative segment sizes and
Multi-channel distribution consumers’ channel preferences under which different distribution strategies are optimal. Our analysis
E-commerce indicates that the most critical factor in channel selection in a vertically integrated supply chain is the
Vertically integrated supply chains
variable cost per unit of product sold using the direct vs. the retail channels. In the presence of
independent retailer, the size of the retail-captive consumer segment relative to the size of the hybrid
consumer segment becomes a major factor in channel selection.
& 2010 Elsevier B.V. All rights reserved.

1. Introduction explicitly consider online-captive consumers; however, with a

The popularity of the Internet and improvements in logistics
have allowed many manufacturers to sell products directly to
consumers (Chiang et al., 2003). In the past, manufacturers could
bypass retailers by opening ‘‘company stores.’’ Nowadays, the
Internet allows manufacturers to bypass retailers without open-
ing ‘‘company stores.’’ The Internet, once a novelty for consumers,
is now a utility for many, and millions of customers are shopping
electronically (Horrigan and Raine, 2002).
In this paper we analyze channel selection and price setting of
a manufacturer who has several distribution options which
include selling through (1) a direct Internet channel, (2) a
manufacturer-owned retail channel, and/or (3) an independent
retail channel. We divide consumers into two segments: (1) A
retail-captive segment whose consumers cannot or will not
purchase using the direct channel and (2) a hybrid segment
whose consumers may use either the direct or the retail channels.
Hybrid consumers are heterogeneous in their channel preference.
We expect the hybrid segment’s size to increase as advances in
e-commerce enable direct online stores for virtually all products.
An online-captive segment, where consumers shop only through
the direct channel due to their geographical distance, can be
incorporated in our model. For the sake of simplicity, we do not
 Corresponding author. Tel.: + 1 704 687 7653; fax: + 1 704 687 6330.
E-mail addresses: mjkhouja@uncc.edu (M. Khouja), supark@uncc.edu (S. Park),
gcai@ksu.edu (G. (George) Cai).
slight modification to our model, the results in this paper can be
easily applied to the case where there are online-captive
consumers.
Our findings indicate that there are three variables which
determine optimal channel choice. The first is the distribution of
consumers among the retail-captive and hybrid segments. The
second is consumers’ channel preference. The third is the relative
values of the variable cost per unit of the product in the direct
channel vs. the retail channel. The last two variables are most
critical in channel selection for a vertically integrated supply
chain whereas the first variable becomes more critical when the
retailer is independent. These three variables interact to create
regions in their space where different distribution strategies are
optimal.
2. Literature review
There is a large body of research on multi-channel distribution
with a good deal of it predating the Internet (Corstjens and Doyle,
1979). Interest in multi-channel distribution has increased due to
the Internet. We focus our review on models which deal with a
manufacturer selling to consumers indirectly through retailers,
directly via the Internet, or both. A comprehensive review of these
models was conducted by Tsay and Agrawal (2004b). There is
another strand of research focusing on a retailer’s decision to
complement a physical channel with a direct channel (Bernstein
et al., 2008).

0925-5273/$ - see front matter & 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.ijpe.2010.01.005
 ARTICLE IN PRESS
M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95
Chiang et al. (2003) developed a model of a manufacturer who
can sell directly on the Internet, exclusively through a retailer, or a
combination of the two. The supply chain can be vertically
integrated or the retailer can be independent. The manufacturer
sets the Internet price and the wholesale price and the retailer
sets consumers’ price as a Stackelberg follower. Consumers’
reservation prices are uniformly distributed on [0,1] for the retail
channel and on [0, y], where y o1, for the direct channel. The
restriction on y reflects the assumption that retail provides a
superior shopping experience. A main finding of the model is that
the direct channel enables the manufacturer to reduce double
marginalization associated with the retail channel. The increased
leverage provided by the direct channel is inversely related to the
parameter y. Also, the direct channel may not always harm the
retailer because, in certain cases, a reduction in the wholesale
price accompanies the use of a direct channel.
Chiang and Monahan (2005) developed a two-echelon dual
channel inventory model in which inventory is kept at a
warehouse and at retailer locations. Warehouse inventory is used
to satisfy direct channel sales. Some consumers prefer retail stores
and others prefer the direct channel. In case of a shortage in the
warehouse, a proportion of consumers switch to the retail channel
and vice versa. The authors use inventory-related operational
costs to evaluate the performance of the system and to compare
retail-only distribution, direct only distribution, and dual channel
distribution. The main finding indicates that dual channel strategy
outperforms single-channel strategies in most cases.
Cattani et al. (2006) developed a model in which a manufac-
turer with an independent retail channel opens a direct Internet
channel. The manufacturer determines the wholesale price as the
Stackelberg leader and sets the direct price equal to the retailer’s
price. The model analyzes three strategies: (1) the manufacturer
keeps the wholesale price charged prior to opening the direct
channel, (2) the manufacturer’s policy results in the retail price
remaining unchanged, and (3) the manufacturer sets the whole-
sale and direct channel prices to the values which optimize its
profit. Consumers are assumed to be heterogeneous in terms
of channel preference. Individual consumers’ utility function is
decreasing in price and in purchase effort. Channel preference is
captured by the purchase effort which is assumed to be uniformly
distributed on ½0; Ef fi , where i is a channel index. Findings
indicate that Strategy 3 is optimal and is often also preferred by
the retailer and consumers because of lower prices.
Fruchter and Tapiero (2005) considered a manufacturer who
sells a product through retail stores and an online virtual store.
Similar to Chiang et al. (2003); Fruchter and Tapiero (2005) assume
that consumers have less valuation for a product purchased online.
The authors conclude that the manufacturer’s optimal strategy is to
charge the same price across both channels.
Rhee and Park (2000) developed a model in which a manufac-
turer operates an online store, uses an independent retailer, or uses
both options. The retailer provides services that the online store
cannot. Consumers are assumed to have uniformly distributed
reservation prices. A fixed proportion of consumers are sensitive to
the retailer’s service. The authors show that a hybrid system is
preferable when consumers’ valuations of the retail service are
similar across segments.
Tsay and Agrawal (2004a) also considered retail and direct
channels. Demand in each channel is a linear function of the
retailer’s and manufacturer’s efforts. If the manufacturer uses
both channels, the demand in each channel is a proportion of the
total demand in both channels. The authors suggest that the
preference for a channel alternative depends on supply chain
efficiency and marketing capability. However, both the manufac-
turer and retailer can benefit from a dual channel if the
manufacturer is willing to reduce the wholesale price.
85
To alleviate potential channel conflict when both the retail and
direct channels are open, Mukhopadhyay et al. (2008a, 2008b)
suggested that allowing the retailer to add value to the product
may result in product differentiation to consumers and hence
increase the manufacturer and retailer’s profit. The second model
(Mukhopadhyay et al., 2008b) focuses on hi-tech industries. The
authors further investigated the impact of the retailer adding value
when the manufacturer has complete vs. incomplete information
regarding the retailer’s cost of adding value, and quantified the value
of information to the manufacturer. They found that the manufac-
turer benefits from more information and the retailer would be
willing to share information with the manufacturer if her cost of
adding value is lower than a threshold value.
Kumar and Ruan (2006) developed a model of a manufacturer
using retail and direct channels. Consumers can be brand-loyal or
retailer-loyal. The retailer carries the manufacturer’s brand and
others. Brand-loyal customers buy only the manufacturer’s
product. The direct channel attracts brand-loyal consumers who
are price insensitive. The retailer maximizes product category
profits rather than just the profits from the manufacturer’s
product. To do so, the retailer must decide on the sales support
level for the manufacturer’s product. The authors find that when
consumers’ price-sensitivity difference between the two channels
exceeds a certain threshold, the manufacturer is better off
without a direct channel. Wang and Webster (2007) analyzed a
supply chain of a single manufacturer selling a perishable product
to a single retailer facing uncertain demand. The manufacturer is
risk neutral and the retailer is loss averse, which decreases the
retailer order quantity and total supply chain profit. The authors
investigate the role of a gain/loss sharing provision for mitigating
the loss-aversion effect.
Our model is related to the models of Cattani et al. (2006) and
Chiang et al. (2003). However, we explicitly consider the existence
of the retail-captive consumer segment (Koufaris and Hampton-
Sosa, 2004). Consumers in this segment do not use the direct
channel for one or more reasons which may include: loyalty to the
retailer (Kumar and Ruan, 2006), lack of access, privacy and
security concerns, inability to touch and feel the product (Ahuja
et al., 2003), difficulty in returning products (Nitse et al., 2004), or
fear of financial theft (Swinyard and Smith, 2003). Moreover, we
explore a wider range of marketing alternatives which received
little or no attention in the literature. Specifically, we analyze the
channel selection for a vertically integrated supply chain where
the manufacturer who, in addition to selling through manufac-
turer-owned stores, can also sell directly using the Internet. Our
model also differs from Chiang et al. (2003) in that we assume
that consumers may prefer either the direct channel or the retail
channel, whereas they assume consumers always prefer the retail
channel.
The distribution strategies available to manufacturers can be
divided as follows:
I. Marketing strategies without an independent retailer. In such
cases, the manufacturer does not use an independent retailer and
may select one of the following options:
I.a. An exclusive manufacturer-owned retail channel. The product
can be obtained only through manufacturer-owned retail
outlets. Examples include chemical firms selling gasoline and
paint such as Devoes and Durons.
I.b. An exclusive direct Internet channel. The product can be
obtained only through the direct channel. Examples include
Dell computers.
I.c. Direct channel and manufacturer-owned retail channel. The
product can be obtained through either channel. Examples of
this strategy are becoming more popular with manufacturers
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86 M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95

since the emergence of the Internet. Bose Corporation, for
example, operates factory stores for retail-captive consumers
but also sells directly on the Internet. Other examples include
Banana Republic and J Crew. Possible reasons for not offering
the product through an independent retailer is to have
complete control over pricing and the image of the product.
II. Marketing strategies with independent retailer(s). In this case,
the manufacturer can choose:
II.a. An exclusive independent retailer(s) channel. Many consumer
products are sold using this strategy.
II.b. An exclusive independent retailer(s) channel and a direct channel.
Since the emergence of the Internet many manufacturers have
opened up a direct channel, in addition to the existing
independent retail channel. Examples include Sony BMG music.
This is partial enumeration of strategies. Some manufacturers,
such as Hanes, offer their products through their own direct
channel, manufacturer-owned retail stores, independent brick
and mortar retailers, and online retailers.
The remainder of this paper is organized as follows. In Section 3,
we analyze the strategies in category I. Table 1 shows the
optimal prices and profits for strategies I.a and I.b. Table 2 shows
the possible optimal solutions for strategy I.c. We discuss channel
conflict resulting from strategies in category II and optimal
channel selection in Section 4 and present some numerical
examples. We provide a summary of results, a discussion, and
conclusions in Section 5.
3. Marketing options without an independent retailer
One segment of consumers does not use the direct Internet
channel at any price, making its consumers retail-captive. Other
consumers belong to a hybrid segment and may purchase from
the direct or the retail channels. We assume that hybrid
consumers are heterogeneous in their preferences for the direct
Table 1
Optimal distribution strategy without an independent retailer.
Strategy Optimal prices Optimal profit
Exclusive 1

a3 a

½a3 ah þ 2R2 að1cr Þ2
PrðV;ERÞ ¼ 2cr þ 2þ 2 h PðV;ERÞ ¼
retail 4 R a M
 
Exclusive 1 b3 ah ½b3 2R2 ð1cr Þ2
PdðV;EDÞ ¼ 2cd þ 2 2 PMðV;EDÞ
¼
direct 4 R
Dual Depends on condition in Depends on condition in
Table 2 Table 2
and retail channels. Some consumers prefer the retail channel
over the direct channel with varying strength and the opposite is
true for other consumers. The following notation is used:
i= r or d where r denotes retail channel and d denotes direct
Internet channel,
ci = the cost per unit of product sold using channel i,
Di =product demand via channel i,
Pi = price per unit of the product sold using channel i
al =size of consumer segment l, which can be hybrid or retail-
captive,
xj = preference strength for the retail channel over the direct
channel of consumer j in $,
f ðÞ = the probability density function of xj , a uniform
distribution on ½a; b, 1 oa o0 and 0 ob o1,
FðÞ= the cumulative distribution function of xj ,
T= index of business entity, R is for retailer, M is for
manufacturer, and S is for the supply chain,
K =index of industry structure, V is for vertically integrated,
and I is for independent retailer,
L= index of distribution strategy, ER is exclusive retail, ED is
exclusive direct, and DL is dual, and
PðK;LÞ
T = profit of entity T under industry structure K and
distribution strategy L.
We assume that consumers are heterogeneous in their
valuation of the product. Let r be the consumption value
(reservation prices) which, similar to the assumption in Chiang
et al. (2003), is assumed to be uniformly distributed between 0
and 1 to maintain analytical simplicity. Therefore, in a market
with a density of 1, if price is P, then demand is given by ð1PÞ and
in a market of size a consumer demand is given by að1PÞ. We
also assume that this consumer demand is valid when the product
is offered on the consumers preferred channel. This implies that
there is no additional utility gained when a consumer purchases
the product on their preferred channel. If the product is offered on
the consumers’ non-preferred channel, then consumers impose a
penalty on the product in this non-preferred channel. The results
in this paper are predicated on the resulting demand function, and
may not be true for other demand functions.
Channel preference of hybrid consumer j is measured by xj . If
xj 4 0 then hybrid consumer j prefers the retail channel, if xj o0
then consumer j prefers the direct channel, and if xj ¼ 0 then
consumer j is indifferent. We assume that 1 oa o 0 and
0 ob o 1 which implies that (1) some hybrid consumers prefer
16R4 a
the direct channel while others prefer the retail channel and
16R4 (2) channel preference is less than or equal to the consumption
value. Our intention from assuming that xj is uniformly distri-
buted on ½a; b instead of having a deterministic value of x is to

Table 2
Optimal dual strategy type without an independent retailer.

Condition Optimal strategy and region Optimal prices Optimal profit

cd Z cr Retail-focused ðR2RFD Þ 1 ðar þ ah Þð1cr Þ2

PrðRFDÞ ¼ ð1 þ cr Þ
2 4
PdðRFDÞ ¼ PrðRFDÞ a þ e; e Z 0
cd o cr o cPD Pure dual ðR2PDL Þ Numerical search
cPD r cr r cd þ 2b Direct-focused, ðR2DFD Þ or pure dual ðR2PDL Þ a þ ðcd ah þ cr ar 2bar Þ 1 2
PdðRFDÞ ¼ ½a ð1cd Þ2 þ a2r ð1cr Þ2 þ 2ah ar ½1cr cd þ cr c1 2bðcd þ bÞ
2a 4a h
PrðDFDÞ ¼ PdðDFDÞ þ b
or using a numerical search
cd þ 2b r cr r 1 Direct-focused ðR2DFD Þ 1 ar ð1cr Þ2 ah ð1cd Þ2
PdðDFDÞ ¼ ð1þ cd Þ þ
2 4 4
1
PrðDFDÞ ¼ ð1þ cr Þ
2
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M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95 87

indicate that by having a lower price on one channel, not all r

hybrid consumers move to that channel. This is especially true
when the price differential between the prices on the two 1
channels is small and does not provide enough incentive for
consumers to leave their preferred channel. Note that having a Pr − a
retail-captive segment is equivalent to assuming that for ah
consumers, preference strength x is distributed according to some B A
pdf on ½a; b and for ar consumers x is distributed according to
Pr + -
some pdf on ½M1 ; M2  where 1o M1 o M2 .

r - Pr +  = 0
3.1. Exclusive retail channel strategy

The demand function of the retail-captive consumers is C

( 0
ar ð1Pr Þ if 0 rPr o1;
Dr ¼ ð1Þ
0 otherwise:
As shown in Fig. 1, hybrid consumers can only purchase from the
retail channel. Hybrid consumers expect that the product will be
available on their preferred channel and will not gain additional
utility beyond their valuation for the product if they purchase it
on this preferred channel. Although consumers do not gain any
additional utility when buying the product on either channel, they
impose a penalty (a disutility) on the product when they buy it on
their non-preferred channel. This penalty represents the
inconvenience consumers encounter in using a non-preferred
channel, thereby discouraging some of them from buying the
product. For example, suppose that hybrid consumer j prefers the
retail channel (i.e. xj 4 0) and has a valuation of rj . If only the retail
channel is available, then this consumer will receive a utility of
rj Pr from purchasing the product from the retail channel and
will buy the product if rj Pr 4 0. Suppose hybrid consumer i
prefers the direct channel (i.e. xj o 0), then because only the retail
channel is available, consumer i imposes a penalty (a disutility) of
xj on the retail channel and will receive a net utility of
rj Pr þ xj orj Pr if the product is purchased on the direct
channel and will buy the product if rj Pr þ xj 4 0.
Fig. 2 shows different areas in the ðr; xÞ space and the resulting
demand of hybrid consumers for a given retail price if only the
retail channel is open. Consumers with xj 4 0 find the product
available on their preferred channel and will buy the product if
rj Pr Z0. This demand is represented by area A in Fig 2. Area C is
excluded because these consumers do not gain additional utility

a 0 Pr b
Fig. 2. Hybrid consumers demand if only a retail channel is open.
when they can buy the product on their preferred retail channel.
Consumers with xj o 0 get a net utility of rj Pr þ xj due to the
penalty they impose on the retail channel. Therefore, these
consumers buy the product if rj Pr þ xj Z0 and are represented

by area B in Fig 2. Let x ¼ E½xj jxj o 0, then area B is equal to the
 
area above the Pr þ x line for a o x o 0. Consumers do not gain
additional utility when they buy the product on their preferred
channel because the utility depends on the product, which is the
same whether the product purchased on the preferred or non-
preferred channel. The penalty on the non-preferred channel is
not due to any degradation in the product but is due to the
inconvenience the consumer encounters in using the non-
preferred channel. For example, suppose a consumer prefers the
retail channel and is interested in buying a movie DVD. If this
consumer does not like to give out her credit card information on
the Internet and the retailer does not carry the product in the
store, then the consumer can buy the DVD only on the direct
channel. If the consumer’s reservation price is only slightly above
the price, then the inconvenience of using the direct channel may
cause her not to buy the product
The expected proportion of hybrid consumers who prefer the
retail channel or are indifferent is
Pah
EðX1 þ X2 þ    þXah Þ j ¼ 1 Pðxj Z0Þ a ½1Fð0Þ b
y¼ ¼ ¼ h ¼ ;
ah ah ah ba
ð2Þ

where Xj ¼ 1 if consumer j prefers the retail channel or is

Manufacturer indifferent and Xj ¼ 0 otherwise. As Fig. 2 shows, the expected
demand function of hybrid consumers who prefer the retail
channel or are indifferent is
(
yah ð1Pr Þ if 0 rPr o 1;
Drh1 ¼ ð3Þ
0 otherwise:
Retailer
If consumers gained additional utility from buying the product on
Pr their preferred channel, then the demand in area C of Fig. 2 must
also be included in the demand of the hybrid segment.
Preference The expected proportion of hybrid consumers who prefer the
Pr direct channel (i.e. xj o0) is 1y ¼ a=ðbaÞ. Those consumers
Pr Pr + - experience less utility from purchase due to their preference for
the direct channel. As Fig. 2 shows, the expected demand for this
Retail Hybrid consumer segment is thus based on an effective price of Pr þ x

Segment Segment and is given by
 1− (   
ð1yÞah ½1ðPr þ x Þ if x rPr o1x ;
Drh2 ¼ ð4Þ
0 otherwise;
Fig. 1. Exclusive retail strategy model.
 ARTICLE IN PRESS
88 M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95

where penalty of xj on the direct channel price. The expected demand

Z 0 function for this portion of the hybrid segment is
a (
x ¼ E½xj jxj o0 ¼  xf ðxjx o 0Þ dx ¼ : ð5Þ
a 2 yah ½1ðPd þ x þ Þ; if x þ r Pr o 1x þ ;
Dd2 ¼ ð11Þ
In a vertically integrated supply chain, which in this case is a 0; otherwise;
manufacturer-owned retail channel, the chain’s profit is where
PðV;ERÞ 
¼ ðPr cr ÞðDr þ Drh1 þ Drh2 Þ ¼ ðPr cr Þa½1ðPr þ ð1yÞðah =aÞx Þ; Z b
M b
x þ ¼ E½xj jxj 4 0 ¼ xf ðxjx 40Þ dx ¼ : ð12Þ
ð6Þ 0 2
where a ¼ ar þ ah . Since @2 PðV;ERÞ
M =@Pr2 ¼ 2a o 0, the sufficient The profit of the manufacturer is
condition for optimality yields  
2 b
PðV;EDÞ
M ¼ ðDd1 þDd2 ÞðPd cd Þ ¼ ðPd cd Þah 1Pd  y : ð13Þ
PrðV;ERÞ ¼ 12ð1 þ cr ÞDPrðV;ERÞ ; ð7Þ 2
;EDÞ
where Since @2 PðV
M =@Pd2 ¼ 2ah o 0, the sufficient condition for optim-
ality of Pd yields
DPrðV;ERÞ ¼ 12ð1yÞðah =aÞx : ð8Þ
PdðV ;EDÞ ¼ 12ð1þ cd ÞDPdðV ;EDÞ ; ð14Þ
Because a o0; DPrðV ;ERÞ 40,
and PrðV ;ERÞ
is lower than the optimal
price without hybrid consumers having a preference for the direct where
channel (i.e. ah ¼ 0 or a ¼ 0). Therefore, the existence of the hybrid b 2
consumer segment places downward pressure on price. The DPdðV ;EDÞ ¼ y : ð15Þ
4
reduction in price by DPrðV ;ERÞ ¼ ð1yÞðah =aÞx =2 indicates that

The resulting profit is
hybrid consumers get a price break proportional to their segment
size and the strength of their preference for the direct channel. ah ð1cd 2DPdðV;EDÞ Þ2
Retail-captive consumers benefit from the existence of the hybrid
PðV;EDÞ
M ¼ : ð16Þ
4
consumers because of the decrease in price. The exclusive direct channel strategy is only attractive when the
The optimal profit of the manufacturer is hybrid segment is large because all potential profit from the
;ERÞ a retail-captive segment is lost. Furthermore, consumers’ prefer-
PðV
M ¼ ð1cr 2DPrðV;ERÞ Þ2 : ð9Þ
4 ence for the retail channel reduces the manufacturer’s profit as if
þ
Eq. (9) shows that the existence of hybrid consumers reduces the the variable cost per unit, cd , was to increase by 2DPdðV;EDÞ ¼ yx as
manufacturer’s profit as if the variable cost per unit, cr , was to shown in (16). This cost increase is the same as the expected
increase by 2DPrðV ;ERÞ ¼ ð1yÞðah =aÞx . Because the probability a
 penalty from a consumer whose preference and segment are not
consumer belongs to the hybrid segment and prefers the direct revealed.
channel is ðah =aÞð1yÞ, this cost increase is equal to the expected
penalty from a consumer whose preference and segment are 3.3. Dual channel strategy
unknown.
When both channels are open, a consumer first decides which
3.2. Exclusive direct channel strategy channel she will use if she buys the product based on the price
difference and her channel preference, i.e., xj . A consumer uses a
As shown in Fig. 3, the retail-captive segment demand goes two-stage process in making her choices. In the first stage, she
unsatisfied. The expected proportion of hybrid consumers who compares the price difference between the two channels and her
prefer the direct channel is ð1yÞ and their expected demand is channel preference. If Pr Pd Z xj then Pr xj ZPd and consumer j
( decides to use the direct channel for any a r xj rb. If Pr Pd o xj
ð1yÞah ð1Pd Þ if 0 rPd o 1; then Pr xj oPd and consumer j decides to use the retail channel
Dd1 ¼ ð10Þ
0 otherwise: for any a r xj r b. Once the decision on which channel to use in
the first stage is made, then in the second stage, the consumer
The expected proportion of hybrid consumers who prefer the
only considers the price on the chosen channel vs. her reservation
retail channel is y. A hybrid consumer who prefers the retail
price. If consumer j decided to shop on the direct channel in the
channel will have less utility from purchase and will impose a
first stage, then, if Pd rrj then consumer j buys the product on the
direct channel. If consumer j decided to shop on the retail channel
in the first stage, then if Pr r rj then consumer j buys the product
Manufacturer on the retail channel. The use of a two-stage decision process can
be used for modeling consumers’ choice in e-commerce (Forman
Pd and Goldfarb, 2008). For example, Degeratu et al. (2000) used a
two-stage consumer choice model in which consumers first
choose whether to shop online or offline and then make brand
choice.
Preference As shown in Fig. 4, retail and direct channel prices may be
different which makes the expected proportion of hybrid
Pd + + Pd
consumers who choose the retail channel a decreasing function
of the price difference Pr Pd . If Pr a rPd (recall a o0) then the
Retail Hybrid
Segment price on the direct channel is high enough to push all consumers
Segment
in the hybrid segment to the retail channel. If Pr Z Pd þb then the
 1− price on the retail channel is high enough to push all consumers in
the hybrid segment to the direct channel. The case of
Fig. 3. Exclusive Direct Channel Strategy. a oPr Pd ob is one in which the price difference is not
 ARTICLE IN PRESS
M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95 89

Pd
Manufacturer

Infeasible
Retail-Focused or Inferior
Pd Dual Strategy
Retailer
1
(Pr-Pd ≤ a)
Pr Pr

Retail Hybrid
Segment Segment Pure Dual
Strategy
 1−

Fig. 4. Dual Channel Strategy. −a Direct-Focused

(a < Pr-Pd < b)
Dual Strategy
sufficient to push all consumers in the hybrid segment to a single
(Pr-Pd ≥ a)
channel. This results in the hybrid segment forming two sub-
segments, one for the retail channel and the other for the direct
channel. Therefore, the expected proportion of hybrid consumers
who prefer the retail channel or are indifferent is b 1
EðX1 þ X2 þ    þXah Þ Pr
y¼
ah
Pah Fig. 5. Three sub-strategies in the dual channel strategy.
j¼1
Pðxj Z Pr Pd Þ
¼
8 h a
>
> 1 if Pr Pd r a;
>
< The manufacturer must decide on the retail price and the direct
bðPr Pd Þ
¼ if a oPr Pd ob; : ð17Þ price to maximize the profit:
>
> ba
>
:0 if Pr Pd Z b: PðV;DLÞ
M ¼ ðDr þ Drh ÞðPr cr Þ þ Ddh ðPd cd Þ; ð19Þ
where
All retail-captive consumers whose reservation prices are met 
yah ð1Pr Þ if 0 r Pr o 1;
purchase from the retail channel at Pr . Drh ¼ ð20Þ
0 otherwise
Retail and direct prices have two boundary conditions
resulting from the demand function and the uniform consumer and
(
channel preference. The demand in the retail (or direct channel) ð1yÞah ð1Pd Þ if 0 r Pd o1;
vanishes if the retail (or direct price) is greater than or equal to 1. Ddh ¼ ð21Þ
0 otherwise:
Also, splitting of the hybrid segment demand between the direct
and retail channels does not occur if Pr Pd is large or small The profit function PðV;DLÞ is twice differentiable in each region
M
enough to make y ¼ 0 or y ¼ 1, respectively. Therefore, three sub-
(R2PDL , R2RFD , or R2DFD ) that represents one of the three dual channel
strategies are possible within the dual channel strategy:
strategies. Considering the boundary conditions, the profit
functions for these strategies can be derived based on (19) as
(1) Pure dual (PDL) channel strategy: The manufacturer serves hybrid
follows:
consumers using both the retail and direct channels. Hybrid
consumers are split between the retail and direct channels. To PðV;PDLÞ
M ¼ ðar þ yah Þð1Pr ÞðPr cr Þ þ ð1yÞah ð1Pd ÞðPd cd Þ if ðPr ; Pd Þ A R2PDL ;
have positive demand in both channels, 0 o Pr o1, 0 oPd o 1,
PðV;RFDÞ ¼ ðar þ ah Þð1Pr ÞðPr cr Þ if ðPr ; Pd Þ A R2RFD ;
and 0 o y o 1 (i.e. a oPr Pd ob) must be satisfied. M

(2) Retail-focused dual (RFD) strategy: The manufacturer serves all

ðV;DFDÞ
PM ¼ ar ð1Pr ÞðPr cr Þ þ ah ð1Pd ÞðPd cd Þ if ðPr ; Pd Þ A R2DFD :
hybrid consumers using the retail channel. The direct channel ð22Þ
is open but inactive due to its high unit price. To make the
direct channel inactive, Pd Z 1 or Pr Pd r a must be satisfied.
If Pd ¼ Pr a then PðV;PDLÞ
M ¼ PðV;RFDÞ
M and if Pr ¼ Pd þ b then
(3) Direct-focused dual (DFD) strategy: The manufacturer serves all
hybrid consumers using the direct channel. In this strategy, PðV;PDLÞ
M ¼ PðV;DFDÞ
M
ðV;DLÞ
. The global maximum of PM : R2 -R must
Pr Z1 or Pr Pd Zb must be satisfied. The retail channel can be be one of the global maxima obtained from the above three profit
;RFDÞ
still active due to the existence of retail-captive consumers if functions. Finding the global maxima for PðV M and PðV;DFDÞ
M is
Pr o1. simple due to their concavity in the solution space. Propositions 1
and 2 show the conditions under which the direct-focused dual
Fig. 5 shows how these strategies are divided into three regions strategy and the retail-focused dual strategy are optimal,
in the ðPr ; Pd Þ vector space: respectively.

R2PDL ¼ fðPr ; Pd Þj0 o Pr o 1; 0 o Pd o1; and a oPr Pd obg; Proposition 1. If cd þ 2b rcr r1 then the direct-focused dual
strategy is globally optimal with unique maximum profit at prices of
R2RFD ¼ fðPr ; Pd ÞjPr 40; Pd 40; and Pr Pd rag;
R2DFD ¼ fðPr ; Pd ÞjPr 4 0; Pd 4 0; and Pr Pd Z bg: ð18Þ PdðV;DFDÞ ¼ 12 ð1 þcd Þ and PrðV;DFDÞ ¼ 12ð1 þcr Þ ð23Þ

90
and maximum profit of
2 2
;DFDÞ ar ð1cr Þ ah ð1cd Þ
PðV
M ¼ þ :
4 4
Proof. See Appendix. & or
Proposition 1 implies that if the variable cost per unit of the
retail channel is sufficiently larger than that of the direct channel
(i.e. cr Z cd þ 2b), then the direct and retail channel prices should
be determined independently. Independent pricing is optimal
because the sufficiently large variable cost per unit of the retail
channel makes the manufacturer serve all hybrid consumers
using the direct channel.
Proposition 2. If cd Z cr then the retail-focused dual strategy is
globally optimal with maximum profit at prices of
PrðV;RFDÞ ¼ 12ð1 þ cr Þ and PdðV ;RFDÞ ¼ PrðV ;RFDÞ a þ e; e Z 0
and maximum profit of
ðar þ ah Þð1cr Þ2
;RFDÞ
PðV
M ¼ : ð26Þ
4
Proof. See Appendix. & there exists a unit profit ðPd cd Þ for any Pd A ½0; 1 in the direct
Proposition 2 implies that if the variable cost per unit for the
direct channel is larger than that for the retail channel, then the
manufacturer is better off setting the direct price high enough to
ensure that all consumers use the retail channel. Thus, the
manufacturer first determines the optimal retail price by max-
imizing the profit as if only retail consumers existed. Then, the
direct price is determined based on that retail price by adding an
amount exceeding the maximum consumers’ preference strength
for the direct channel.
Now we analyze the optimal solution when cd ocr rcd þ 2b.
This range is broken up into two: cd o cr o cPD and
cPD r cr r cd þ 2b, where cPD is given by Eq. (27). In the first range,
the optimal strategy is the pure dual strategy (where hybrid
consumers are split between the two channels) because the small
cost advantage of using the direct channel is not sufficient to
warrant moving all hybrid consumers to that channel. In the
second range, a relatively larger cost advantage encourages the
manufacturer to serve all hybrid consumers in the direct channel.
However, the independent pricing in Proposition 1 is not
advantageous because the cost difference is not large enough.
Instead of using independent pricing, the manufacturer tries to set
the retail price just high enough to keep all hybrid consumers in
the direct channel, which is why the solution is at the boundary of
R2PDL and R2DFD . Let c1 ¼ cd þ2b and R ¼ ba and
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
að1c1 Þ þ2ar R ½2ar R þ að1c1 Þ2 þ 8ar abð1c1 þ bÞ
cPD ¼ c1 þ
2ar
Lemma 1. If the unit profit from the direct channel ðPd cd Þ is greater
than or equal to hybrid consumers’ maximum preference for the retail
channel (b), then cPD r cd þ2b.
Proof. See Appendix. &
Proposition 3. If cd rcPD rcr rcd þ 2b then the global optimal
solution is
(a) on the boundary of R2DFD with an optimal prices of
1 cd ðcd þ2bcr Þar
PdðV;DFDÞ ¼ þ  and PrðV;DFDÞ ¼ PdðV;DFDÞ þ b
2 2 2a
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M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95
and a maximum profit of
1 2
PðV;DFDÞ ½a ð1cd Þ2 þ a2r ð1cr Þ2 þ 2ah ar ½1cr þ cd þ cr c1 2bðcd þ bÞ
ð24Þ M ¼
4a h
ð29Þ
(b) in R2PDL .
Proof. See Appendix. &
Our analysis indicates that the global optimal solution is
frequently given by solution (a) of Proposition 3. Even when the
global solution is given by solution (b), the local maximum
solution given by (a) has an optimal profit close to (b). While both
conditions in Propositions 1 and 3 result in an optimal solution in
R2DFD , PdðV ;DFDÞ ; and PrðV;DFDÞ are determined independently only
under the condition in Proposition 1 (i.e. cd þ 2b r cr r 1). Given a
ð25Þ relatively larger variable cost per unit for the retail channel
(cd ocPD rcr ), Lemma 1 and Proposition 3 show that as long as
the marginal profit from the direct channel is greater than
hybrid consumers’ maximum preference for the retail channel
(i.e., Pd cd Zb), it is usually optimal for the manufacturer to serve
all hybrid consumers using the direct channel. In other words, if
channel which can offset the maximum penalty imposed by the
retail-preferring hybrid consumers, the manufacturer tries to
move those consumers to the direct channel. The manufacturer
attracts those retail-preferring consumers by setting the direct
price lower than that from independent pricing, under which the
total profit in the direct channel is maximized. This dependent
pricing given in (28) occurs because the variable cost per unit for
the retail channel is not sufficiently larger ðcr 4 cd þ2bÞ than that
for the direct channel.
Proposition 4. If cd ocr ocPD then the global optimal solution is in
R2PDL and a pure dual strategy is globally optimal.
Proof. See Appendix. &
Propositions 1–3 show that a pure dual strategy should not be
used if there is a large difference in the variable costs per unit.
Corollary 1 further shows that even if both variable costs per unit
are equal, the retail-focused dual strategy may be preferred to the
pure dual channel strategy because opening an inactive direct
channel is usually less expensive than opening an active direct
channel.
Corollary 1. For cr ¼ cd ¼ c, the optimal profit of the manufacturer is
að1cÞ2
PðV;DLÞ ¼ ð30Þ
M
4
at
: PrðV ;DLÞ ¼ PrðV;PDLÞ ¼ PrðV;RFDÞ ¼ 12ð1 þ cÞ;
ð27Þ
PdðV ;DLÞ ¼ PdðV;RFDÞ ¼ PrðV;RFDÞ a þ e or PdðV;DLÞ ¼ PrðV;PDLÞ ; e Z0:
ð31Þ
Proof. See Appendix. &
4. Discussion and numerical examples
We begin by illustrating the strategies without an independent
retailer using a numerical example and then discuss the more
difficult strategies with an independent retailer. Consider a
manufacturer with the following parameters for demand and
consumers’ preference: ar ¼ 0:3; ah ¼ 0:7; a ¼ 0:2; and b ¼ 0:2.
As Table 3 shows, if cr ¼ 0:5 and cd ¼ 0:6; then a retail-focused
ð28Þ dual strategy is the best, followed by an exclusive retail strategy. If
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M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95 91

Table 3
Optimal marketing strategies under different parameters.

cr cd cPD Condition Strategy(* indicates best) Retail price Direct price Profit

0.5 0.6 cr o cd Exclusive retail 0.741 0.0582

Retail-focused* 0.750 0.950 0.0625

0.5 0.5 cr ¼ cd Retail-focused* 0.750 0.950 0.0625

Pure dual* 0.750 0.750 0.0625

0.5 0.45 0.557 cd o cr o cPD Direct-focused 0.873 0.673 0.0652

Pure dual* 0.772 0.701 0.0682

0.5 0.4 0.498 cPD r cr r cd þ 2b Retail-focused 0.750 0.950 0.0625

Direct-focused* 0.855 0.655 0.0770

0.5 0.05 cd þ 2b r cr Direct-focused* 0.733 0.533 0.1760

Exclusive direct 0.513 0.1500

cr ¼ 0:5 and cd ¼ 0:5; then both the retail-focused and pure dual retailer’s profit is given by
strategies are optimal with a profit of 0.0625. If cr ¼
PRðI;ERÞ ¼ ðPr wÞðDr þ Drh1 þ Drh2 Þ ¼ ðPr wÞa½1ðPr þð1yÞðah =aÞx Þ:
0:5 and cd ¼ 0:45; then cPD ¼ 0:557 and cd ocr ocPD . By Proposition
4, a pure dual strategy is optimal with a profit of 0.0682. If ð32Þ
cr ¼ 0:5 and cd ¼ 0:4; then cPD ¼ 0:498 and cPD r cr r cd þ 2b. By Since @ 2
PRðI;ERÞ =@Pr2 ¼ 2a o0, the sufficient condition for
Proposition 3, a direct-focused strategy with direct and retail price optimality of Pr is
difference of b is optimal and the optimal profit is 0.0770. If
PrðI;ERÞ ¼ 12ð1 þwÞDPrðI;ERÞ ð33Þ
cr ¼ 0:5 and cd ¼ 0:05; then cd þ 2b rcr . By Proposition 1, a direct-
focused strategy is optimal with independently determined optimal where DPrðI;ERÞ ¼ DPrðV;ERÞ
shown in (8). Since is DPrðI;ERÞ 4 0, PrðI;ERÞ
prices and an optimal profit of 0.176. This numerical example does lower than the optimal price without the hybrid consumer
not consider the fixed cost of operating a retail or direct channel. As a segment. The resulting optimal retailer profit is
result, the exclusive retail channel strategy and the exclusive direct a
channel strategy are always inferior to dual channel strategies. PRðI;ERÞ ðwÞ ¼ ð1w2DPrðI;ERÞ Þ2 : ð34Þ
4
A Stackelberg equilibrium where the manufacturer is the
4.1. Marketing options with an independent retailer leader is obtained by optimizing the manufacturer’s profit given
the retailer’s optimal pricing. The manufacturer’s profit is
Selling directly to consumers makes a manufacturer a ðI;ERÞ 
PM ðPr Þ ¼ 12ðwcr Það1w2DPrðI;ERÞ Þ ð35Þ
competitor to its market intermediaries and gives rise to channel
2 ðI;ERÞ 
conflict (Tsay and Agrawal, 2004b). This channel conflict is best Since @ PM ¼ a o0, the sufficient condition for
ðPr Þ=@w2
illustrated by a letter Home Depot sent to more than 1000 optimality of w yields
suppliers (Brooker, 1999) in which they state ‘‘We think it is short- wðI;ERÞ ¼ 12ð1 þ cr ÞDPrðI;ERÞ : ð36Þ
sighted for vendors to ignore the added value that our retail stores
contribute to the sales of their productsy’’. The letter goes on to The resulting optimal manufacturer profit is
state ‘‘However, we too have the right to be selective in regard to the a 1 ðV;ERÞ
vendors we select and we trust that you can understand that a
ðI;ERÞ
PM ¼ ð1cr 2DPrðI;ERÞ Þ2 ¼ P : ð37Þ
8 2
company may be hesitant to do business with its competitors.’’
Substituting for w in (33) with wðI;ERÞ from (36), the retailer’s
Despite the possibility of channel conflict, selling directly to
optimal price in a Stackelberg equilibrium can be written as
consumers using the Internet provides several advantages to
manufacturers including the ability to have closer contact with cr 3 3 1cr DPrðI;ERÞ
PrðI;ERÞ ¼ þ  DP ðI;ERÞ ¼ PrðV;ERÞ þ  ð38Þ
consumers, direct control over price, protection from crises that 4 4 2 r 4 2
may arise with intermediaries, and ability to offer a broader and the retailer’s optimal profit is
product selection (Tsay and Agrawal, 2004b). Direct selling may
harm the intermediaries whose central role is to build brand and a 1 ðV;ERÞ
PRðI;ERÞ ¼ ð1cr 2DPrðI;ERÞ Þ2 ¼ P : ð39Þ
product awareness by educating consumers, advertising, provid- 16 4 R
ing customer support, collecting market information, etc. If direct From Eqs. (37) and (39), regardless of the value of in a DPrðI;ERÞ ,
selling hampers the ability of the retailer to perform these decentralized supply chain the manufacturer gets half of the
functions and the manufacturer is unable to assume these profit of a vertically integrated firm, and the retailer gets one
functions, the ultimate result may be a loss in market share fourth. Thus, there is a decrease in supply chain profit. This is a
and/or profit. property of ‘‘double marginalization’’ which occurs even if
We study a Stackelberg game in which the manufacturer DPrðI;ERÞ ¼ 0 (implying that there are no consumers who prefer
(leader) sets the wholesale price and the retailer (follower) the direct channel). Consumers also face an increase of
responds by setting its retail price. Stackelberg games are ð1cr Þ=4DPrðI;ERÞ =2 in price over the vertically integrated supply

commonly used in multi-channel studies (e.g., Chiang et al., chain. Since DPrðI;ERÞ =2 ¼ ð1yÞðah =aÞx =4; this price increase
2003; Tsay and Agrawal, 2004a; Yao and Liu, 2005) as well as decreases as the size of the hybrid segment increases and/or
analyzes of non-cooperative supply chains (e.g., Li et al., 2002; Xie their preference for the direct channel increases.
and Ai, 2006). The independent retailer buys the product at a Now suppose the manufacturer opens a direct channel. In this
wholesale price of w and sells it to consumers at price Pr . The case, the retailer serves both retail and hybrid segments while the
 ARTICLE IN PRESS
92 M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95
Unit price, $
Proportion of hybrid consumers, αh
Fig. 6. Retail, direct, and wholesale prices vs. ah .
Proportion of hybrid consumers, αh
Fig. 7. Manufacturer, retailer, and supply chain profits vs. ah .
manufacturer serves only the hybrid segment. This case is too
complex to obtain analytical results and we therefore analyze it
numerically. The manufacturer has to decide the wholesale price
w and the direct channel price Pd and the retailer determines Pr .
Figs. 6 and 7 show optimal prices and profits as a function
of the size of the hybrid segment for ah þ ar ¼ 1, b ¼ a ¼ 0:2;
and cr ¼ cd ¼ 0:2. Fig. 6 shows that holding the total market
size constant, as the size of the hybrid segment increases, the
retailer has to decrease the retail price to compete with the
manufacturer’s direct channel, since there are less retail-captive
consumers. The manufacturer charges the same wholesale and
direct price, which is similar to the result obtained by Chiang et al.
(2003). As the size of the hybrid consumer segment increases, the
manufacturer first decreases the wholesale/direct price to capture
more consumers and to encourage more sales to retail-captive
consumers. As the hybrid consumer segment becomes dominant,
the manufacturer has less incentive to try to increase sales on the
retail channel and starts increasing the wholesale/direct price.
Fig. 7 shows that as the size of the retail-captive segment
decreases, the manufacturer’s profit increases whereas the
retailer’s profit decreases. The net result is that the total supply
chain profit increases due to the increase in direct channel sales
and the reduction in double marginalization. As ah approaches 1,
the supply chain profits approach the profits of a vertically
integrated chain with a small penalty due to retail channel
preference of some hybrid consumers.
4.2. Choice of channel
We develop some conclusions on the best channel choice
when cd ¼ cr . If there is no independent retailer, the manufacturer
compares the following options:
1. Sell only through its own retail outlets. Optimal price and profit
are given by Eqs. (7) and (9). A fixed cost of F1 for operating the
retail channel should be subtracted from the profit.
2. Sell only through a direct channel. Optimal price and profit are
given by Eqs. (14) and (16). A fixed cost of F2 for operating the
direct channel should be subtracted from the profit.
3. Sell through a direct channel and manufacturer-owned retail
outlets. Optimal prices and profit are given by the optimal case in
the equations of Table 2. A fixed cost of F1 þ F2 for operating the
direct and retail channels should be subtracted from the profit.
In order for option 3 to be better than option 1, the following
should be satisfied:
F2 o aDPrðV;ERÞ ð1c þ DPrðV;ERÞ Þ ð40Þ
Intuitively, option 3 is more profitable than option 1 if F2 is small
and the consumers’ preference for the direct channel is high.
Similarly, option 3 is better than option 2 if
ar
F1 o ð1cÞ2 þ ah DPdðV;EDÞ ð1cDPdðV;EDÞ Þ ð41Þ
4
Choosing between options 1 and 2 depends on the values of F1
and F2 and consumers’ preference. Corollary 2 establishes the
condition for option 1 to be preferable to 2 when F1 ¼ F2 .
Corollary 2. For a vertically integrated firm with cd ¼ cr ,
the exclusive retail strategy is always better than the exclusive
direct channel if consumers on average prefer the retail channel
(i.e., E½xj  4 0, a þb 4 0 or DPrðV;ERÞ o DPdðV;EDÞ ).
Proof. See Appendix. &
Corollary 3 and Proposition 5 provide some insights into
channel selection if the retailer is independent.

0.57
0.55 Direct Channel
0.53
0.51
αh
0.49
Retail Channel
0.47
0.45
0 0.2 0.4
-a
Fig. 8. Optimal channel choice: direct vs. retail.
Corollary 3. If hybrid consumers are indifferent between the direct
and retail channel ðxj ¼ 08jÞ and cd ¼ cr then the exclusive direct
channel can be more profitable than the exclusive independent retail
channel only if ah Z ar .
Proof. See Appendix. & solutions are possible. If the cost difference is small enough, a
Corollary 3 implies that for an exclusive direct channel to be
more profitable that an exclusive independent retail channel, at
least 50% of all consumers must be in the hybrid segment
and they are indifferent between the direct and retail channels.
This may explain why many manufacturers have not opted for
exclusive direct channel selling. For many products, more than
50% of consumers are retail-captive consumers. Even when more
than 50% of consumers are hybrid consumers, large portions of
them may still prefer the retail channel.
Proposition 5. If hybrid consumers are on average indifferent
between the direct and retail channel (i.e. E½xj  ¼ 08j) and cd ¼ cr ,
then as the range of channel preference strength increases, the size of
the hybrid segment must increase in order for the exclusive direct
channel to remain more profitable than the exclusive independent
retail channel.
Proof. See Appendix. & same as the retail price if a direct channel is available. Given this
Let ba ¼ 1, then 100|a| is the percentage of hybrid consumers
who prefer the direct channel. Also, let D1 ¼ PðV;EDÞ
M
ðI;ERÞ
PM be
the difference between optimal manufacturer’s profit under
exclusive direct and exclusive independent retail channel strate-
gies. Let a1 ¼ a þ1, D1 ¼ 0 then
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
42½2 þ 3að2 þ að2 þ aÞÞ þ a61  ða31 2Þ2 ½44ð1 þ 2aÞða1 þ a2 Þ þ a61 
ah ¼
a6
is the size of hybrid consumer segment needed in order for the
direct channel and the independent retail channel strategies to yield
the same profit. A plot of Eq. (42) divides the space into two regions
shown in Fig. 8. In the first region an exclusive direct channel is
optimal whereas in the second region an exclusive independent
retail channel is optimal. As the size of the hybrid segment increases
and its consumers’ preference for the direct channel increases, the
exclusive direct channel strategy becomes more profitable.
5. Summary of results and conclusions
In a vertically integrated supply chain where a manufacturer
must use either a direct or a manufacturer-owned retail channel,
the exclusive retail channel is optimal if the variable unit cost of
the direct channel is equal to or greater than that of the retail
channel and consumers on average prefer the retail channel or are
indifferent. This result holds for any hybrid segment size. If the
ARTICLE IN PRESS
M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95 93
variable cost per unit for the direct channel is lower than the retail
channel, the retail channel may still be optimal because the direct
channel cost advantage may be offset by losing the retail-captive
segment. Similarly, if the variable cost per unit for the direct
channel is lower than that of the retail channel, the retail channel
remains optimal as long as the expected penalty for not satisfying
consumers’ retail channel preference is large. The exclusive direct
channel strategy should be used only when the retail-captive
segment is small and the expected penalty for not satisfying a
consumers’ direct channel preference is small.
0.6 0.8 1 The retail-focused dual strategy is more effective than the pure
dual channel strategy if the variable cost per unit of the direct
channel is greater than that of the retail channel. On the other
hand, the direct-focused dual strategy is more effective when the
variable cost per unit of the retail channel is larger than that of the
direct channel by twice the maximum preference for the retail
channel. If the variable cost per unit of the retail channel is larger
than that of the direct channel by an amount smaller than twice
the maximum preference for the retail channel, then two
pure dual strategy in which the hybrid segment is split between
channels is optimal. If the cost difference is relatively large, a
direct-focused strategy where the price difference is given by the
maximum consumer preference for the retail channel is optimal.
When the retailer is independent, numerical analysis indicates
that the manufacturer sets the wholesale price and direct price
equal to each other. As the size of the hybrid consumer segment
increases, the manufacturer first decreases the wholesale/direct
price to capture more consumers and to encourage more sales
to retail-captive consumers. As the hybrid consumer segment
becomes dominant, the manufacturer has less incentive to try to
increase sales on the retail channel and starts increasing the
wholesale/direct price. As ah approaches 1, supply chain profits
approach the profits of a vertically integrated chain with a small
penalty due to retail channel preference of some hybrid consumers.
A critical underlying assumption of the exclusive retail strategy
model is that consumers believe that the direct price would be the
assumption, the dual channel strategy is always more profitable
because the manufacturer can choose to open an inactive direct
channel to remove any penalty caused by consumer channel
preference. The unit price on the direct channel is set high enough
to ensure that there is little or no demand on it. Along the same
lines, a manufacturer may make the product available on a retail
channel at a high retail price in order for retail-preferring hybrid
consumers to believe their preferences can be satisfied.
Before the Internet, hybrid consumers with a preference for a
ð42Þ direct channel may have believed that a direct channel was
impractical. Had a direct channel been available, consumers
would probably have believed that its price would be very high.
The Internet opened the possibility of direct channel. Therefore,
the exclusive retail channel model should apply because con-
sumers may presume that, in the absence of a direct channel, the
direct price would be the same as the retail price. If no direct
channel is available, consumers may impose a penalty for their
unsatisfied preference.
Recent efforts in supply chain management also make it
possible for consumers to shop on the retail channel for the
products that they have traditionally purchased from the direct
channel. For example, Dell, who has a direct channel, recently
opened retail stores for some of products. In addition, Dell has
opened more than one hundred kiosks in malls to display
products and take orders (Darlin, 2006). The reason for these
efforts may be to attract retail-captive consumers who were
ignored before. Another reason might be to give retail-preferring
hybrid consumers the ability to see and examine the product,
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94 M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95

;DFDÞ
thereby avoiding penalties that may result from the consumers’ Therefore, PðVM is the global optimal strategy if
preference for the retail channel. cr Z cd þ 2b. &
In this paper, we incorporated the existence of a retail-captive
segment into channel selection models. In addition, we assumed Proof of Proposition 2. We show that PðV M
;RFDÞ
: R2RFD -R is
heterogeneous hybrid consumers. These extensions reflect actual concave and derive its global maximum. We then show that if
;RFDÞ
consumer market characteristics. Many consumers lack access to cd Zcr then PðV
M Z PðV;PDLÞ
M and PðV;RFDÞ
M Z PðV;DFDÞ
M .
the Internet or are not willing to use for product purchases for
The second derivative of PðV;RFDÞ
M with respect to Pr satisfies
many reasons. The results indicate that conditions under which
2
an exclusive direct channel is optimal are uncommon and the @ PðV;RFDÞ
M =@Pr2 ¼ 2ðar þ ah Þ o0
dual channel or the exclusive retail channel options are more Therefore, the solution to @PðV;RFDÞ
M =@Pr ¼ 0 given by
likely to be optimal. Our analysis indicates that the size of the
PrðV ;RFDÞ ¼ 1
2ð1 þcr Þ is a global optimum of PðV;RFDÞ
M . Also, Pd can be
retail-captive segment plays a critical role in channel choices. The
cost advantage of a direct channel may be easily offset by the loss set at any value that satisfies PrðV;RFDÞ PrðV;RFDÞ ra. Hence,
of the retail-captive segment. This necessitates having a retail PdðV ;RFDÞ ¼ PrðV;RFDÞ a þ e for any e Z 0. Using pðP; cÞ defined in
channel open. (A.1), the optimal profit for the retail-focused dual strategy can be
The strong preference of consumers for the retail channel, with written as
the existence of a sizable retail-captive segment, may explain
some of the reasons for the predictions of e-commerce not being PðV;RFDÞ
M ¼ ðar þ ah ÞpðPrðV;RFDÞ ; cr Þ: ðA:3Þ
realized. Consumers who have not grown with the Internet may
be reluctant to use it for purchasing products. Over time, the size Suppose y^ is the optimal proportion of hybrid consumers served
of retail-captive segment is expected to decrease and preference on the retail channel in the optimal pure dual channel strategy.
for the direct channel is expected to increase. This implies that the Because cd Z cr results in p ðcr Þ Z p ðcd Þ and PrðV;RFDÞ ¼ P  ðcr Þ, the
establishment of a direct channel may lead to an increase in the following holds:
market size. On the other hand, retailers are expected to resist
the establishment of a strong direct channel that competes with PðV;RFDÞ ¼ ðar þ y^ ah Þp ðcr Þ þ ð1y^ Þah p ðcr Þ
them, particularly when a retailer is dominant in the supply chain. Zðar þ y^ ah ÞpðPrðV;PDLÞ ; cr Þ þ ð1y^ Þah p ðcd Þ
Finding optimal distribution strategies under those conditions is
Zðar þ y^ ah ÞpðPrðV;PDLÞ ; cr Þ þ ð1y^ Þah pðPdðV ;PDLÞ ; cd Þ
an important area for future research.
¼ PðV;PDLÞ
M : ðA:4Þ

Acknowledgements
Similarly, PðV;RFDÞ
M Z PðV;DFDÞ
M can be also shown by setting
The authors would like to thank the referees for their helpful ^y ¼ 0. &
comments and suggestions. The third author (Gangshu Cai)
gratefully acknowledges support from the National Science Proof of Lemma 1. . From Eq. (27), the sign of cPD ðcd þ 2bÞ
Foundation through Grant 0927591. depends on the sign of the numerator, which is
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
að1c1 Þ þ2ar R ½2ar Rþ að1c1 Þ2 þ 8ar ab½1c1 þ b:
Appendix A
The square root term is greater than or equal to the first two
terms if 1ðc1 bÞ Z0.
Proof of Proposition 1. We show that PðV;DFDÞ : R2DFD -R is The inequality, 1ðc1 bÞ Z 0, or equivalently 1cd Z b, holds if the
concave and derive its global maximum. We then show that direct price in Pd A ½0; 1 is greater than or equal to b because
;DFDÞ ;PDLÞ
PðV
M 4 PðV
M and PðV;DFDÞ
M 4 PðV;RFDÞ
M for cr Z cd þ 2b. Now let 1cd Z Pd cd Z b. Therefore, if Pd cd Zb, then
us define a function cPD rc1 ¼ cd þ 2b. &
pðP; cÞ ¼ ð1PÞðPcÞ; 0 oP o 1; ðA:1Þ Proof of Proposition 3. Substituting Pr ¼ Pd þ d into PðV;PDLÞ and
M
which is concave and has a maximum at P  ðcÞ ¼ 12ð1 þ cÞ of p ðcÞ ¼ taking the first derivative w.r.t. Pd to obtain the necessary
condition for Pd to be optimal yields
ð1cÞ2 =4 for any c o 1. The profit of the direct-focused strategy
can be written as PðV;DFDÞ ¼ ar pðPr ; cr Þ þ ah pðPd ; cd Þ which is the a½a þcd ah þ ar ðcr 2dÞ þ ah dðcr cd 2dÞbað1þ cr 2dÞ
M PdðV ;PDLÞ ¼ :
2Ra
sum of two concave functions on ðPr ; Pd Þ, and therefore PðV;DFDÞ
is
M ðA:5Þ
also a concave function on ðPr ; Pd Þ.
The global maximum of PðV;DFDÞ M : R2DFD -R is obtained by Substituting for PdðV;PDLÞ into PðV;PDLÞ
M gives PðV;PDLÞ
M ðPdðV;PDLÞ ; dÞ.
optimizing the profit from the direct channel given by ah pðPd ; cd Þ Taking the first derivative of PðV;PDLÞ ðPdðV ;PDLÞ ; dÞ w.r.t. d and
M
and the profit from the retail channel given by ar pðPr ; cr Þ which evaluating it at d ¼ b gives
gives (23). Since cr Zcd þ2b, PdðV;DFDÞ PrðV;DFDÞ Zb is satisfied.
Suppose y^ is the optimal proportion of hybrid consumers who dP ðV;PDLÞ
M ðPdðV;PDLÞ ; d ¼ bÞ
use the retail channel in the pure dual channel. Because dd
cr Z cd þ 2b results in PrðV;DFDÞ ¼ P  ðcr Þ and PdðV;RFDÞ ¼ P ðcd Þ, the
ah ½2b2 a þ2bað1c1 Þ þðc1 cr Þðah c1 þðcr 2RÞar aÞ
¼ : ðA:6Þ
2aR
following must hold:
Solving dPðV;PDLÞ
M ðPdðV;DFDÞ ; d ¼ bÞ=dd ¼ 0 w.r.t. cr yields
PðV
M
;DFDÞ
¼ ðar þ y^ ah Þp ðcr Þ þ ð1y^ Þah p ðcd Þ qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
að1c1 Þ þ2ar ðc1 þRÞ 7 4R2 a2r þ a2 ðc1 1Þ2 þ 4ar a½2b þ Rþ 2b2 c1 ð2b þRÞ
Z ðar þ y^ ah ÞpðPrðV;PDLÞ ; cr Þ þ ð1y^ Þah pðPdðV;PDLÞ ; cd Þ 7
cPD ¼
2ar
:
;PDLÞ
¼ PðV
M : ðA:2Þ ðA:7Þ
 ARTICLE IN PRESS
M. Khouja et al. / Int. J. Production Economics 125 (2010) 84–95 95

pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
Inside the range of the two roots, dPðV;PDLÞ ðPdðV;DFDÞ ; d ¼ bÞ=dd 4 0. ½ð8ZÞ þ 64 þ Z2 =Z2 . If 0 o 8 o Z then ah;2 41 and 0:5 o ah;1 o 1
M
;PDLÞ ðV ;PDLÞ and ah;1 is the root of interest. D1 Z 0 for 0:5 o ah;1 o1 and since
Thus, if cd rcPD rcr rcd þ2b and d 4b then PðV
M ðPd ; dÞ
;PDLÞ ðV ;PDLÞ
ah þ ar ¼ 1, ah Z ar must hold. &
o PðV
M ðPd ; bÞ and the optimal solution is given by solution
(a) in Proposition 3 or is in R2PDL . & Proof of Proposition 5. As Z increases, the range of strength of
consumers’ preferences increases. Since
Proof of Proposition 4. Suppose cd ocr ocPD and the optimal  ,
dah;1 16
solution is in R2DFD then by Proposition 2, PrðV;DFDÞ PdðV;DFDÞ ob and ah;1 ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi 4 0 for Z o 8: ðA:12Þ
dZ 64 þ Z2 þð8ZÞ 64 þ Z2
therefore the solution must exist at the boundary of R2DFD where
;PDLÞ
Pr ¼ Pd þ b and therefore PðV
M ¼ PðV;DFDÞ
M . Substituting Pr ¼ Pd þb An increases in Z requires a larger size of the hybrid segment to
into PðV ;DFDÞ
and taking first and the second derivatives w.r.t. Pd keep the direct channel more profitable. &
M
shows that the sufficient condition for optimality of Pd is given by
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