European Journal of Operational Research 205 (2010) 127–135

Contents lists available at ScienceDirect

European Journal of Operational Research

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

Production, Manufacturing and Logistics

Using MSRP to enhance the ability of rebates to control distribution channels

Shilei Yang a,1, Charles L. Munson b,2, Bintong Chen c,*
a
School of Business Administration, Southwestern University of Finance and Economics, Chengdu, Sichuan 610074, PR China
b
College of Business, Box 644736, Washington State University, Pullman, WA 99164-4736, United States
c
Department of Civil and Environmental Engineering, University of Delaware, Newark, DE 19716, United States

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

Article history: Manufacturers have increasingly instituted widespread mail-in rebate programs in recent years. Two pri-
Received 6 June 2009 mary purposes for rebates are to: (1) more directly impact consumer demand by reducing net retail price,
Accepted 18 December 2009 and (2) capitalize on consumers’ slippage behavior because not all consumers who intend to redeem the
Available online 24 December 2009
rebate at purchase time end up actually redeeming it. However, retailers can counteract the power of
rebates to impact demand by simply raising the retail price by the amount of the manufacturer’s rebate.
Keywords: We show that by combining a manufacturer’s suggested retail price (MSRP) along with a rebate, the man-
Supply chain management
ufacturer can better control the channel by inhibiting the retailer’s ability to raise price, particularly when
Marketing
Rebates
consumers exhibit loss aversion. As a result, incorporating MSRP with a rebate promotion plan increases
MSRP the manufacturer’s profit. More surprisingly, the profit of the supply chain as a whole also increases, and
Channel control the channel efficiency increases as well. In fact, contrary to results from the existing rebate literature sug-
gesting that rebates should always be offered whenever slippage exists, we demonstrate that MSRP can
actually be a more effective tool than rebates in managing retailer and consumer behavior when consum-
ers do not have sufficient loss aversion and the slippage rate is low enough.
Published by Elsevier B.V.

1. Introduction
Originating in the 1960s, mail-in rebates have become a popular
form of consumer promotion in today’s retail markets, especially
for products such as electronics, automobiles, and durable goods.
In fact, rebates have become the expected norm in some indus-
tries: ‘‘Rebates are the meat and potatoes of the ultimate tech deal,
no matter what you are buying” (Unger, 2009). The total face value
of rebates was estimated to be $6 billion in the US in 2005 (Grow
and Chhatwal, 2005). Even though mail-in rebate business is
increasing while the use of traditional cents-off coupons is declin-
ing (Bulkeley, 1998), there is not much research on consumer pro-
motion by rebates (Neslin, 2002). The traditional explanations for
offering rebates focus on using them to price discriminate among
consumers (Gerstner and Hess, 1991). More recent researchers
have shown that manufacturers are implementing rebate pro-
grams to exploit consumers’ slippage behavior (Silk, 2004; Chen
et al., 2005; Gilpatric, 2009). Slippage occurs when consumers
are enticed to purchase as a result of a rebate offer but later fail
to apply for the rebate. Grow and Chhatwal (2005) report that
‘‘fully 40% of all rebates never get redeemed”, which gives manu-
facturers a large enough ‘‘arbitrage” space. Due to slippage, manu-
facturers can potentially accrue large profits by using rebates to
attract consumers who subsequently fail to redeem them.
In addition to the slippage benefits, rebate promotions allow
manufacturers to bypass retailers and offer price reductions di-
rectly to consumers. The intention is to reduce the impact of dou-
ble marginalization3 and increase total consumer demand by
lowering the net retail price. However, rebate promotions cannot
spur demand if the retailers completely counteract direct discounts
by raising the corresponding retail prices by the amount of the re-
bate. Researchers have shown theoretically that the retailer tends
to increase price after a manufacturer offers a rebate (Gerstner and
Hess, 1991; Aydin and Porteus, 2009; Arcelus et al., 2006). Claims
of this type of retailer behavior from disgruntled consumers can be
found regularly on forum websites (e.g., Digital Photography Review,
2008; TractorByNet.com, 2005).
By law, manufacturers cannot dictate prices to retailers; they
can only publicly suggest a retail price at which the product is ex-
pected to sell. This recommended retail price is usually called the

3
Double marginalization refers to the phenomenon of two parties in a vertical
* Corresponding author. Tel.: +1 302 831 2756. supply chain each setting prices to maximize their own profits, producing a final
E-mail addresses: syang@swufe.edu.cn (S. Yang), munson@wsu.edu (C.L. Mun- consumer price being higher and resulting demand being lower than what would
son), bchen@udel.edu (B. Chen). result from optimization of the full supply chain. In other words, as each link in the
1
Tel.: +86 28 87354893. supply chain takes out its own ‘‘cut” (profit margin), consumers see higher prices and
2
Tel.: +1 509 335 3076. fewer units are sold.

0377-2217/$ - see front matter Published by Elsevier B.V.

doi:10.1016/j.ejor.2009.12.018
128 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135
manufacturer’s suggested retail price (MSRP). The MSRP is typi-
cally printed on the sales tag, the product tag, or the featured
advertising, all of which can easily be observed by consumers at
the time of purchase. In the Internet age, there is a tendency for
consumers to adopt the MSRP as one of the most official and pop-
ular reference prices when they price shop the Internet to deter-
mine a reference point before placing an order. For example,
many eBay e-tailers provide a hotlink to the specific model on
the manufacturer’s website that states the MSRP information
(Hardesty and Suter, 2005). Deal and bargain sites (fatwallet.com,
techdeals.net, etc.) typically list a hot rebate deal with the MSRP,
for example, ‘‘MSRP $300 machine sells for $150 after $100 MIR.”
Some online retailers such as mikescamera.com even display three
prices for rebate promoted products: MSRP, Mike’s price, and price
after rebates.
In this paper, we explore the following questions. Will the addi-
tion of MSRP to a rebate program increase the manufacturer’s prof-
it? How will the profits of the whole supply channel be impacted?
Will channel efficiency be affected? What are the primary drivers
that characterize the equilibrium structure of the respective chan-
nel prices and rebates?
The rest of the paper is organized as follows: Section 2 reviews
the related literature. In Section 3, we describe the modeling envi-
ronment. Section 4 presents the equilibrium solutions and pro-
vides an analytical answer to the questions of MSRP impact on
manufacturer’s profit, system profit, and channel efficiency. Sec-
tion 5 presents analytical and numerical sensitivity analysis to
add more insight into our primary research questions. Finally, we
summarize major findings and identify potential areas for future
research in Section 6.
2. Relevant literature
We focus in this paper on mail-in rebates, which can only be
redeemed after purchasing the product at the regular price. The
redemption of rebates typically requires consumers to perform
arduous tasks (filling out forms, clipping labels, and mailing
them). Although the marketing literature on sales promotion is
saturated with both theoretical and empirical works, only a hand-
ful of papers have attempted to explain the existence and the
influence of the slippage phenomenon. Soman (1998) suggests
that consumers’ purchase decisions for products offering a de-
layed incentive can be independent of the decisions to redeem
the delayed incentives themselves. The author finds that consum-
ers perceptually underestimate the effort of redeeming the rebate.
Based on Soman’s research, Silk (2004) experimentally suggests
that the discrepancy between consumers’ redemption confidence
and their actual redemption behavior causes the slippage. Inter-
estingly, recent research on brain-imaging (McClure et al., 2004)
finds that consumers are engaging different neural activities
when making a decision on choosing delayed or immediate
incentives. Other researchers provide different explanations for
slippage by building in behavioral factors, such as consumers’
anchoring and adjustment on effort-discounting (Gourville and
Soman, 2005), different post-purchase states (Chen et al., 2005),
and present-biased preferences (Gilpatric, 2009). Some papers
have begun to address how to take advantage of slippage behav-
ior. Moorthy and Soman (2005) address a way to exacerbate the
slippage effects by highlighting the reward and partially conceal-
ing the effort required to redeem. Moorthy and Lu (2007) indicate
that rebates are more efficient than coupons in price discriminat-
ing between consumer types.
Early channel studies on rebates can be traced to several pa-
pers by Gerstner and Hess (Gerstner and Hess, 1991, 1995; Gerst-
ner et al., 1994); however, the ‘‘instant” rebates discussed in their
papers are equivalent to traditional coupons, which do not cap-
ture the inconsistency between consumers’ purchase behaviors
and redemption behaviors. Only recently have quantitative
researchers studied the impact of mail-in rebates on distribution
channels.
Chen et al. (2007) find that as long as some customers that are
attracted by a mail-in rebate will forgo the rebate, offering rebates
is always beneficial for manufacturers. Unlike the sequential deci-
sion making in that paper, Aydin and Porteus (2009) adopt simul-
taneous Nash equilibrium decision making to compare consumer
rebates to channel rebates. Two recent papers (Khouja, 2006; Arce-
lus et al., 2006) study the problem of the joint pricing-inventory
decision involving rebates with different models: Khouja (2006)
uses a deterministic EOQ-based model, while Arcelus et al.
(2006) implement a stochastic newsvendor-based model. Khouja
et al. (2008) solve the models for jointly determining optimal price
and rebate value for heterogeneous consumer markets. Cho et al.
(2009) consider a competitive vertical channel where both the
manufacturer and the retailer could possibly offer rebates at regu-
lar frequency. They show that it is in the common interest for both
the manufacturer and the retailer to improve the effectiveness of
the manufacturer’s rebate program, which is also illustrated in
our paper. Previous channel-based research on rebate promotion
has used a pre-determined demand function, whereas we derive
the demand function using a consumer utility-based approach that
captures the aspects of demand that are particularly relevant to
products with rebates.
A number of authors have examined the rebate-related channel
coordination issues. Yue et al. (2006) study the supply chain coor-
dination of cooperative advertisement together with rebate pro-
motion. Nalla et al. (2008) find that a manufacturer-sponsored
rebate program cannot effectively coordinate the channel, but a re-
tailer-sponsored rebate together with a wholesale price discount
can achieve coordination. Khouja and Zhou (2009) introduce
incentive contract mechanisms, which negatively link the manu-
facturer’s rebate value and the retailer’s retail price via MSRP, to
limit the retailer’s price increase. They show that these contracts
always increase the channel’s and manufacturer’s profits. Unlike
Khouja and Zhou’s paper where the manufacturer actively adjusts
the rebate value according to the changes of retail price, our ap-
proach with MSRP restricts the retailer’s pricing ability due to con-
sumers’ intrinsic reference pricing and loss aversion effects
(described next).
The consumers’ reference price effect can be attributed to two
theories: adaptation level theory (Helson, 1964) and prospect the-
ory (Kahneman and Tversky, 1979). Both theories suggest that con-
sumers do not make decisions solely based on purchase price, but
they have a standard by which they can evaluate the current price.
The utility (satisfaction) from comparing the purchase price rela-
tive to the reference price is called transaction utility, or deal value.
As a counterpart to transaction utility, acquisition utility is the va-
lue derived from the intrinsic utility provided by an item, relative
to its purchase price (Neslin, 2002). So the total value of a transac-
tion to a consumer is the sum of acquisition utility and transaction
utility. Prospect theory further suggests that losses (negative trans-
action utility) should loom larger than gains (positive transaction
utility), i.e., loss aversion effects. The support for the existence of
the reference price and loss aversion effects can be found in a vari-
ety of empirical studies (see Kalyanaram and Winer, 1995 for a re-
view) and a recent brain-imaging study (Tom et al., 2007). Our
paper adopts a contextual mechanism (Rajendran and Tellis,
1994), in which the consumers utilize a currently available price
as the reference point instead of using a historical price stored in
memory. Specifically, we use the MSRP to serve as an external ref-
erence point (Mayhew and Winer, 1992; Hardesty and Suter,
2005).
 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135
Fig. 1. A Schematic Framework of the Modeling Environment.
3. The modeling environment
Fig. 1 displays our proposed market environment, in which a
manufacturer sells a product to final consumers through an inde-
pendent retailer. The manufacturer serves as the Stackelberg lea-
der in this system, and the retailer serves as the follower (i.e.,
backward induction is used to obtain the subgame perfect Nash
equilibrium). The sequence of decisions begins with the manufac-
turer determining the wholesale price w and the rebate face value
R, along with announcing the MSRP Ps. Given the manufacturer’s
decisions, the retailer then chooses the retail price Pr. Both parties
seek to maximize their respective profits.
We model the effects of rebates on an aggregate level. The
parameter rs represents the estimated probability that consumers
expect to redeem the rebates at the time of purchase. By introduc-
ing rs, we can measure the desirability of a rebate promotion, i.e.,
consumers treat a rebate of $1 as being equivalent to a direct dis-
count of $ rs. On the other hand, the parameter ro represents the ac-
tual proportion of consumers who redeem the rebates after their
purchases. The slippage rate q, therefore, is defined as (rs  ro)/rs,
representing the degree to which consumers fail to redeem a re-
bate that they originally had planned to redeem. Table 1 summa-
rizes this and other notation used throughout the paper.
Utilizing multiple levers, the manufacturer strives to dictate the
behavior of the other two channel members: (1) the retailer – di-
rectly via w and indirectly via Ps, and (2) consumers – directly via
R and indirectly via Ps.
3.1. Consumer demand
We define the product’s quality level s > 0 as a summary mea-
sure denoting the product’s overall attractiveness, exclusive of
price. We use s to incorporate all of the product’s attributes, such
as product value, reliability, durability, service, warranty, etc.
Given that consumers differ in their willingness to pay for the
product, we define a consumer of ‘‘type” t as one who is willing
to pay up to ts dollars for the utility (satisfaction) derived from
consuming the product with quality level s. A consumer who is
more quality sensitive is designated as a ‘‘higher” type. As such,
higher type consumers are willing to pay more for the same prod-
uct than lower type consumers. Alternatively, the consumer’s type
can be viewed as the importance weight on overall quality relative
to an importance weight of 1 on product retail price. We further as-
129
Table 1
Summary of notation.
s A summary measure of product quality level
t Consumer type
b The highest consumer type level
Pr The retail price determined by the retailer
Ps The MSRP determined by the manufacturer
a The coefficient for reference price effect when Ps > Pr
b The coefficient for reference price effect when Ps < Pr
rs Estimated probability that consumers expect to redeem the
rebates at the time of purchase
ro Proportion of consumers who actually redeem the rebates
q The slippage rate = (rs  ro)/rs
u A consumer’s overall utility
R The rebate face value determined by the manufacturer
w The wholesale price determined by the manufacturer
D The market demand
Q
Qm
The profit of the manufacturer
The profit of the retailer
Qr
The profit of the integrated channel
I
 
h(a, b) The threshold level on slippage = max 0; að1þbÞðb aÞ
ð1þaÞð1þbÞ
sume that consumer types are distributed uniformly on [0, b],
which captures consumer heterogeneity in the market. Similar
assumptions using the uniform distribution can be found in classic
marketing literature (Moorthy, 1988; Blattberg and Wisniewski,
1989; Rhee, 1996).
Given that the retailer can choose any retail price Pr, consumers
can enjoy utility gain a(Ps  Pr) when they observe Ps > Pr; how-
ever, they suffer utility loss b(Ps  Pr ) when Ps < Pr. Here, a and b
are the coefficients for the reference price effect, i.e. the impor-
tance weight on transaction utility relative to an importance
weight of 1 on product retail price.4 We set 0 < {a, b} 6 1 to ensure
that the importance weight on transaction utility derived from the
reference effect cannot be greater than the importance weight on
acquisition utility derived from the economic value of the purchase.
In other words, the range of alpha and beta is designed to normalize
the impact of the reference price effect on the utility function, given
the range of values for the other part of the utility function. We fur-
4
In reality, coefficients a and b can be influenced by price, promotion, past
purchase experience, etc. Researchers typically estimate these coefficients from
scanner data containing consumers’ purchase records (see Erdem et al., 2001 for
examples of empirical estimation).
130 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135

aP s
ther assume a < b to capture the loss aversion effect. This assumption Pr ¼ rs Rþ
1þa
and at P r ¼ bsþr1þb
s RþbP s
, respectively. Fig. 2 illustrates the
is explained theoretically by prospect theory and also supported by kinked demand curve.
empirical findings (see Kalyanaram and Winer, 1995).
To illustrate, consider an example with a = 0.10, b = 0.20, and 3.2. The retailer and manufacturer objectives
the MSRP Ps = $50. If the retailer prices the product at Pr = $40, then
the consumers’ utility will increase by 0.10(10) = 1. On the other Without loss of generality, we assume no variable costs for the
hand, if the retailer prices the product above the MSRP at retailer other than wholesale price and no production costs for the
Pr = $60, then the consumers’ utility will decrease by 0.20(10) = 2. manufacturer (see, for example, Lal, 1990; Chu and Desai, 1995).
Loss aversion exists because the utility loss of 2 for a $10 price pre- Based on the demand function in (2), the retailer’s profit function
mium over the MSRP is greater than the utility gain of 1 for a $10 can be written as:
price discount under the MSRP. In other words, consumers are Y
ðPr jw; R; Ps Þ ¼ ðPr  wÞ  DðPr ; R; Ps Þ:
more dissatisfied with pricing above the MSRP than they would
r
be satisfied with the same level of pricing below the MSRP.
When both a rebate promotion and an MSRP are present, our The manufacturer will choose the optimal combination of w, R and
assumptions on consumer behavior imply that the consumer’s Ps to maximize its profit by anticipating the retailer’s best response
overall utility is Pr*(w, R, Ps). The manufacturer’s profit function can be written as:
Y  
u ¼ ts  ðP r  rs RÞ þ aðPs  Pr Þþ  bðPr  Ps Þþ ; ð1Þ ðw; R; P s Þ ¼ ðw  r o RÞ  D Pr ðw; R; Ps Þ; R; Ps :
m

where (x)+ = max{0, x}.

A consumer will purchase the product if u P 0, where 0 is the 4. Equilibrium strategies
reservation utility for each consumer. Some logical boundary con-
ditions include: (A1) 0 < a < b 6 1, (A2) 0 < ro 6 rs 6 1, (A3) 4.1. Rebate combined with MSRP
Pr P w P roR, Pr P rsR, and (A4) w 6 Ps 6 bs, Ps P rsR.
The consumer’s utility function (Eq. (1)) above can be expressed As the retailer has to take into account the consumer’s reference
as: price effect, its optimal choice depends upon the four sub-func-
 tions of D(Pr, R, Ps) and can be characterized by the following
ts  ðPr  r s RÞ þ aðPs  Pr Þ when P s P Pr ;
u¼ lemma:
ts  ðPr  r s RÞ þ bðPs  Pr Þ when P s < Pr :
Lemma 1. The retailer’s optimal choice of retail price Pr, depending on
By integration, the derived demand function can be obtained as w and R, is given by:
8
> 1 P r 6 rs Rþ aPs
; 8 rs RþaPs
>
>
>
1þa
>
> 1þa
6 Ps for w 6 aPs þr 1þa
s Rbs
;
>
< bsð1þaÞPr þrs RþaPs r s RþaPs
< Pr 6 Ps ; >
>
bs 1þa > bsþr
< 2 þ 2ð1þ
w s Rþ aP s
< P for aP s þr s Rbs
< w < Ps  rs RþbsP s
;
DðPr ; R; Ps Þ ¼ ð2Þ aÞ s 1þa 1þa
>
>
bsð1þbÞPr þr s RþbPs
P s < Pr < bsþr1þb
s RþbP s
; Pr ðw; R;Ps Þ ¼
>
> bs >
> Ps for Ps  rs RþbsP s
6 w 6 P s  rs RþbsP s
;
>
: >
> 1þa 1þb
0 Pr P bsþr s RþbPs
: >
: w bsþrs RþbPs r s RþbsP s
1þb
2
þ 2ð1þbÞ > Ps for Ps  1þb < w 6 Ps :
aP s
Obviously the lowest retail price is Pr ¼ rs Rþ1þa
, since the retailer can-
not convince any additional consumers to purchase the product by Proof. See online supplements. h
further reducing its retail price. On the other end, if the retailer
chooses P r > bsþr1þb
s RþbP s
, there will be no consumers left to buy the We can observe that if the wholesale price w is sufficiently low,
product. The demand function D(Pr, R, Ps) has two kinks at the retailer chooses a retail price that is low enough to reach all
consumer types such that the customer demand equals 1. The re-
tail price is nondecreasing in w, from below the suggested price
Ps to eventually above Ps. Notice that there is a segment of w ,
i.e., P s  rs RþbsP
1þa
s
6 w 6 P s  rs RþbsP
1þb
s
, in which the manufacturer
can induce the retailer to adopt the suggested price Ps.
Anticipating the retailer’s reaction to w, R and Ps, the manufac-
turer follows the optimal strategies summarized in the following
proposition.
Proposition 1. The manufacturer’s optimal strategy is jointly deter-
mined by the consumers’ slippage behavior and their magnitude of loss
aversion, as shown in Table 2.

Proof. See online supplements.

From Table 2 we observe that, when using an MSRP, the manu-
facturer will provide rebates only after the slippage rate breaks the
threshold level h(a, b). It can be easily verified that this threshold
level on slippage rate is strictly decreasing in b. Hence, if consum-
ers have sufficient loss aversion, i.e., b P 2a/(1  a), h(a, b) be-
comes 0 and Table 2 reduces to three columns. In that case, the
manufacturer should provide rebates given any positive slippage
rate, which is consistent with the existing rebate literature. How-
ever, if consumers do not have sufficient loss aversion, i.e.,
Fig. 2. The Kinked Demand Curve. b < 2a/(1  a), h(a, b) is greater than 0, implying that an effectively
 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135 131

Table 2
The equilibrium solution sets of independent channelb.

Labela N/L S/E M/G L/G

Conditions 0 6 q < h(a, b) hða; bÞ 6 q < b b
6q< 1 1
q P 1þb
1þb 1þb 1þb
1þ2ð1þbÞð1qÞ
 
w bs bs 2þb
2 2ð1þð1þbÞð1qÞÞ bs 2þ2b þ 12 ð1  qÞ bs
R 0 1þb
 bs ð1þbÞ
 bs bs
rs
2ð1þð1þbÞð1qÞÞ rs ð1þð1þbÞð1qÞÞ rs
Ps bs bs bs bs
3þ2ð1þbÞð1qÞ
 
Pr 3
4 bs
bs 3ð2þbÞ
2þ2ð1þbÞð1qÞÞ bs 4ð1þbÞ þ 14 ð1  qÞ bs
D 1þa ð1þbÞ ð1þbÞ 1
4 2ð1þð1þbÞð1qÞÞ 2þ2ð1þbÞð1qÞÞ 4 ð2 þ b  ð1 þ bÞ  ð1  qÞÞ
Q
1þa
r 16 bs
ð1þbÞ
bs ð1þbÞ
bs 1
16ð1þbÞ ð2 þ b  ð1 þ bÞð1  qÞÞ2 bs
4ð1þð1þbÞð1qÞÞ2 4ð1þð1þbÞð1qÞÞ2
Q
1þa
m 8 bs
ð1þbÞ
4ð1þð1þbÞð1qÞÞ bs
ð1þbÞ
bs 1
8ð1þbÞ ð2 þ b  ð1 þ bÞð1  qÞÞ2 bs
2ð1þð1þbÞð1qÞÞ2
Q Q
3ð1þaÞ ð1þbÞð2þð1þbÞð1qÞÞ
r þ m 16 bs bs 3ð1þbÞ
bs 3
16ð1þbÞ ð2 þ b  ð1 þ bÞð1  qÞÞ2 bs
4ð1þð1þbÞð1qÞÞ2 4ð1þð1þbÞð1qÞÞ2

a
X/Y  rebate size/retail price, where X 2 (N  none, S  small, M  medium, L  large), and Y 2 (L  <MSRP, E  = MSRP, G  >MSRP).
b
At the corner points where q = h(a, b) and q = b/(1+ b), the equilibrium solution can be any combination of the two consecutivesolution sets. Moreover,  When q = 0 and
b P 2a/(1  a), R, Pr and Ps have multiple solutions, which can be represented by w ¼ ð1 þ j  1þb bs 1þb bs 3þb
2þbÞ 2 ; R ¼ j  4þ2b  r s , and P r ¼ P s ¼ ð1  jÞ 4þ2b þ j bs, where j 2 [0, 1] is a
fraction parameter.

Fig. 3. A Schematic Framework for the Independent Channel.

priced MSRP should actually replace a rebate (the N/L column of of the kinked demand function from Fig. 2. The channel profit func-
Table 2) under a low enough slippage rate. This surprising result tion can be written as:
reveals that if both MSRP and rebates are available, the manufac- Y
ðPr ; R; Ps Þ ¼ ðPr  ro RÞ  DðPr ; R; Ps Þ:
turer may not necessarily provide rebates even when positive slip-
I
page exists. In any case, once the slippage rate breaks the threshold
level h(a, b), a rebate should be offered, and the rebate amount is Following similar proof techniques of Proposition 1, we can derive
then increasing in q. Fig. 3 illustrates the progression as a function the optimal strategies for the integrated channel, summarized in
of the slippage rate. Proposition 2 below.
Proposition 2. The optimal strategies for the integrated channel are
4.2. Further analysis of the MSRP benefits shown in Table 3.

In this subsection, we further demonstrate the improvement to
manufacturer’s profit, channel profit, and channel efficiency by
including MSRP with a rebate policy. For this analysis, we first need
to determine the equilibrium strategies of a rebate-only policy, as
well as the optimal strategies for an integrated channel.
4.2.1. Rebate-only policy
To evaluate the case where the manufacturer offers a rebate to
the final consumers but does not incorporate an MSRP, we set
a = b = 0, eliminating the MSRP from the demand function. The
equilibrium conditions collapse to the M/G column of Table 2, with
b = 0. Similar to the exiting rebate literature, we see that the man-
4.2.3. MSRP improvement for profit and channel efficiency
As shown in Proposition 3 below, the introduction of MSRP al-
lows the manufacturer to have more control over channel pricing,
leading to both its own and system-wide benefits.
Proposition 3. Introducing an MSRP along with a consumer rebate
provides the following benefits: (1) the manufacturer’s profit is higher
Table 3
The optimal solution sets for the integrated channelb.
Labela N/L S-M/E L/G L/E

ufacturer should always provide rebates in the presence of Condition q 6 1þa a a

1þa <
b
q < 1þb b
1þb
1
6 q < 1þb 1
q P 1þb
slippage. R 0 bs
2ro
bs
rs
bs
rs
Ps bs bs bs bs
  
Pr bs bs 1 þ 12 1þb
1
 q bs bs
2
4.2.2. Integrated channel
D 1þa 1 1 1
2 ð1 þ ð1 þ bÞqÞ
To demonstrate the impact of MSRP on channel efficiency, we Q
2 2ð1qÞ
ð1þaÞ 1
4ð1qÞ bs
1
þ ð1 þ bÞqÞ2 bs qbs
need to analyze a vertically integrated distribution channel. If the I 4 bs 4ð1þbÞ ð1

manufacturer and the retailer act as one company, the wholesale a

price w as a decision variable disappears, and manufacturer can
dictate the actual retail price. Hence, system profits are maximized
by choosing the optimal combination of (Pr, R, Ps) for each segment
X/Y  rebate size/retail price, where X 2 (N  none, S  small, M  medium,
L  large), and Y 2 (L  <MSRP, E  =MSRP, G  >MSRP)
b
At the corner points where q = a/(1 + a) and q = b/(1 + b), the optimal solution
can be any combination of the two consecutive solution sets.
132 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135

than it would be with a rebate policy alone, (2) the system profit is 5. Sensitivity analysis and numerical studies
higher than it would be with a rebate promotion alone, and (3) the
channel efficiency increases as long as a rebate is offered. 5.1. Analytical sensitivity analysis

Based on the equilibrium policies of Tables 2 and 4 summarizes

Proof. To prove statements (1) and (2), we compare the profits analytical sensitivity analysis when either the slippage rate or loss
between the joint MSRP-rebate promotion versus the rebate pro- aversion increases.
motion alone. We examine each of the segments of Table 2 Slippage rate and loss aversion are the big drivers in this envi-
separately. ronment, as demand and the profit of both parties are all increasing
in both slippage rate and loss aversion. For example, in the real
(a) In the N/L segment, we need to prove that marketplace we observe substantial use of rebates for software
products due to high slippage. With slippage rates ranging be-
Pm þ Pr jjoint Pm jjoint ð1 þ aÞð2  qÞ2
¼ ¼ > 1 () tween 80% and 90% (Bulkeley, 1998), approximately 60% of the
Pm þ Pr jrebate Pm jrebate 4
 software sold through major retailers comes with a rebate (Becker,
1 2002). (Industry slippage rates are typically reported as the per-
q < 2 1  pffiffiffiffiffiffiffiffiffiffiffiffi :
1þa centage of purchasers who receive rebate checks.) Some software
pffiffiffiffiffiffiffiffiffiffiffiffi producers even provide free-after-rebate software products to lure
pffiffiffiffiffiffiffiffiffiffiffiffi ð1 þ bÞð2 þ a  2 1 þ
Since  aÞ þ ðb  aÞ > 0 ) hða; bÞ < 2ð1  1=
pffiffiffiffiffiffiffiffiffiffiffiffi more purchasers.
1 þ aÞ, the condition q < 2 1  1= 1 þ a holds automatically in
the N/L segment. Thus, both the manufacturer’s and the channel’s The results of the L/G segment are a bit surprising: Pr decreases
profits are higher than in the rebate-only case. as the slippage rate q increases. To benefit from a high slippage
(b) In the S/E segment, we need to prove that rate, the manufacturer prefers a high customer demand. There
are two approaches to increasing demand: either increasing the re-
Pm jjoint ð1 þ bÞð2  qÞ2 bate value or reducing the retail price. Since the rebate has reached
¼ > 1 () ð1 þ bÞð2 þ q2 Þ > 2;
Pm jrebate 2ð1 þ ð1 þ bÞð1  qÞÞ its maximum level in the L/G segment, the manufacturer and the
retailer have to decrease w and Pr, respectively, to boost customer
which is true;
demand enough to fully exploit the benefit of high slippage.
Pm þ Pr jjoint ð1 þ bÞð2 þ ð1 þ bÞð1  qÞÞð2  qÞ2 At the same time, rebate promotions become more effective
¼ when consumers exhibit significant loss aversion. This occurs be-
Pm þ Pr jrebate 3ð1 þ ð1 þ bÞð1  qÞÞ2
cause the manufacturer can lower the net price to consumers
> 1 () 4b þ b2  qð1 þ bÞðð1 þ bÞ through a rebate while the retailer will be unable to completely
þ 2ð1  qÞ þ ð1 þ bÞð1  qÞ2 Þ > 0: offset the rebate amount with a higher retail price. In fact we see
from Table 4 that the retail price is actually decreasing in some
Since f(q) = 4b + b2  q(1 + b)((1 + b) + 2(1  q ) + (1 + b)(1  q)2) is segments as loss aversion increases. At the same time, the manu-
b b 3b2
decreasing in q when q < 1þb ; f ðqÞ > f ðq ¼ 1þbÞ ¼ 1þb > 0 holds in facturer is increasing the rebate amount until it reaches the upper
the S/E segment. Thus, both the manufacturer’s and the channel’s bound. Thus, we observe that manufacturer has more control on
profits are higher than in the rebate-only case. the retailer’s behavior when the magnitude of loss aversion
(c) In the M/G segment, the function f ðxÞ ¼ ð1þð1x qÞxÞ2 is increas- increases.
ing in x when 1 < x < 11 q, which leads to f ðx ¼ 1Þ ¼ ð21qÞ2 <
ð1þbÞ 5.2. Numerical studies
f ðx ¼ 1 þ bÞ ¼ ð1þð1þbÞð1qÞÞ2
, so both the manufacturer’s and
channel’s profits are higher than in the rebate-only case.
P þP j P j qÞ2 ð2qÞ2 5.2.1. Base case example
(d) In the L/G segment, PmmþPrrj joint ¼ Pmmj joint ¼ ð1þð1þbÞ
4ð1þbÞ
,
rebate rebate To illustrate some of our findings, we introduce a base case
which is an increasing function in 1 + b, so
2 2
 
2 2
example with the following parameter settings: bs = $300, a = 0.2,
Pm jjoint
Pm j > ð1þqÞ 4ð2qÞ ¼ 2þq2q > 1, implying that both the b = 0.4, rs = 0.9, and ro = 0.7 (implying q = .22). For the joint
rebate

manufacturer’s and the channel’s profits are higher than in MSRP-rebate policy, using the S/E column of Table 2, the manufac-
the rebate-only case. turer will choose a wholesale price of $228.19, an MSRP of $300,
and a consumer rebate of $111.70. In turn, the retailer will set
Next, to prove statement (3), we compute the channel effi- the retail price equal to the MSRP of $300. The resulting demand
ciency, which is defined as the ratio of the independent channel
profit to the integrated channel profit, i.e., (Pm + Pr)/PI. The
Table 4
channel efficiency of the rebate-only promotion is less than 3/4, Analytical sensitivity analysis.
i.e., PmPþIPr ¼ 3
< 34. Note that a rebate is offered in both
ð2þqq2 Þ2 Sensitivity S/E M/G L/G
independent and integrated channels only when q > a/(1 + a). First,
analysis
it is easy to verify that the channel efficiencies of joint promotion
w ; with q and " Constant ; with q and ;
in the S/E and L/G segments are all greater than 3/4, and the result
with b with b
follows immediately. For the M/G segment, we have the following:
R " with q and " "with q and " Constant
with b with b
 2
Pm þ Pr ð1 þ bÞ Ps Constant
¼3 " with q and ; ; with q and ;
PI ð1 þ ð1 þ bÞð1  qÞÞð1 þ ð1 þ bÞqÞ Pr Constant
with b with b
3
> () 1  qð1 þ bÞð1  qÞ > 0: D " with q and " with b
ð2 þ q  q2 Þ2 Q
r " with q and " with b
The condition 1  q(1 + b)(1-q) > 0 holds because q(1 + b) < 1. Q
m " with q and " with b
Therefore, we have proven that the channel efficiency improves Q Q
r þ m " with q and " with b
with joint promotion in each rebate-offered segment of Table 2. h
 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135
will be 0.3351. Profits will be $50.27 and $24.06 for the manufac-
turer and retailer, respectively, for a total system profit of $74.33.
By comparison, using a rebate-only policy, setting a = b = 0, and
using the M/G column of Table 2, the manufacturer will choose a
wholesale price of $300 and a consumer rebate of $187.50. In turn,
the retailer will set the retail price of $384.38, which creates a net
price to the consumer of $196.88, compared to a net price in the
joint MSRP-rebate case of $188.30. Demand in the rebate-only case
is 0.2813, or 16.05% less than in the joint case. Profits will be
$47.46 and $23.73 for the manufacturer and retailer, respectively,
for a total system profit of $71.19. All three profits are lower than
their joint-policy counterparts. Finally, using Table 3, the channel
efficiency for the joint policy is 77.08% compared to 63.54% for
the rebate-only policy. These results are all consistent with Propo-
sition 3.
5.2.2. Sensitivity analysis on slippage rate and loss aversion
To examine the effect of slippage rate on some of the major
equilibrium values from Table 2, we take the base case example
and iterate ro between 0.10 and 0.90 in increments of 0.01. The val-
ues of Im, D, R, Ps, Pr and w are plotted in Fig. 4. From these graphs,
we can observe that the manufacturer’s profit and the market de-
mand increase smoothly with the slippage rate; however, the
curve of the optimal rebate value R increases in a partially stepwise
fashion with the slippage rate. From graph (d), we can observe that
the retail price follows nearly the same pattern as the wholesale
price, as expected.
Fig. 4. Sensitivity Analysis on Equilibrium Values as the Slippage Rate Varies.
133
Fig. 5 illustrates the same variation on q, but this time focusing
on comparing the joint MSRP-rebate policy with a rebate-only pol-
icy. The joint promotion results in a lower retail price, higher prof-
its for the manufacturer and the system, and better channel
efficiency (approximately 10% better after the rebate is offered)
as compared to the rebate-only policy. We can observe that MSRP
helps the manufacturer to restrict the retailer’s tendency to in-
crease its price when rebates are offered to consumers.
Finally, we explore how the slippage rate and loss aversion
jointly affect the manufacturer’s profitability. By varying b be-
tween a (=0.2) and 0.8, we can observe from the three-dimensional
graph of Fig. 6 that the stronger the magnitude of loss aversion, the
larger the manufacturer’s profits. However, the profit contribution
of the loss aversion effects is smaller than that brought on by slip-
page effects. And, as expected, high loss aversion coupled with high
slippage creates the largest profit opportunity for the manufacturer
when implementing a joint MSRP-rebate policy.
6. Conclusion
In this paper, we have demonstrated how the addition of MSRP
to a consumer rebate policy affects system behavior in a distribu-
tion channel with reference-dependent consumers. This promotion
combination is linked to two consumer behavior characteristics:
slippage behavior and loss aversion. Existing literature suggests
that the manufacturer can profit by consumers’ slippage, which
134 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135

Fig. 5. Comparison of the Joint vs. Rebate-Only Policies as the Slippage Rate Varies.

Fig. 6. Joint Effects of Loss Aversion and Slippage Rate on the Manufacturer’s Profit.
 S. Yang et al. / European Journal of Operational Research 205 (2010) 127–135
is also supported by our results. Furthermore, the manufacturer
can introduce an MSRP to exploit consumers’ loss aversion and bet-
ter control the channel, thus enhancing the effectiveness of con-
sumer rebates even more. In fact, we have demonstrated that
both the manufacturer and the system will benefit from combining
MSRP information with a rebate promotion. Under certain condi-
tions, an MSRP should replace a rebate, and under all other condi-
tions, the MSRP will enhance the effectiveness of the rebate.
According to industry reports, slippage rates can rise as high as
60% for electronics (Spencer, 2002) to even 90% for software prod-
ucts (Bulkeley, 1998). This reveals why so many companies are
issuing rebates nowadays, especially for electronics which usually
have MSRP information easily available. Even for a promoted prod-
uct facing high rebate redemptions, publically announcing the
MSRP to consumers will help manufacturing firms increase profit-
ability and control the distribution channel.
Hopefully, our results will provide insights for researchers who
would like to further analyze the slippage phenomenon on rebates
and the loss aversion effect on MSRP. One extension would be to
associate the redemption rate with the consumer’s type, i.e.
assuming ro is decreasing with t. With this assumption, rebate pro-
motions can price-discriminate between consumer types after pur-
chase, which implies that high consumer types have a low
probability to redeem because they usually have high redemption
costs and low marginal utilities of income. Hence, the manufac-
turer can possibly achieve higher profits by only serving the high
consumer types. Another line of extension would be to apply this
model to the research on new product design. In that case, the
manufacturer can adjust the product quality level s, which has an
increasing production cost such that the manufacturer needs to
determine an optimal quality level. Finally, researchers could
incorporate the important promotional mix element of advertising
into these models.
Appendix A. Supplementary data
Supplementary data associated with this article can be found, in
the online version, at doi:10.1016/j.ejor.2009.12.018.
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