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European Journal of Operational Research

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

Retailer’s vertical integration strategies under different business modes

Pei Li a,∗, Dan Tan b, Guangyong Wang c, Hang Wei b, Jilan Wu d
a
School of Business Administration, Shanghai Lixin University of Accounting and Finance, Shanghai 201209, China
b
College of Business, Shanghai University of Finance and Economics, Shanghai 200433, China
c
Institute of Applied Economics, Shanghai Academy of Social Sciences, Shanghai 20020, China
d
School of Information Management and Engineering, Shanghai University of Finance and Economics, Shanghai 200433, China

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

Article history: Currently, increasingly more retailers wish to gain a competitive advantage through vertical integration.
Received 30 April 2019 We consider a three-echelon supply chain comprising a retailer, a service supplier, and a manufacturer.
Accepted 28 July 2020
The service supplier is responsible for the service level, and the manufacturer is responsible for product
Available online xxx
quality. The retailer has two business modes: reseller mode and platform mode. The retailer chooses one
Keywords: of three strategies, i.e., no vertical integration, forward integration, or backward integration, for these two
Vertical integration business modes. By comparing the retailer’s equilibrium profit under these vertical integration strategies,
Business mode we obtain the optimal choice for the retailer and a high profit for the supply chain under different busi-
Improvement in vertical integration strategy ness modes. Moreover, we characterize the effects of the proportional fee, product quality, service level
Endogenous proportional fee and business mode on vertical integration. We find that the cost effect is determined by product qual-
ity and service level and that the income distribution effect is determined by the proportional fee. The
cost effect is a key factor affecting the retailer’s vertical integration strategy under the reseller mode, and
both of these effects jointly affect the retailer’s choice under the platform mode. Furthermore, we design
a cost-sharing contract to improve vertical integration efficiency and investigate the effect of vertical in-
tegration decisions on improvement strategies. Lastly, we consider an extension to analyse the effect of
an endogenous proportional fee on retailers’ vertical integration strategies.
© 2020 Elsevier B.V. All rights reserved.

1. Introduction Joyoung and more than 10 other well-known brands to produce

In the traditional supply chain, service levels and product
quality are determined by the service provider and manufacturer,
respectively. To control the product quality or service level, the
retailer must implement a vertical integration strategy. In practice,
the direction of vertical integration is diverse, some retailers
choosing to forward integrate with service providers, whereas
others opt to backward integrate with manufacturers. A forward
integration strategy extends the retailer’s functions to product
service, tightening its connection with the consumer side. For
example, JD.COM set up logistics distribution centres in Beijing,
Shanghai, and Guangzhou in 2004 (Eastland, 2014). Moreover,
in 2014, JD.COM introduced a warranty service to consumers to
strengthen its control over product service. Conversely, a backward
integration strategy stretches the retailer’s operations towards
production, tightening its control on the manufacturer side. For
example, Tmall, China’s largest online retailer, joined with Midea,
∗
Corresponding author.
E-mail address: lipei_1020@126.com (P. Li).
customized products (DZH, 2014).
What is the major reason driving retailers to vertically inte-
grate? Some studies find that a vertical integration strategy can
eliminate the adverse effect of double marginalization (Lin, Par-
laktürk & Swaminathan, 2014). In addition, forward and backward
integration strategies can provide additional benefits for retailers.
A forward integration strategy enables a retailer to control the
product service level more effectively, enabling the retailer to
better respond to changes in consumer requirements. The value
of this advantage increases with the diversity of consumer needs.
Moreover, forward integration can also raise the retailer’s revenues.
In contrast, a backward integration strategy enables a retailer to
control product quality more effectively. The quality of products is
an important factor in determining demand. Furthermore, forward
integration and backward integration strategies allow the retailer
to better control its price because product quality and service level
will affect product price.
In addition, pricing power, which is different under differ-
ent business modes, will affect the retailer’s vertical integration
strategy; thus the retailer will choose a different vertical inte-
gration strategy under different business modes. Traditionally, re-
tailers have primarily been resellers that purchase products from

https://doi.org/10.1016/j.ejor.2020.07.054
0377-2217/© 2020 Elsevier B.V. All rights reserved.

Please cite this article as: P. Li, D. Tan and G. Wang et al., Retailer’s vertical integration strategies under different business modes,
European Journal of Operational Research, https://doi.org/10.1016/j.ejor.2020.07.054
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manufacturers and resell them to consumers (e.g., mom-and-pop
stores). These retailers will determine the retail price. Recently,
with the rapid growth of e-commerce, some retailers can serve as
a platform to connect manufacturers and buyers directly through
the Internet (e.g., Tmall). Under the platform mode, the manufac-
turer determines the retail price and shares the revenue (by a pro-
portional fee) with the retailer.
Forward integration and backward integration strategies ben-
efit the retailer differently, but each of these integration strate-
gies must incur some costs. We wish to understand the trade-off
when one integration strategy dominates another integration strat-
egy in terms of the benefits and costs of vertical integration and
how these trade-offs are influenced by different business modes.
All of these issues lead to several research questions. Which ver-
tical integration strategy should a retailer choose under different
business modes? How do product quality, service level and busi-
ness mode affect the retailer’s vertical integration strategy? Can
these vertical integration strategies be improved under different
business modes? Which vertical integration strategy should the re-
tailer choose when vertical integration strategies can be improved?
Furthermore, how does an endogenous proportional fee affect the
answers to the above questions?
To answer these questions, we now consider a three-echelon
supply chain comprising a retailer, a service supplier, and a man-
ufacturer. The service supplier is responsible for the service level
and the manufacturer is responsible for product quality. Retailers
have two business modes: the reseller mode and platform mode.
Under the reseller mode, the retailer purchases the product from
the manufacturer and resells it to the consumer. Under the plat-
form mode, retailers serve as a platform to connect manufacturer
and buyer. A retailer under different business modes has three ver-
tical integration strategies: no integration (disintegration), forward
integration, or backward integration. By comparing the retailer’s
equilibrium profit under these vertical integration strategies, we
obtain the optimal choice for the retailer under different business
modes, respectively. Moreover, we design a vertical integration im-
provement strategy to improve supply chain efficiency and inves-
tigate the retailer’s optimal choice in this improvement strategy.
Lastly, we considered an extension—analysing the effect of an en-
dogenous proportional fee on a retailer’s vertical integration strat-
egy choices.
We find that different business modes will affect the retailer’s
optimal choice of vertical integration strategy. First, under the
reseller mode, when all three strategies have positive solutions,
disintegration cannot be an optimal strategy. This result is consis-
tent with the results of Lin et al. (2014), although their research
objects are manufacturers. Second, when all three strategies have
positive solutions, the chosen direction depends upon the cost
advantage of vertical integration compared with each of the other
directions. We call this reason the cost effect, which is influenced
by the marginal cost of service improvements and the marginal
cost of quality improvements (we standardize marginal cost of
quality improvements to 1). We show that the forward (backward)
integration is an optimal strategy when the marginal cost of
service improvements is lower (higher) than the marginal cost of
quality improvements. The fundamental cause of the retailer’s opti-
mal strategy lies in the marginal cost of service improvements and
the marginal cost of quality improvements that will affect demand.
On the one hand, when marginal cost of service improvements is
lower, the fixed investment can facilitate a higher service level, and
the demand for forward integration is higher, which makes the
profit of forward integration higher. On the other hand, when the
marginal cost of quality improvements is lower, the fixed invest-
ment can deliver higher product quality, and the demand for back-
ward integration is higher. Therefore, backward integration will
Please cite this article as: P. Li, D. Tan and G. Wang et al., Retailer’s vertical integration strategies under different business modes,
European Journal of Operational Research, https://doi.org/10.1016/j.ejor.2020.07.054
[m5G;August 20, 2020;12:5]
become more attractive. Lastly, the supply chain performance is
consistent with the retailer’s optimal strategy.
Under the platform mode, some conclusions are the same as
under the reseller mode. For example, when all three strategies
have positive solutions, disintegration cannot be an optimal strat-
egy. Because the proportional fee will affect the retailer’s profit dis-
tribution with the manufacturer, the retailer’s optimal strategy is
different from when it is under the reseller mode when all three
strategies have positive solutions. First, if the marginal cost of ser-
vice improvements is relatively moderate and the proportional fee
is relatively high, or the marginal cost of service improvements
is relatively high, the retailer gains the highest profit by choos-
ing forward integration; otherwise, the retailer gains the highest
profit by choosing backward integration. The reason is that two
types of effects exist that will affect the retailer’s profit: the cost
effect (influenced by the marginal cost of service improvements
and the marginal cost of quality improvements) and the income
distribution effect (influenced by the proportional fee). When the
marginal cost of service improvements is relatively high, the cost
effect makes the backward integration strategy dominant; when
the marginal cost of service improvements is relatively low, the
cost effect makes the forward integration strategy dominant. By
contrast, when the proportional fee is relatively high, the income
distribution effect makes the forward integration strategy domi-
nant; when the proportional fee is relatively low, the income dis-
tribution effect makes the backward integration strategy domi-
nant. Second, supply chain performance is inconsistent with the
retailer’s optimal strategy, and when the retailer chooses a forward
integration strategy, the entire supply chain always gets higher
profits.
Moreover, forward integration strategy enables the retailer to
better control service price and retail price, whereas backward in-
tegration strategy enables the retailer to better control wholesale
price and retail price. These two integration strategies can only be
used to control one side. Thus, we design a cost-sharing contract to
control both these sides (production and service) simultaneously.
This cost-sharing contract can increase the profits of the retailer,
manufacturer and service provider under different vertical integra-
tion strategies. In our paper, we call this contract a vertical integra-
tion improvement strategy. In the vertical integration improvement
strategy, we first find that the retailer’s optimal strategy is identical
to a common strategy (vertical integration strategy without con-
sidering a cost-sharing contract) under the reseller mode, but dif-
ferent from a common strategy under the platform mode. Under
the platform mode, when the proportional fee and the marginal
cost of service improvements are both lower, the retailer’s opti-
mal strategy is backward integration; otherwise, the retailer’s op-
timal strategy is forward integration. Second, the efficiency of this
improvement strategy decreases with an increase in the marginal
cost of service improvements and increases with an increase in the
proportional fee.
Lastly, we consider an extension, the endogenous proportional
fee, and then compare the six strategies simultaneously. We find
that if the marginal cost of service improvements is relatively low,
forward integration is the retailer’s optimal strategy under the re-
seller mode; if the marginal cost of service improvements is rela-
tively high, backward integration is the retailer’s optimal strategy
under both the reseller and platform modes.
The remainder of this paper is organized as follows.
Section 2 briefly reviews the related literature, and Section 3 de-
tails our key assumptions, notation and basic model. In Sections 4,
we investigate the retailer’s optimal vertical integration and
the supply chain performance under the two business modes.
In Section 5, we consider a vertical improvement integration
strategy and investigate the retailer’s optimal choices and the
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efficiency of the improvement strategy under the two business
modes. In Section 6, we consider an extension of the endogenous
proportional fee. Lastly, we offer concluding remarks and future
directions in Section 7. For clarity of exposition, all proofs are
provided in the appendix.
2. Related literature
This paper addresses two streams of closely related research:
vertical integration and business mode.
Several papers in the industrial organization and marketing
literature and in operations management have examined how ver-
tical integration affects a firm’s decision. Some papers study the
effect of vertical integration on investment, pricing, collusion or
innovation. Mataubayashi (2007) considers the differentiation and
vertical integration strategy and concludes that monopolistic ver-
tical integration is profitable for all the parties in the supply chain
under some mild conditions. Buehler and Schmutzler (2008) built
a linear Cournot model and studied the interaction between ver-
tical integration and reduced cost downstream investment under
successive oligopolies. They find that vertical integration increases
their investment and reduces the investment of competitors. Arya
and Mittendorf (2013) study the impact of forward integration
on the purpose of a firm’s strategic investments. They find that
integration can shift a firm’s strategy from weakening investment
retail competitors to stimulating demand through investment.
Annunzio (2017) studies the impact of vertical integration on in-
vestment in premium content in the media market. She finds that
independent suppliers’ investment quality incentives were higher
than those of vertically integrated content providers. Bragança and
Daglish (2017) analyse the impact of market structure on vertical
integration investment decisions and find that the firm will be
reluctant to expand its retail business when demand is low or
very high. Reyniers (2001) investigates the effect on the price of a
vertical merger between a manufacturer and its retailer by consid-
ering inventory costs. He finds that consumer prices will decrease
after a vertical merger when inventory costs are sufficiently small.
Liu (2016) studies how vertical integration affects innovation by
considering risky R&D investments. She finds that firms favour
vertical integration only when innovation is important to both up-
stream and downstream firms. Biancini and Ettinger (2017) study
the impact of vertical integration on downstream firms’ ability
to collude. They show that vertical integration can increase total
collusive profits and make the profits of the integrated firm higher
than those of unintegrated competitors. Other papers compare
strategies of vertical integration and no vertical integration.
Maruyama and Minamikawa (2009) focus on vertical integration
and mixed bundling and find that these two strategies are a dom-
inant strategy except when components are highly differentiated.
Matsui (2012) finds that vertical integration will dominate the
separation strategy when demand, product substitutability and
fixed costs fall into a specific region. Glock and TaebokKim (2015)
consider the integration of suppliers and retailers and find that
integration can benefit all parties in the supply chain under certain
conditions. Fiocco (2016) investigates the incentives for the degree
of vertical integration. Han, Ge and Lei (2016) compare three
different strategies: no integration, horizontal integration and
vertical integration. They find that horizontal integration would
benefit firms, whereas vertical integration would benefit the
government. Most of these papers analyse vertical integration and
no vertical integration strategies in a two-echelon supply chain
comprising a manufacture (vendor) and a retailer. However, our
work examines three different vertical integration strategies: no
vertical integration, forward integration, or backward integration
at the same time in the three-echelon supply chain.
Please cite this article as: P. Li, D. Tan and G. Wang et al., Retailer’s vertical integration strategies under different business modes,
European Journal of Operational Research, https://doi.org/10.1016/j.ejor.2020.07.054
[m5G;August 20, 2020;12:5]
3
Because we investigate the retailer’s vertical integration prob-
lem under different business modes, this paper is related to the lit-
erature stream on business mode. Hagiu (2007) investigates the re-
tailer’s business mode problem by considering network effects and
the supplier’s information about product quality. Ryan, Sun and
Zhao (2012) focus on market expansion and participation costs and
analyse the strategy of a retailer with a distribution channel that
adds a platform channel. Mantin, Krishnan and Dhar (2015) focus
on market activity and investigate the same problem as Ryan et
al. (2012). Kwark, Chen and Raghunathan (2014) investigate an in-
fluence on intermediary mode choice in online product reviews.
Hagiu and Wright (2015) find that whether the marketplace or the
reseller mode is preferred depends upon whether the supplier or
the intermediary has the greater amount of important informa-
tion relevant to the optimal tailoring of marketing activities. Tan,
Carrillo and Cheng (2016), considering the wholesale model and
the agency model in the digital goods supply chain, find that be-
cause the agency model can pre-agree to income distribution, it
can coordinate competitive retailers. Abhishek, Jerath and Zhang
(2016) build a stylized theoretical model to analyse an e-tailer’s
strategy for an agency selling format and reselling format. Yan,
Zhao and Liu (2018) consider the combined effects of network spill
over, platform fee, etc., to investigate whether and under what
conditions one can introduce dual-channel sales (reseller channels
and marketplace channels). Tian, Vakharia, Tan and Xu (2018) com-
pare reseller, marketplace and hybrid strategies by considering the
effects of the order-fulfilment cost and the competition intensity.
Wirl (2018), Zhu and Yao (2018), and Zennyo (2020) compare the
wholesale and agency model under different backgrounds. Zhang,
Cao and He (2019) study an e-tailer’s contract choice between the
revenue-sharing contract and the fixed-fee contract as well as a
manufacturer’s product quality decision. Liu and Ke (2020) study
how the cap-and-trade regulation affects an e-tailer’s choice of re-
tailing formats between marketplace and reseller. Zhang and Zhang
(2020) study the e-tailer’s demand information sharing strategy
with the supplier’s offline entry under agency selling and reselling
mode. Most of the papers on business mode studied whether or
under what conditions the platform (marketplace/agency) mode,
reseller (wholesale) mode or hybrid mode is preferred. However,
none of these papers considers the choice of no vertical integra-
tion, forward integration, or backward integration under different
business modes.
Furthermore, our paper closely relates to the following papers.
Fronmueller and Reed (1996) examine the idea that backward
vertical integration will provide companies with a low-cost com-
petitive advantage, while forward vertical integration will provide
companies with differentiated advantages. They find that the
relationship between backward vertical integration and low cost is
not significant and that the relationship between forward vertical
integration and differentiated advantages is strongly significant.
Lin et al. (2014) consider two competing supply chains, with each
manufacturer choosing one of three strategies: forward integra-
tion, backward integration, or no vertical integration. They find
that both forward and backward integration options can be an
equilibrium outcome in different regions, but disintegration cannot
be an equilibrium outcome. All of these papers considered three
different vertical integration strategies (no vertical integration, for-
ward integration, or backward integration). However, Fronmueller
and Reed (1996) empirically study different vertical integration
strategies, and this paper takes an analytical approach to research.
Lin et al. (2014) focus on the effect of vertical integration on
profitability, product price, and quality in a competitive setting,
whereas this paper considers the effect of a proportional fee,
product quality, and service level on retailer vertical integration
strategies under different business modes. In summary, our work
differs from these papers as follows: (i) we consider the effects
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Table 1 proportional fee α , the service provider charges a per-unit service

price of λi to the manufacturer, and the manufacturer sells the
Parameters and decision variables. j

Symbol Definition j
product to consumers directly at retail price pi . The retailer’s
θ Basic market demand profit is the commission, which is the proportional fee multiplied
by sales (α pi qi ).
j j
tij Product quality under i mode j strategy
sij Service level under i mode j strategy Three vertical integration strategies. Three types of vertical
qij Realized demand under i mode j strategy
integration strategy exist for the retailer: no integration (disin-
pij Retail price under i mode j strategy
tegration), forward integration, and backward integration. When
wij Wholesale price under i mode j strategy
λij Service price under i mode j strategy retailers do not integrate, the manufacturer and service provider
k Marginal cost of service improvements each function independently. However, when the retailer backward
α Proportional fee integrates, the retailer and the manufacturer are amalgamated;
ϕ Cost-sharing ratio of improvement strategy when the retailer forward integrates, the retailer and the service
ijk Firm k’s profit under i mode j strategy
provider are amalgamated.
i = R, P Reseller mode and platform mode, respectively
j = N, F, B No integration, forward integration, and backward Six different configurations. In our setting, different market con-
integration, respectively figurations can arise based on the different business modes (re-
k = R, M, S Retailer, manufacturer and service provider, respectively seller mode and platform mode) and vertical integration strategies
(no integration, forward integration, and backward integration). In
summary, the interaction between the business mode and the ver-
of a proportional fee, product quality, and service level on retailer tical integration strategy choice will lead to the following six con-
vertical integration strategies in a three-echelon supply chain. (ii) figurations:
We analyse the retailer vertical integration strategy under different (i) RN strategy—The retailer employs the reseller mode and no
business modes. All parties in the supply chain realize different vertical integration. (ii) RB strategy—The retailer employs the re-
profits under different business modes. Therefore, the business seller mode and backward integration. (iii) RF strategy—The re-
mode will also be an important factor affecting the retailer’s verti- tailer employs the reseller mode and forward integration. (iv) PN
cal integration strategy choice. Lastly, (iii) we consider the effect of strategy—The retailer employs the platform mode and no verti-
a cost-sharing contract on different vertical integration strategies. cal integration. (v) PB strategy—The retailer employs the platform
mode and backward integration. (vi) PF strategy—The retailer em-
3. Model ploys the platform mode and forward integration.
Game sequence. The basic model is a dynamic noncooperative
In this paper, we consider a standard model of a supply chain game, and we aim to find the subgame perfect Nash equilibrium.
in which a manufacture sells products through a service provider We solve the games by backward induction. We first find the sub-
and retailer. The service provider can provide logistics and after- game equilibria of stage 2 (RB strategy, RF strategy, PN strategy,
sales services (e.g., warranty and upgrade). The retailer functions as PB strategy, PF strategy), or stage 3 (RN strategy). Then we solve
an intermediary to connect consumer and manufacturer. The busi- for the equilibrium of stage 1 or stage 2 based on the subgame
ness mode of the retailer can be either reseller or platform. Below, equilibria of stage 2 or stage 3. Finally, we obtain the equilibrium
we introduce our basic demand model, cost structure, two busi- results in the RN strategy of stage 1. From Fig. 1, the game under
ness modes, three vertical integration strategies, game sequence, different strategies can be expressed as follows:
and equilibrium results. Table 1 summarizes the parameters and
decision variables of our model. (i) RN strategy—In stage 1, the manufacturer is responsible for
j
Demand structure. The demand function takes the following production, decides the product quality ti , and sells products
form, j
to the retailer at a certain wholesale price wi . In stage 2,
qij =θ + tij + sij − pij the service provider is responsible for logistics, distribution
services, and after-sales service and decides the service price
j j
where qi and pi refer to the realized demand and retail prices for λij and service level sij . In stage 3, the retailer is responsible
product (i = R, P , j = N, F , B), respectively, and denote basic market j
for product sales and decides the retail price pi . Most small
demand. Following Arya and Mittendorf (2013), we assume the net retailers, such as community stores, convenience stores, and
demand intercept is θ . The effect of product quality and service mom-and-pop stores, employ this strategy.
j j
level on basic market demand is ti and si , respectively. Therefore, (ii) RB strategy—In stage 1, the service provider is responsible
the net demand intercept is θ + ti + si .
j j
for logistics, distribution services, and after-sales service and
decides the service price λi and service level si . In stage 2,
j j
Cost structure. Following Arya and Mittendorf (2013), we as-
sume that the variable cost includes product quality cost and ser- the retailer (manufacturer) is responsible for production and
j j
vice level cost. The (net) demand intercept can be increased by the decides the product quality ti and retail price pi . For exam-
j j2
quality level of ti through manufacturer quality investment ti and ple, a store brand in which the retailer produces the product,
j
the service level of si through service provider service investment such as Watsons, has more than 20 0 0 products in its store
j2 brand in China, with annual sales of ¥3 billion in 2013, ac-
ksi . Without loss of generality, we do not consider the fixed cost
counting for approximately 18 percent of store sales.
and the variable production cost.
(iii) RF strategy—In stage 1, the manufacturer is responsible for
Two business modes. Retailers have two different business j
production, determines product quality ti , and sells products
modes: the reseller mode and platform mode. Under the reseller j
mode, the manufacturer charges a per-unit wholesale price of to the retailer at a certain wholesale price wi . In stage 2 the
j
wi to the retailer, the service provider charges a per-unit service retailer (service provider) is responsible for logistics, distri-
bution services, after-sales service, and decides the service
price of λi to the retailer, and the retailer resells the product to
j
j j
j
level si and retail price pi . For example, household appli-
consumers at a retail price pi . The retailer’s profit is obtained by ance retailers sell products and provide distribution services
j j
selling the product ( pi qi ).
Under the platform mode, the retailer at the same time. Examples include Best Buy, Suning, and
provides a sales channel for the manufacturer and charges a Gome.

Please cite this article as: P. Li, D. Tan and G. Wang et al., Retailer’s vertical integration strategies under different business modes,
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Fig. 1. Six different strategies.

(iv) PN strategy—In stage 1, the retailer provides a channel for

the manufacturer to sell product and charges a proportional max BR  B 
Stage 2 : = pr − λBr qBr − trB 2 (5)
fee α , the service provider is responsible for logistics, dis- pBr , trB r
tribution service, after-sales service, and decides the ser-
vice price λi and service level si . In stage 2, the manufac-
j j
max F M
turer is responsible for production and decides the product RF : Stage 1 : = wFr qFr − trF 2 (6)
wFr , trF r
j j
quality ti and retail price pi . For example, Tmall, China’s
max F R  F 
largest online retailer, the logistics and distribution services
in the marketplace are provided by third-party enterprises, Stage 2 : = pr − wFr qFr − ksFr 2 (7)
pr , sr
F F r
while provides a marketplace for manufacturers, and some
manufacturers sell products marked with "For the exclu-
max NS
sive Tmall" on Tmall platform, such as C2M in the cloth- PN : Stage 1 : = λNp qNp − ksNp 2 (8)
ing and FMCG industry (C2M is customer-to-manufacturer, λNp , sNp p

which drives the production in reverse from the customer’s

requirements). max NM
Stage 2 : N N = (1 − α ) pNp qNp − λNp qNp − t pN2
(v) PB strategy—In stage 1, the service provider is responsible pp , tp p
(9)
NR
for logistics, distribution services, after-sales service, and de- s.t. = α pNp qNp ≥ 0, α ≥ 0
cides the service price λi and service level si . In stage 2, the
j j p

retailer merges with manufacturer, thus, the retailer (manu-

max BS
facturer) is responsible for production and decides the prod- PB : Stage 1 : = λBp qBp − ksBp 2 (10)
j j
uct quality ti and retail price pi . Thus, the PB strategy is the λBp , sBp p

same as the RB strategy.

(vi) PF strategy—In stage 1, the retailer (service provider) pro- max BR BR  B 
Stage 2 : = = p p − λBp qBp − t pB 2 (11)
vides a channel for the manufacturer to sell product, charges pBp , t pB r p
a proportional fee α , is then responsible for logistics, distri-
bution services, after-sales service, and decides the service max F R
price λi and service level si . In stage 2, the manufacturer
j j PF : Stage 1 : = α pFp qFp + λFp qFp − ksFp2
λFp , sFp p (12)
is responsible for the production and decides the product
j j
s.t. α ≥ 0
quality ti and retail price pi . For example, JD.COM, China’s
second-largest online retailer, has provided logistics deliv-
max F M
ery services since its inception and now extends services to Stage 2 : = (1 − α ) pFp qFp − λFp qFp − t pF 2 (13)
pFp , t pF p
after-sales services, and cooperated with manufacturers to
implement C2M, the proportion of home appliances devel- Equilibrium results. Equilibrium results are listed in Table 2. De-
oped in C2M has reached 40%. tails are provided in the appendix.
max NM Conditions on the parameter k of six strategies guarantee that
RN : Stage 1 : = wNr qNr − trN 2 (1) all the firms in the supply chain can get positive price, quality, ser-
wNr , trN r
vice level, and profit. From the equilibrium, the PB strategy is the
max NS same as the RB strategy. In the PB strategy, the retailer backward
Stage 2 : = λNr qNr − ksNr 2 (2)
λNr , sNr r integrates to the manufacturer, and the manufacturer no longer
max NR  N  must pay commissions to the retailer; thus, the platform mode is
Stage 3 : = pr − wNr − λNr qNr (3) no different from the reseller mode. Because the retailer’s prof-
pNr r
itability is different under different business modes, the retailers’
max BS vertical integration strategy options will be considered separately
RB : Stage 1 : = λBr qBr − ksBr 2 (4)
λBr , sBr r under the reseller mode and platform mode.

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Table 2 marginal cost of service improvements is relatively high (k > 1),

Equilibrium results under the six strategies.
we find that equilibrium product quality, service level and realized
RN strategy PN strategy demand are the maximum in backward integration (RB) because if
Conditions: k > 2 −α
Conditions: k > 2(13+ the marginal cost of service improvements is relatively high, then
15 α)
the retailer choosing backward integration will incur relatively low
wNr = θ15(8k−1)
k−2
θ ( 1 −α ) k costs and increase investment in improving product quality. There-
trN = 15θkk−2 t pN = 2k (3+α )+α −1
4θ k θ (1−α )(3+α )k
fore, product quality, service level and realized demand will be
λ =
N
λ =N
2k (3+α )+α −1
r 15k−2 p
higher when the retailer chooses backward integration.
θ θ ( 1 −α )
sNr = 15k−2
sNp = 2k(3+ α )+α −1
Lemma 1. Under the reseller mode, we obtain the conditions for the
pNr = θ (15
14k−1)
k−2
pNp = 2k(θ3+(5+α )k
α )+α −1
2θ k
positive price, quality, service level, and profit for each strategy as fol-
qNr = qNp = 2k(3+2αθ)k+α −1
15k−2 lows:
NR NM NR 2θ 2 α (5+α )k2 NM
4θ 2 k2
= 15θk−2 = θ (1−α )(3+α )k 2 ,
2 2 2
k
r = , r , p = (2k (3+α )+α −1)2 , p
(15k−2)2 (2k(3+α )+α −1)
NS θ 2 k(8k−1) NS θ 2 ( 1 −α ) k (i) If the marginal cost of service improvements is relatively
= p = 2k (3+α )+α −1 2
< k < 16 ), the RN strategy has positive solutions.
r (15k−2) 2
low (i.e., 15
RB strategy PB strategy
(ii) If the marginal cost of service improvements is relatively
1 1
Conditions: k > 6
Conditions: k > 6 moderate (i.e., 16 < k < 27 ), the RN and RB strategies have
trB = θk t pB = θk
6k−1 6k−1 positive solutions.
3θ k 3θ k
λBr = 6k−1
λBp = 6k−1
(iii) If the marginal cost of service improvements is relatively
sBr = θ sBp = θ high (i.e., k > 27 ), the RN, RB, and RF strategies all have pos-
6k−1 6k−1

pBr = 5 kθ
pBp = 5 kθ itive solutions.
6k−1 6k−1
2θ k 2θ k
qBr = 6k−1
qBp = 6k−1 In Lemma 1, all conditions are to guarantee positive price, pos-
BR 3θ 2 k2 BS θ2k BR 3θ 2 k2 BS
= 6θk−1
2
r =
(6k−1)2
, r = 6k−1 p =
(6k−1)2
, p
k
itive quality, positive service level, and positive profit under dif-
RF strategy PF strategy ferent strategies. Because the conditions for positive solutions vary
2 1 under different strategies that depend upon the marginal cost of
Conditions: k > 7
Conditions: k > 6−2α
service improvements, the optimal strategies of retailers and sup-
wFr = θ (74kk−2
−1)
λFp = 36θk−1( 1 −α ) k 2

trF = 7kθ−2
k
t pF = 6θk−1
( 1 −α ) k
sFr = θ sFp =
7k−2
pBr = θ (76kk−2
−1)
pFp = 6θk(−1
5−3α )k
−2α k
2θ k
qFr = 7k−2
qFp =
F R  F R
= θ k(4k−12 ) , Fr M = 7θk−2
2 2
k
r p = 6k−1−2α k
(7k−2)
4. Vertical integration strategy under different business modes
In this section, we focus on two questions: First, what is the
retailer’s optimal vertical integration strategy under the reseller
mode or the platform mode? Second, how do product quality, ser-
vice level and business mode affect the retailer’s vertical integra-
tion strategy?
4.1. Vertical integration strategy under the reseller mode
Consider a situation in which the retailer chooses the reseller
mode. In this case, the retailer chooses no integration, forward in-
tegration, and backward integration, or equivalently, the RN strat-
egy, RF strategy or RB strategy. Based on the equilibrium results
given in Table 2, we obtain the following proposition:
Proposition 1. Under reseller mode, comparing the equilibrium re-
sults of product quality, service level and realized demand, we obtain
(i) if 72 < k < 1, then trN < trB < trF , sN B F N B
r < sr < sr and qr < qr < qr .
(ii) if k > 1, then trN < trF < trB , sN
r < s F < sB and qN < qF < qB .
r r r r
Proposition 1 summarizes a comparison of the equilibrium
product quality, service level and realized demand from differ-
ent vertical integration strategies under the reseller mode. If the
marginal cost of service improvements is relatively low ( 27 < k <
1), we find that equilibrium product quality, service level and real-
ized demand are maximum in forward integration (RF) because if
the marginal cost of service improvements is relatively low, then
a retailer choosing forward integration will incur relatively low
costs and increase investment in improving service level. Therefore,
product quality, service level and realized demand will be higher
when the retailer chooses forward integration. However, if the
−2α k ply chains vary in the interval range of the marginal cost of service
−2α k improvements.
θ
6k−1−2α k
Proposition 2. Consider the retailer employing the reseller mode, the
retailer’s optimal vertical integration choice is as follows:
2θ k
6k−1−2α k
F M (i) When only RN strategy has positive solutions (i.e., 15 2
<k<
θ2k = θ (1−α )(3+α )2k
2 2
, p
(6k−1−2α k)
1
6 ), the retailer will choose disintegration (RN).
(ii) When the RN and RB strategies have positive solutions si-
multaneously (i.e., 16 < k < 27 ), the retailer will choose back-
ward (RB) integration. The supply chain gains the highest
profit on backward (RB) integration.
(iii) When the RN, RB and RF strategies have positive solutions
simultaneously (i.e., k > 27 ), if the marginal cost of service
improvements is relatively low (i.e., 27 < k < 1), then the re-
tailer will choose forward (RF) integration and the supply
chain gains the highest profit on forward (RF) integration. If
the marginal cost of service improvements is relatively high
(i.e., k > 1), the retailer will choose backward (RB) integra-
tion and the supply chain gains the highest profit on back-
ward (RB) integration.
From Fig. 2, we observe that in the regions of k > 27 , the RN,
RB and RF strategies have positive solutions. Proposition 2 states
that the RN strategy cannot be an optimal strategy when k > 27 ;
the choice between the RB strategy and the RF strategy depends
on the cost advantage of vertical integration. We call this reason
the cost effect, and it is influenced by the marginal cost of service
F
improvements and the marginal cost of quality improvements (we
r
standardize the marginal cost of quality improvements to 1). When
k > 1, the cost of improving the service level is greater than the
cost of improving the quality, indicating that the cost of backward
integration is lower than that of forward integration. In this case,
the retailer chooses backward (RB) integration. When 27 < k < 1,
the cost of improving the service level is lower than the cost of
improving the quality, indicating that the cost of backward inte-
gration is greater than that of forward integration. In this case, the
retailer chooses forward (RF) integration. The fundamental cause of
the choice of the retailer is that the cost of improving the service
level (product quality) will affect demand. When the cost of im-
proving the service level (marginal cost of service improvements)

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Fig. 2. Retailer’s optimal strategies under the reseller mode.
is lower, fixed investment can achieve a higher service level and
the demand for forward integration is higher, which in turn makes
forward integration more attractive. Conversely, when the cost of
improving product quality (marginal cost of quality improvements)
is lower, fixed investment can achieve higher product quality and
the demand for backward integration is higher. Therefore, back-
ward integration will become more attractive.
Proposition 2 also states that the retailer’s optimal strategy is
consistent with the maximum profit of the entire supply chain.
Vertical integration eliminates double-marginalization and can im-
prove sales by using cost advantages. Therefore, the marginal cost
of service improvements can also affect the profits of the entire
supply chain.
4.2. Vertical integration strategy under the platform mode
Consider a situation in which the retailer chooses the platform
mode. In this case, the retailer chooses no integration, forward in-
tegration, and backward integration, or equivalently, the PN, PF and
PB strategies. Based on the equilibrium results given in Table 2, we
obtain the following proposition:
Proposition 3. Under the platform mode, comparing the equilibrium
results of product quality, service level and realized demand, we ob-
tain
1 1 N B F 1
(i) If 6−2 α < k < 4 , then t p < t p < t p ; if k > 4, then t pN < t pF <
B
tp .
(ii) sNp < sBp < sFp , qNp < qBp < qFp .
Proposition 3 summarizes the comparison of the equilibrium
product quality, service level and realized demand from various
vertical integration strategies under the platform mode. When the
retailer chooses forward (PF) integration, the service level and re-
alized demand will increase. This result differs from the reseller
mode because the manufacturer decides the price under the plat-
form mode, partially reducing the double marginal effect, and the
retailer will obtain a greater advantage by choosing the forward
integration strategy.
Lemma 2. Under the platform mode, we obtain the conditions for the
positive price, quality, service level, and profit for each strategy as fol-
lows:
(i) If the marginal cost of service improvements is relatively
−α
low (i.e., 2(13+ 1
α ) < k < 6 ), the PN strategy has positive solu-
tions.
(ii) If the marginal cost of service improvements is relatively
moderate (i.e., 16 < k < 6−2 1
α ), the PN and PB strategies have
positive solutions.
(iii) If the marginal cost of service improvements is relatively
1
high (i.e., k > 6−2 α ), the PN, PB and PF strategies all have
positive solutions.
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[m5G;August 20, 2020;12:5]
7
In Lemma 2, all conditions are to guarantee positive price, pos-
itive quality, positive service level, and positive profit under dif-
ferent strategies. Because the conditions for the positive solutions
vary under different strategies, which depend upon the marginal
cost of service improvements and the proportional fee, the optimal
strategies of retailers and supply chains vary in the interval range
of the marginal cost of service improvements and the proportional
fee.
Proposition 4. For a retailer employing the platform mode, the re-
tailer’s optimal vertical integration choice is as follows:
(i) When only the PN strategy has positive solutions
−α
(i.e., 2(13+ 1
α ) < k < 6 ), the retailer will choose disintegra-
tion (PN).
(ii) When both the PN and PB strategies have positive solutions
simultaneously (i.e., 61 < k < 6−2 1
α ), the retailer will choose
backward integration (PB).
(iii) When the PN, PB and PF strategies simultaneously have pos-
itive solutions (i.e., k > 6−2 1
α ), if the marginal cost of service
improvements is relatively moderate and the proportional
fee is relatively high or the marginal cost of service improve-
α < k < k = 3 and α > α ,
ments is relatively high (i.e., 6−2 1 ∗ 1 ∗
or k > k∗ = 13 ), then the retailer will choose forward (PF)
α < k < k = 3 and α < α ),
1
integration; otherwise (i.e., 6−2 ∗ 1 ∗
the retailer will choose backward (PB) integration.
Fig. 3 shows the results of Proposition 4. The higher the pro-
portional fee, the higher the revenue share of the manufacturer to
the retailer, therefore, the PB strategy will intuitively be the opti-
mal strategy when the proportional fee is relatively low and the
PF strategy will be the optimal strategy when the proportional fee
is relatively high. However, the result of Proposition 4 is opposite
to our intuition when k > k∗ = 13 , because two types of effect exist
that will affect the retailer’s profit: the cost effect, which is pri-
marily affected by the marginal cost of service improvements k,
and the income distribution effect, which is primarily affected by
the proportional fee α . When k is relatively high, the cost effect
makes the PB strategy dominant; when k is relatively low, the cost
effect makes the PF strategy dominant. On the other hand, when
α is relatively high, the income distribution effect makes the PF
strategy dominant; when α is relatively low, the income distribu-
tion effect makes the PB strategy dominant. These opposite effects
cause the result of Proposition 4.
Proposition 5. When the retailer employs the platform mode and all
1
vertical integration strategies have positive solutions (i.e., k > 6−2 α ),
the entire supply chain always achieves higher profits when the re-
tailer moves from disintegration (PN) to backward (PB) integration to
forward (PF) integration.
Fig. 4 shows the results of Proposition 5, vertical integration
eliminates double-marginalization; therefore, both the PB and PF
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8 P. Li, D. Tan and G. Wang et al. / European Journal of Operational Research xxx (xxxx) xxx

Fig. 3. Retailer’s optimal strategies under the platform mode.

Fig. 4. Higher profits of the entire supply chain under the platform mode.

BSp = λ p q p − (1 − ϕ )ks p . In the PF strategy, the profit func-

strategies can achieve higher profits than can the PN strategy. For ∗ B∗ B∗ B∗ 2 ∗

the PB and PF strategies, the PB strategy eliminates the double
marginal effect between the manufacturer and the retailer, and the
PF strategy eliminates the double marginal effect between the ser-
vice provider and the retailer and partially eliminates the double
marginal effect between the manufacturer and the retailer. There-
fore, the PF strategy achieves higher profits than does the PB strat-
egy.
tions are as follows:  p = α p p q p + λFp∗ qFp∗ − ksFp∗ 2 − ϕ t pF ∗ 2 , and
F R ∗ F ∗ F ∗
FpM∗ = (1 − α ) pFp∗ qFp∗ − λFp∗ qFp∗ − (1 − ϕ )t pF ∗ 2 .
The basic model is a dynamic noncooperative game, and we
aim to find the subgame perfect Nash equilibrium. We solve the
games by backward induction and the decision sequence is con-
sistent with §3. The equilibrium results are listed in Table 3. The
details are given in the appendix.

5. Vertical integration improvement strategy

Cost is an important factor influencing the retailer’s vertical in-
tegration strategy. In this section, we consider a cost-sharing con-
tract to improve the efficiency of the retailer and supply chain.
Although vertical conglomerates that govern the entire supply
chain are less common (Lin et al., 2014), we can use the com-
plete integration of the entire supply chain as a benchmark strat-
egy, which we call the I strategy. The profit function of the sup-
2 strategy under the reseller mode; if the marginal cost of service im-
ply chain is I
= pI qI − tI = − ksI 2 pI (θ
+ − + tI sI
We impose the constraint of k > 13 to guarantee a positive price,
positive quality, positive service level, and positive profit. The re-
sults are as follows: t I = 3kθ−1
k
, sI = 3kθ−1 , pI = 32kθ−1
k 2kθ
, qI = −1+3
I = θ 2k .
3k−1
We now consider a cost-sharing contract under two different
business modes and then compare it with the I strategy to deter-
mine which strategy is more efficient. It is noteworthy that we
do not consider an RN or PN strategy because neither of them
is the optimal strategy for the retailer when no vertical integra-
tion strategy, forward integration strategy or backward integration
strategy has a positive solution. We will use the superscript “∗ ” to
denote the improvement vertical integration strategy. The retailer
gives a cost-sharing ratio ϕ . In the RB∗ strategy, the profit func-
tions are as follows: rBS∗ = λBr ∗ qBr ∗ − (1 − ϕ )ksBr ∗ 2 and BR
5.1. Vertical integration improvement strategy under reseller mode
In this section, we consider a retailer choosing between the
RF∗ and RB∗ strategies. To simplify the analysis, we only consider
the case of the positive solutions. Based on the equilibrium results
given in Table 3, we obtain the following proposition:
Proposition 6. Consider the retailer implementing an improvement
pI ) − tI 2 − ksI 2 . 4
provements is relatively low (i.e., 13 < k < 1), then the retailer will
choose forward integration (RF∗ ); otherwise, the retailer will choose
backward integration (RB∗ ) (i.e., k > 1). Moreover, the optimal strat-
,
k egy of the retailer under different conditions can also maximize the
profit of the entire supply chain.
The marginal cost of service improvements will influence the
retailer’s equilibrium choice; thus, the cost can also influence the
efficiency of the improvement strategy. We use the ratio of the
retailer’s equilibrium profit with the basic strategy and equilib-
rium profit with the improvement strategy to show the efficiency
of the improvement strategy. Thus, BR r /r
∗ BR (BS∗ /BS ) repre-
r r
sents the improved efficiency for the retailer (service provider),
and rF R∗ /Fr R (Fr M∗ /Fr M ) represents the improved efficiency
r
∗ = for the retailer (manufacturer). When BR r /r > 1, r /r >
∗ BR BS∗ BS

( pr − λr )qr − tr − ϕ ksr . In the RF strategy, the profit func-

B ∗ B ∗ B ∗ B ∗ 2 B ∗ 2 ∗ 1(r /r > 1 and r /r > 1), the RB (RF ) improvement
F R ∗ F R F M∗ F M ∗ ∗

tions are as follows: rF R∗ = ( pFr ∗ − wrF ∗ )qrF ∗ − ksFr ∗ 2 − ϕ trF ∗ 2 , and strategy is effective. The greater the rBR∗ /BR r and BS∗
r /r
BS

rF M∗ = wFr ∗ qFr ∗ − (1 − ϕ )trF ∗ 2 . In the PB∗ strategy, the profit func- (rF R∗ /Fr R and rF M∗ /Fr M ), the higher the efficiency of the im-
tions are as follows: BR ∗ = ( pB∗ − λB∗ )qB∗ − t B∗ 2 − ϕ ksB∗ 2 , and provement.
p p p p p p

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Fig. 5. Relationship between k and the efficiency of the RF∗ and RB∗ strategies.

Table 3 5.2. Vertical integration improvement strategy under platform mode

Equilibrium results under the four improvement strategies.

RB∗ strategy PB∗ strategy In this section, we consider a retailer that is choosing between
Conditions: k > 1
Conditions: k > 1 the PF∗ and PB∗ strategies. To simplify the analysis, we only con-
4 4
sider the case of the positive solutions. Based on the equilibrium
ϕ∗ = 1
12k
ϕ∗ = 1
12k
12kθ −θ 12kθ −θ
results given in Table 3, we obtain the following proposition:
trB∗ = 72k−18
t pB∗ = 72k−18
12kθ −θ 12kθ −θ
λBr ∗ = 24k−6
λBp∗ = 24k−6 Proposition 7. Consider the retailer employing the improvement
2θ 2θ strategy under the platform mode. If the marginal cost of ser-
sBr ∗ = 12k−3
sBp∗ = 12k−3
12k−1)θ
pBr ∗ = 5(72 12k−1)θ
pBp∗ = 5(72 vice improvements √and the proportional fee are relatively low
k−18 k−18

qBr ∗
= 12kθ −θ
qBp∗ = 12kθ −θ
1
(i.e., k < 600 (119 + 9361) and α < α ∗ ), the retailer will choose
BR∗
36k−9
(1+12k)θ 2 BR∗
36k−9
1+12k )θ 2 BS∗ (12k−1)θ 2
backward integration (PB∗ ); otherwise, the retailer
√ will choose for-
= = (36 p = 72k−18
BS∗
r 36(4k−1)
, p (4k−1) , ward integration (PF∗ ) (i.e., k < 600
1
(119 + 9361)and α > α ∗ , or
= (12k−1)θ 2 √
r 72k−18 k > 6001
(119 + 9361)). Moreover, if U > 0, the entire supply chain
RF∗ strategy PF∗ strategy achieves higher profits when the retailer moves from forward integra-
Conditions: k > 4
Conditions: α > α1 and k > 23−104α −α 2 , or α < α1 and tion (PF∗ ) to backward integration (PB∗ ). Moreover, if U < 0, the en-
√ √
13
2(−2α 2 + 2 α 4 +10α 3 +32α 2 +38α +15−16α +18)
4
23−10α −α 2
<k< α 4 +22α 3 +60α 2 −326α +147 , tire supply chain achieves higher profits when the retailer moves from
where α1 fulfills − α 4 − 22α 3 − 60α 2 + 326α − 147 = backward integration (PB∗ ) to forward integration (PF∗ ). Parameter U
0.
is defined as follows:
1+α
ϕ∗ = k
4(4k−1)
ϕ∗ = 3 −α   2
wrF ∗ = (15k−4)θ
λFp∗ = k (1−α ) (13+α )θ
2
U = (36k − 1 ) α 2 + 10α − 23 k + 4
26k−8 k (23−10α −α 2 )−4
   
trF ∗ = 2 kθ
13k−4
k ( 3 −α ) θ
t pF ∗ = k(232−10 α −α 2 )−4 + 144k(4k − 1 ) 3 α 2 + 6α − 11 k + 4 .
(15k−4)θ
srF ∗ = sFp∗ = k(23−104αθ−α 2 )−4
8−58k+104k2
In the PB∗ strategy, the retailer chooses backward integration
(6k−1)(15k−4)θ 21−12α −α )θ
pFp∗ = kk((23
2
pFr ∗ = 8−58k+104k2 −10α −α 2 )−4 with the manufacturer. The manufacturer will not pay a commis-
k (15k−4)θ
qrF ∗ = 4−29k+52k2
qFp∗ = k(23−108kαθ−α 2 )−4 sion to the retailer; therefore, the equilibrium results and the ef-
F R ∗
= 4((417 k−4)θ k
,
2 F R ∗
= k(23−104kθ 2 ficiency of the improvement strategy of the PB∗ strategy are the
r −29k+52k2 ) p α −α 2 )−4 ,
F M ∗
= (15k−4)θ 2 k F M ∗
= 8k2 (1−α )(5+α )θ 2 same as the RB∗ strategy. Therefore, we only consider the efficiency
r 8−58k+104k2 p (k(23−10α −α )−4)
of the PF∗ strategy. In addition to the marginal cost of service im-
2 2

provements, the proportional fee will influence the efficiency of

the improvement strategy.
Corollary 1. The efficiency of the RF∗ strategy and RB∗ strategy de- Fig. 6 shows the result of the efficiency of the PF∗ strategy. We
creases as the marginal cost of service improvement increases. will use EI, ER and EM, which represent the efficiency of the PF∗
strategy in the supply chain, the retailer and the manufacturer, re-
Fig. 5 shows the result of Corollary 1. First, both the RB∗ spectively. We find that the efficiency of the PF∗ strategy decreases
and RF∗ strategies are effective (BR r /r > 1 and r /r > 1,
∗ BR BS∗ BS as the marginal cost of service improvements increases and the
rF R∗ /Fr R > 1 and Fr M∗ /Fr M > 1). Second, if the marginal cost proportional fee decreases.
of service improvement increases, the cost-sharing ratio ϕ de-
creases; therefore, the efficiency of the RF∗ and RB∗ strategies de- 6. Extensions
creases. Lastly, although the RF∗ and RB∗ strategies can increase
the profits of retailers and service providers (manufacturer), inef- In this section, we consider the proportional fee endogenous
(BR ∗
r +r )
BS∗
ficiency remains compared with the I strategy. By I
= and compare the six strategies simultaneously. In §4, we consid-
(3k−1)(36k−1) (Fr R∗ +Fr M∗ ) ered the proportional fee exogenous, in which the manufacturer
< 1 and = (43(k4−1 )(47k−12)
< 1, when k →
36k(4k−1) I −29k+52k2 ) will accept a proportional fee of less than 1 (0 < α < 1). We now
∗
(r +r )
BR BS∗ F R ∗
(r +r ) F M∗
∞, I
→ 0.75 and I
→ 0.68. The reason for this consider the proportional fee endogenous, and the retailer must
is that the I strategy can maximize the elimination of the double ensure that the manufacturer is willing to accept the proportional
marginal effect, whereas the RB∗ and RF∗ strategies can only par- fee offered. Note that the manufacturer can choose whether to ac-
tially eliminate these effects. cept the proportional fee by comparing its profits with the reseller

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0.5

Fig. 6. The relationship between k & α and the efficiency of the PF∗ strategy.

mode. If the manufacturer decides not to accept the proportional forward integration and reseller mode (RF∧ ) because the down-
fee, then the retailer should purchase the products from the stream of the supply chain (the service provider) has more cost
manufacturer and resell them to consumers. We will use the su- advantages than does the upstream of the supply chain (the manu-
perscript “^” to denote the situation of exogenous proportional fee. facturer). Moreover, when the retailer chooses forward integration,
the manufacturer will accept no proportional fee given by the re-
Lemma 3. When the √retailer chooses not to vertically integrate, tailer; therefore, the retailer will choose the reseller mode. If the
√
2 k4 +20k3 −4k2 −2k+1
if α = α ∧ = −27k +2 3 1975 k2 +2k+1
, then the manufacturer marginal cost of service improvements is relatively high, the re-
will agree to sell products on the retailer’s platform. Consequently, tailer will choose backward integration (RB∧ or PB∧ ) because the
NR∧ 2 ∧ ∧ 2
the equilibrium profits are as follows: p = 2θ α ∧(5+α ∧)k 2 , upstream of the supply chain (the manufacturer) has more cost
(2k(3+α )+α −1) advantages than does the downstream of the supply chain (the
NM∧ ∧ ∧ 2 N S ∧ ∧
= θ (1−α ∧)(3+∧α )k 2 , and = 2k(θ3+(α1∧−)α+α)∧k −1 , where α ∧ =
2 2
p (2√k(3+α )+α −1) p service provider). Moreover, when the retailer chooses backward
√ integration, the retailer has the same structure under the reseller
−27k2 +2 3 75k4 +20k3 −4k2 −2k+1
19k2 +2k+1
. mode and platform mode.
Lemma 4. When the retailer chooses forward integration, the manu-
facturer will accept no proportional fee given by the retailer. Therefore, 7. Conclusions
there is no equilibrium when the manufacturer sells products on the
retailer’s platform. We consider a supply chain comprising a retailer, a man-
ufacturer, and a service provider. Retailers have two business
Lemma 4 indicates that the PF ∧
strategy cannot be an opti- modes: reseller mode and platform mode. A retailer with different
mal one; thus, when the proportional fee is endogenous, the four business modes chooses one of three strategies: no integration,
strategies that retailers can choose are as follows: RN∧ , PN∧ , RB∧ forward integration, or backward integration. By considering the
(PB∧ ), and RF∧ . We now do not limit the retailer’s business mode proportional fee, product quality and service level, we study
but compare the equilibrium profits of the retailer under these four which vertical integration strategy the retailer should adopt under
strategies. different business modes and how the business mode affects the
Proposition 8. Consider the proportional fee exogenous; if the retailer’s vertical integration strategy. Can these vertical integra-
marginal cost of service improvements is relatively low (i.e., 27 < tion strategies be improved, and what vertical integration strategy
k < 1), then the retailer’s profit relationship under different modes is should the retailer adopt when employing the improvement
the following: RF∧ > RB∧ = PB∧ > PN∧ > RN∧ ; if the marginal cost strategy? Furthermore, how does an endogenous proportional fee
of service improvements is relatively high (i.e., k > 1), then the re- affect the answer to above question?
tailer’s profit relationship under different modes is the following: We find that under the reseller mode, when all three strategies
RB∧ = PB∧ > RF∧ > PN∧ > RN∧ . have positive solutions, if the cost of improving product quality is
lower (higher) than the cost of improving service level, backward
Proposition 8 states that the retailer’s optimal strategy occurs (forward) integration is an optimal strategy. When the cost of
when the proportional fee is exogenous. If the marginal cost of improving service level is lower, the fixed investment can achieve
service improvements is relatively low, the retailer will choose a higher service level, and the demand for forward integration

Please cite this article as: P. Li, D. Tan and G. Wang et al., Retailer’s vertical integration strategies under different business modes,
European Journal of Operational Research, https://doi.org/10.1016/j.ejor.2020.07.054
JID: EOR
ARTICLE IN PRESS
P. Li, D. Tan and G. Wang et al. / European Journal of Operational Research xxx (xxxx) xxx
is higher, which makes forward integration more attractive in
return. When the cost of improving product quality is lower, fixed
investment can achieve higher product quality, and the demand
for backward integration is higher; thus, backward integration will
become more attractive. Under the platform mode, because the
proportional fee will affect the profit distribution of enterprises in
the supply chain, the retailer’s optimal strategy differs from that of
the reseller mode when all three strategies have positive solutions.
If the marginal cost of service improvements is relatively moderate
and the proportional fee is relatively high, or the marginal cost
of service improvements is relatively high, the retailer gains the
highest profit by choosing forward integration; otherwise, the
retailer gains the highest profit by choosing backward integration.
The reason is that the cost effect and the income distribution
effect will affect the retailer’s profit. When the marginal cost
of service improvements is relatively high (relatively low), the
cost effect makes the backward integration strategy (the forward
integration strategy) dominant. In contrast, when the proportional
fee is relatively high (relatively low), the income distribution effect
makes the forward integration strategy (the backward integration
strategy) dominant.
Lastly, we consider two extensions: a vertical integration im-
provement strategy and an endogenous proportional fee. In the
vertical integration improvement strategy, we find that the re-
tailer’s optimal strategy is identical to the common strategy (verti-
cal integration strategy without cost-sharing contract) under the
reseller mode but is different from the common strategy under
the platform mode. When we consider the vertical integration im-
provement strategy under the platform mode, if the proportional
fee and the marginal cost of service improvements are both lower,
backward integration is the retailer’s optimal strategy; otherwise,
forward integration is the retailer’s optimal strategy. When the
proportional fee is endogenous, if the marginal cost of service im-
provements is relatively low, the retailer’s optimal strategy is for-
ward integration under the reseller mode; if the marginal cost of
service improvements is relatively high, the retailer’s optimal strat-
egy is backward integration under both the reseller and platform
modes.
In summary, our conclusion can provide guidance for retailer
vertical integration under different business modes based on key
factors such as the proportional fee, product quality, service level
and different types of contract. Future work on this topic could
consider channel competition (competition between direct and in-
direct channels) and different types of products (competitive and
complementary products). Lastly, the model can be extended to the
case of the consumer utility function.
Supplementary materials
Supplementary material associated with this article can be
found, in the online version, at doi:10.1016/j.ejor.2020.07.054.
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European Journal of Operational Research, https://doi.org/10.1016/j.ejor.2020.07.054
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