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Customer rebates and retailer incentives in the

presence of competition and price
discrimination

Article in European Journal of Operational Research · November 2011

DOI: 10.1016/j.ejor.2011.04.006 · Source: DBLP

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 European Journal of Operational Research 215 (2011) 268–280

Contents lists available at ScienceDirect

European Journal of Operational Research

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

Interfaces with Other Disciplines

Customer rebates and retailer incentives in the presence of competition

and price discrimination
Ozgun Caliskan Demirag a,⇑, Pinar Keskinocak b, Julie Swann b
a
Sam and Irene Black School of Business, The Pennsylvania State University Erie, Erie, PA 16563, USA
b
School of Industrial and Systems Engineering, Georgia Institute of Technology, Atlanta, GA 30332, USA

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

Article history: Promotions are important tools for matching supply and demand in many industries. In the United States
Received 29 May 2010 automotive industry, promotions are frequently offered, which may be given directly to customers
Accepted 5 April 2011 (rebates) or given to dealers (incentives) to stimulate demand. We analyze the performance of customer
Available online 12 April 2011
rebate and retailer incentive promotions under competition. We study a setting with two manufacturers
making simultaneous pricing and promotion decisions, and with two price-discriminating retailers as
Keywords: Stackelberg followers making simultaneous order quantity decisions. In the benchmark case with no pro-
Retailer incentives
motions, we characterize the equilibria in closed form. We find that retailer incentives can be used by
Customer rebates
Competition
manufacturers to simultaneously improve each of their profits but can potentially lead to lower retailer
Automotive industry profits. When manufacturers use customer rebates, we show that a manufacturer is able to decrease the
First-degree price discrimination profit of her competitor while increasing her own profit, although she is also at risk for her competitor to
use rebates in a similar fashion. Unlike the monopoly case where the manufacturers are always better off
with retailer incentives, customer rebates can be more profitable under some cases in the presence of
competition. Using numerical examples we generate insights on the manufacturers’ preference of promo-
tions in different market settings.
Ó 2011 Elsevier B.V. All rights reserved.

1. Introduction In one type of promotion, auto manufacturers offer cash pay-

Promotions are used by manufacturers and retailers in different
industries for several reasons. In some cases, companies offer pro-
motions to increase sales, advertise new products, or to reduce
their inventories; in others, promotions are used as strategic tools
to specifically react to competitors’ actions. The automotive (auto)
industry in the United States (U.S.) is one example where promo-
tions play an important role in the marketing strategies of the com-
panies, often accounting for high expenses of manufacturers.
Edmunds.com estimates the industry’s aggregate incentive spend-
ing as approximately $2.93 billion in July 2010 (Edmunds.com,
2010).
Competition is an important component of the U.S. auto indus-
try and can be a factor in firms’ promotion decisions. It is com-
monly observed that promotions offered by one auto
manufacturer may lead competitors to start or intensify their
own promotions. For example, General Motors introduced a zero-
percent financing option in September 2001, and was quickly fol-
lowed by Ford and Chrysler’s similar promotions.
⇑ Corresponding author. Tel.: +1 8148986717.
E-mail addresses: ozc1@psu.edu (O.C. Demirag), pinar@isye.gatech.edu (P.
Keskinocak), jswann@isye.gatech.edu (J. Swann).
ments to the end customers (‘‘customer rebates’’). These rebates
are paid instantly at the time of purchase and they differ from
mail-in rebates that are offered in other industries. We have access
to detailed sales data of auto dealers throughout the U.S. during
the period June 2000–May 2003. The data were collected by a ma-
jor market research firm and contain transaction-based informa-
tion including the wholesale price and the selling price of the
vehicles as well as the rebate amount offered by the manufactur-
ers. Fig. 1 displays the customer rebates offered by two American
auto manufacturers on two high sales-volume car models. The
cross-correlation between the two time series data is 0.87, and
there is an increasing trend in rebate amounts for both manufac-
turers. Although the correlation itself is not sufficient to claim that
the manufacturers’ rebate promotions were closely affected by
those of the competitors, there is also significant anecdotal evi-
dence for competitive effects of promotions, e.g., in June 2005,
General Motors offered to all customers the employee discount
program, which increased the manufacturer’s sales by 41% in that
month, and it was matched by Chrysler and Ford the next month
(Autochannel.com, 2002). Promotions offered under competition
do not only affect the manufacturers’ decisions but they also affect
the customers’ decisions (e.g., ‘‘switching’’ from one car manufac-
turer to another in the existence of a promotion (Keskinocak

0377-2217/$ - see front matter Ó 2011 Elsevier B.V. All rights reserved.
doi:10.1016/j.ejor.2011.04.006
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
Fig. 1. Rebates by two competing American auto manufacturers in the U.S. market.
et al., 2009)), which in turn have an impact on the promotions’
effectiveness in increasing the manufacturers’ profits.
Auto manufacturers may also offer incentives to their dealers
(‘‘retailer incentives’’), which are not often widely publicized to
the end customers. Retailer incentives can be offered in different
forms, e.g., as lump-sum payments, per-vehicle payments, or in
combination with bonus payments based on sales thresholds.
Lump-sum incentive is generally offered with no conditions at-
tached to the sales performance and provides the retailer highest
flexibility ‘‘to use the incentive as he sees fit’’ (Anwyl, 2004). While
the retailer can exert more control over the pass-through of the
incentive towards a particular sale, the manufacturer offers the
customer rebate to every buyer. In the U.S., the American auto
manufacturers offer more frequent and deeper customer rebates
than the non-American auto manufacturers, which tend to offer
dealer incentives more often (Henderson, 2005). Some questions
of interest are how the different promotion decisions affect profits
of companies and what leads one manufacturer to offer one pro-
motion over the other. Caliskan Demirag et al. (2010) tackle such
questions by analyzing customer rebate and retailer incentive pro-
motions in a channel with a single manufacturer and a single price-
discriminating retailer. The authors find that retailer incentives are
always preferred when demand is deterministic, but rebates can be
preferred if demand is highly uncertain. Competition can be an-
other reason for rebates’ effectiveness but it is ignored in their
analysis.
In this paper, we incorporate competition in a model of promo-
tions and price-discriminating retailers. We analyze a duopoly set-
ting with two manufacturers who sell competing products through
their exclusive retailers (dealers), who are competitors in the end
market. Our goal is to investigate the impact of competition on
profits and sales when the manufacturers offer retailer incentive
or customer rebate promotions. We do not analyze the choice of
promotion as an endogenous decision by the manufacturers but
rather focus on comparing the equilibrium performance of the
two promotions when the manufacturers have previously commit-
ted to a specific type. We are also interested in using our models to
understand manufacturers’ promotion decisions observed in prac-
tice. We adopt a game theoretical framework to analyze the prob-
lems where assumptions and scenarios are motivated by our
discussions with a major auto manufacturer and analysis of sec-
ondary data in the industry.
When there are no promotions given, we explicitly character-
ize the equilibrium decisions and identify market conditions
where a unique equilibrium is observed. We give examples to
compare the sales and profits of the manufacturers with different
characteristics such as price sensitivity and production cost.
When manufacturers offer retailer incentives, we find that the
incentives can be used to increase the profits and sales of the
manufacturers, while the profits of the retailers may decrease.
269
The latter result is observed as the market potential increases.
This is partly due to the fact that, in cases with high market po-
tential, manufacturers select higher wholesale prices but keep the
incentive amounts constant, which is also observed in the
monopoly case (Caliskan Demirag et al., 2010). Thus, we find that
retailer incentives can be one tool for a manufacturer to increase
market share and profit even under competition. When manufac-
turers offer customer rebates, we find that there are equilibrium
outcomes where high customer rebates can be effectively used by
a manufacturer to drive the competitor’s profits to zero and to
achieve monopoly sales and profits when the competitor’s rebate
value is zero. Note that this result is different from the conclusion
in the monopoly case, where rebates are found ineffective under
deterministic demand. Using data from practice, we also analyze
a case with bounded rebate values and find that an equilibrium
outcome is possible where both manufacturers obtain lower sales
and profits than the no-promotion case, which represents a situ-
ation similar to that in the prisoner’s dilemma. This can also be
observed in practice where rebates are dictated by the competi-
tive market and may make all parties worse off (Smith, 2004).
We numerically analyze cases where the manufacturers differ in
their promotion choices. We motivate numerical examples with
characteristics of the American and Japanese auto manufacturers.
We observe that a manufacturer often generates the highest
profit by offering the same type of promotion as that of the
competitor except when the manufacturer with high production
cost and price sensitivity can offer large rebates. In the latter case
she prefers a customer rebate when the competitor is offering a
retailer incentive. Overall, we show that competition has an im-
pact on the profitability of the promotions for the manufacturers.
Although our motivation comes from the auto industry, our anal-
ysis may give insights on other industry settings where manufac-
turers (or suppliers) that sell their products through retailers have
the option of directing promotions to their retailer or to the end
customers. Further, we also incorporate industry characteristics
such as price discriminating retailers and competitive interactions
among different supply chains, which are not limited by the auto
industry.
The remainder of the paper is organized as follows. We review
the relevant literature in Section 2. In Section 3, we explain our
assumptions, describe the competitive interactions in the supply
chains, and develop our models. We analyze three combinations
of promotions. In Section 3.1, we present the base model where
no promotion is offered by the manufacturers. In Sections 3.2
and 3.3, we analyze the cases where both manufacturers offer cus-
tomer rebates and retailer incentives, respectively. The case with
different promotions by the manufacturers is investigated numer-
ically in Section 4, where further insights are provided through
computational studies. Finally, we summarize our findings in
Section 5.
270 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
2. Literature review
Retailer incentives and customer rebates are examples of sales
promotions, which are important components of firms’ marketing
strategies. Correspondingly, the marketing and economics litera-
tures contain many studies investigating sales promotions. Blatt-
berg et al. (1995) provide a review of empirical work in this area
and present common observations from these studies, some of
which are incorporated in our models, e.g., competitive implica-
tions of promotions. On the theoretical side, articles investigate a
variety of questions such as why promotions are offered, how they
impact firm/customer behavior, and which promotion type should
be selected by the promoting firms. Narasimhan (1984) identifies
price discrimination as one possible motivation for offering cou-
pons. Other explanations for promotions include increased con-
sumption (Blattberg et al., 1981) and demand expansion due to
switchers from other brands (Raju et al., 1990).
Gerstner and Hess (1991) analyze customer rebates (or pull
promotions) and retailer incentives (or push promotions such as
temporary wholesale price reductions, manufacturer allowances/
trade deals, and cash rebates/incentives). Gerstner et al. (1994)
introduce competition at the retailer level and study a monopolis-
tic manufacturer’s customer rebates. Kim and Staelin (1999) study
a four-player model where competition exists both at the manu-
facturers’ level and the retailers’ level of the supply chain, similar
to ours. However, since their model relates to the consumer pack-
aged goods industry, the retailers sell both manufacturers’ prod-
ucts at fixed prices, which is different from our setting in the
auto industry where the retailers generally sell one manufacturer’s
products exclusively and negotiate prices with customers, leading
to price discrimination by the retailers. The authors show that the
manufacturers find it profitable to offer promotions which are
modelled in the form of side payments; this corresponds to the
lump-sum incentives in our setting, and in addition we also ana-
lyze customer rebates. (Raju (1995) reviews the prior theoretical
work in sales promotions from a marketing perspective.) In a re-
cent work, Martin-Herran et al. (2010) compare trade deals with
instant rebates such as those offered for automobiles and house-
hold appliances. Although we seek to make a similar comparison,
our study differs in that we consider multiple players in each stage
of the channel and assume the retailers can price discriminate.
Profitability of rebate and trade promotions have also been
investigated in the operations and marketing/operations interface
literatures often in conjunction with inventory decisions and/or
manufacturer-retailer interactions. Goyal et al. (1991) provide a re-
view of articles investigating the retailer’s inventory decisions in
response to manufacturer’s incentives. Ardalan (1994) also ana-
lyzes similar problems but considers price-sensitive demand. Sev-
eral studies investigate the profit advantages of cash mail-in rebate
promotions, which are referred to as delayed incentives since the
buyer receives the payment post purchase. For example, Khouja
(2006) proposes that joint optimization of rebate value, sale price,
and order size can lead to profit gains. In a supply chain setting,
Khouja and Zhou (2010) show that buyer’s uncertainty regarding
the rebate valuation and redemption can bring advantages to the
promoting firms. In a related study, Yang et al. (2010) find that re-
bate promotions, when combined with manufacturer’s suggested
retail pricing, can dampen price-setting retailers’ possible adverse
response to the promotion and hence increase channel efficiency.
Our work also considers supply chain interactions with the manu-
facturers jointly determining wholesale price and rebate values,
but we focus on comparing rebates with retailer incentives and
addressing the impact of horizontal competition. Since we study
instant rebates in the auto industry, the issues of customer valua-
tion per rebate dollar and the redemption rates are not considered.
Analyzing a manufacturer’s rebates to the customers and to the re-
tailer simultaneously, Aydin and Porteus (2009) find in a stochastic
model that the channel members can be better off with either of
the two promotions. In the case of competing manufacturers, we
also find that there is no simple answer as to when one promotion
is always better. Treating firms’ rebate decisions as endogenous,
Cho et al. (2009) consider rebates offered by a manufacturer and
a retailer. Their study assumes a deterministic demand with linear
structure, similar to ours, but considers vertical competition within
the channel while we analyze competition between two supply
chains. The two-channel setting has been commonly used in the
literature to model competition under various dimensions, e.g.,
Boyaci and Gallego (2004), Ha et al. (2010), and Kim and Staelin
(1999).
In the auto industry, analysis of promotions has attracted some
attention from researchers due to its economic significance and
auto manufacturers’ increased use of promotions in recent years.
Empirical studies have investigated diverse issues such as auto
dealers’ price discrimination (Goldberg, 1996; Scott Morton et al.,
2003; Zettelmeyer et al., 2006), dealers’ pass-through rates of pro-
motions to the buyers in the existence of information asymmetries
(Busse et al., 2006), and the effects of promotions on customer and
dealer behaviors (Keskinocak et al., 2009). Although our focus is
analytical rather than empirical, we provide insights using numer-
ical examples and compare the results with those found in these
papers or in industry reports. Bruce et al. (2005) and Bruce et al.
(2006) analytically study auto manufacturers’ promotions and con-
sider product durability as a factor on promotion decisions, which
we do not model but address implicitly through differences in
manufacturer characteristics such as price sensitivity. In Bruce
et al. (2005), the channel structure is similar to ours, although in
their case the dealers set fixed prices and customer rebates are
not analyzed. Bruce et al. (2006) analyze manufacturers’ cash re-
bates but ignore competition and do not consider retailer incen-
tives. We analyze both promotions in a competitive setting and
numerically analyze situations where the competing manufactur-
ers offer different types of promotions.
In our analysis, we assume that the retailer can implement first-
degree (perfect) price discrimination. This is mainly motivated by
the practices in the auto industry where the final purchase price of
a vehicle is generally negotiated between the dealer and the buyer.
As a result, the dealer has the opportunity to learn (or estimate) the
customer’s willingness to pay and price discriminate accordingly.
Although first-degree price discrimination can be difficult to achieve,
many researchers argue that car dealers have the means and motiva-
tion to implement this (e.g., Allen, 2005; Carroll and Coates, 1999;
Zettelmeyer et al., 2003). The literature on first-degree price discrim-
ination includes Spulber (1979) and White and Walker (1973),
however, neither considers manufacturers’ promotion decisions in
two-stage supply chains where competition exists both among
manufacturers and retailers, which is the focus of our study. As noted
previously, Caliskan Demirag et al. (2010) analyze customer rebate
and retailer incentive promotions in the auto industry and consider
price discrimination, but they do not include competition. The
authors determine which promotion provides higher sales and prof-
its for a monopolistic manufacturer and find that the retailer’s price
discrimination may impact the manufacturer’s promotion decision.
In this paper, we analyze supply chain models with retailer’s first-
degree price discrimination and include competition, which we
believe is the first work that considers both of these elements.
3. Models and analysis
In our setting, two competing manufacturers sell their products
through two independent retailers who are also competitors in the
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
end market. We differentiate the supply chains with the subscript
i = 1, 2, and we assume retailer i sells products of manufacturer i
exclusively, which is commonly observed in the form of franchised
dealerships of auto manufacturers. (In the auto industry, manufac-
turers generally sell through exclusive dealers. Occasionally, multi-
ple products are sold at one dealership but these are usually not key
competitors. Multiple dealerships or retail outlets may be owned by
the same company although each outlet may be operated by sepa-
rate management and sales force.) We further make the following
assumptions: (i) Retailers can implement first-degree price dis-
crimination. (ii) Retailer i purchases from his manufacturer at
wholesale price wi and has a reservation price wi + mi, mi P 0, be-
low which he is not willing to sell. (iii) Manufacturers have ample
capacity and there are no administrative or redemption costs.
The auto dealers’ ability to price discriminate by negotiating
with each individual buyer has been studied in several articles,
e.g., Goldberg (1996), Scott Morton et al. (2003), and Zettelmeyer
et al. (2003), and may be achieved by differences in quoted prices
or by other mechanisms such as trade-in value. To implement first-
degree price discrimination, the dealers may also incur a cost,
which we assume is constant for each buyer and thus can be ab-
sorbed in the retailer’s reservation price, defined as the lowest
acceptable price the retailer would be willing to sell. Although
the retailer’s operational cost can affect his reservation price, we
assume the two are not equivalent. (Otherwise, Caliskan Demirag
et al., 2010 show in the monopoly setting that retailer incentive
and customer rebate promotions become identical and have no ef-
fect on the manufacturer’s or retailer’s sales and profits.) The reser-
vation price assumption about dealer behavior can be thought
similar to the assumption about customer behavior; the customer
buys the product if the price is below his reservation price. The
inclusion of a minimum reservation price for a seller is useful in
industries such as housing and auto retailing, where there may
be some negotiation of price or price discrimination of customers.
Although their modelling is different, Scott Morton et al. (2004)
and Zettelmeyer et al. (2006) also mention the notion of seller’s
reservation price in the auto industry. Our assumptions on manu-
facturers’ capacity levels and the cost of the promotions are not
restrictive since most auto manufacturers in the U.S. operate with
sufficient capacity (Jakobson, 2005), and rebates are per-unit pay-
ments given automatically to all buyers when they are offered. Due
to our interest in comparing profits under two promotions, we as-
sume administration costs are insignificant. We focus on retailer
incentives in the form of lump-sum payments; in practice, other
types of incentives can also be offered, such as per-unit incentive.
Caliskan Demirag et al. (2010) show that the manufacturers’ pro-
motion decisions are qualitatively similar for lump-sum incentives
and per-unit incentives when demand is deterministic, although
the analysis becomes complex with the latter type. We investigate
per-unit incentives numerically and find that our main findings re-
main unchanged. We assume that model parameters are under
common knowledge, and all parties seek to maximize their own
objectives. We focus on profit maximization but also quantify
sales, which is important in the auto industry.
Most articles in the literature model competition by reflecting
the characteristic that a firm’s demand (or sales) is linearly down-
ward sloping in the firm’s own price and upward sloping in the
competitor’s price as a result of substitution (e.g., Kim and Staelin,
1999). However, these articles use demand functions that relate
quantity to the fixed selling prices of the firms and do not consider
first-degree price discrimination, hence their demand models can-
not be used directly in our study. When firms can engage in first-
degree price discrimination, demand is conveniently modelled
with inverse demand functions (e.g., Spulber, 1979 and White
and Walker, 1973) relating price to each unit sold, where the price
is decreasing in sales. In the presence of competition, we would ex-
271
pect that the price that a seller gets does not only decrease due to
his own sales but also decreases due to the competitor’s sales.
Based on the preceding observations, we model the retailers’ (in-
verse) demand as a continuous function of their order/sales quan-
tities. We assume the demand function is deterministic and has a
linear structure in the order/sales quantities. (See Eq. (1).) Linear
demand functions are used by some auto manufacturers (Biller
et al., 2005), and the deterministic nature helps us isolate the ef-
fects of competition. Note that (x)+ = max{0, x}.
(
ða  ðbio þ bic ÞQ i Þþ if Q i 6 Q j
Pi ðQ i ; Q j Þ ¼ þ
i; j 2 f1; 2g; i–j:
ða  bic Q j  bio Q i Þ otherwise
ð1Þ
Pi(Qi, Qj) denotes the price retailer i receives when he sells Qi units
and the competing retailer sells Qj units. Note that, as also implied
by Eq. (1), we assume that the products are differentiable and sub-
stitutable. We denote the maximum price with a, which we refer as
the market potential when sensitivity is fixed. We denote the effect
of retailer i’s sales on his own price with bio > 0 (‘‘own-price sensi-
tivity’’), and the effect of the competitor’s sales on retailer i’s price
with bic > 0 (‘‘cross-price sensitivity’’). All else being equal, a unit in-
crease in the retailer’s own order quantity often creates a larger de-
crease in his price than a unit increase in the competitor’s order
quantity. Hence, we assume bio P bic and bio P bjc, i,j 2 {1, 2}, i – j.
For the case with Qi 6 Qj, retailer i is competing with retailer j on
the first segment of the demand function until his sales reach the
competitor’s sales Qj, and he is selling additional units beyond Qj
on the second segment of the demand function, where Qi P Qj. Re-
tailer i experiences a faster decrease in the price that the customers
are willing to pay on the first segment than on the second segment.
Table 1 summarizes our notation. Manufacturers select wi P ci,
i = 1, 2 for nonnegative profits. Further, it follows from Eq. (1) that
the highest selling price that retailers can receive is a, which must
be at least as large as the retailers’ reservation prices for sales to
occur, i.e., wi + mi 6 a, i = 1, 2. Note that the preceding assumptions
imply that a P mi + ci, i = 1, 2. Since the manufacturers do not sell
below their costs and the retailers satisfy their reservation prices,
a0i ¼ a  mi  ci represents the highest per-unit profit retailers can
earn, which can also be interpreted as the ‘‘net’’ market potential.
0
We can also denote bi ¼ bio þ bic as the ‘‘total’’ price sensitivity of
retailer i (or manufacturer i) since the selling price is affected by
both bio and bic in the region where the retailers sell simulta-
Table 1
Notation.
a: Market potential
bio: Retailer i’s price sensitivity of own customers, i = 1, 2
bic: Retailer i’s competitor’s price sensitivity of customers affecting
retailer i’s price
0
bi : ‘‘Total’’ price sensitivity of retailer i (or manufacturer i), i.e.,
0
bi ¼ bio þ bic
Q ki : Retailer i’s order/sales quantity under promotion type k 2 {o, I, R},
where
o = no promotion, I = retailer incentive, R = customer rebate
Pi(Qi, Qj): Retailer i’s price when the retailers sell Qi, Qj units respectively
(i, j 2 {1, 2}, i – j)
PkM;i : Profit of manufacturer i under promotion k
PkD;i : Profit of retailer i under promotion k
wi: Wholesale price of manufacturer i
wi + mi: Reservation price of retailer i
ci: Production cost of manufacturer i
Ki: Lump-sum incentive given to retailer i by manufacturer i
Ri: Per-unit customer rebate offered by manufacturer i
di: The effect of manufacturer i’s rebate on the competitor’s market
potential
A0 : Complement of set A including all elements in the set of real
numbers not in A
272 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280

neously. We refer to the manufacturer or the retailer with higher In both problems, the retailer’s objective is to maximize profits
sales quantity as the ‘‘market leader’’. while ensuring that no products are sold below his reservation
The members of the supply chains interact in two stages. The price. Note that, for any Qj, retailer i can feasibly solve the problem
manufacturers move first and simultaneously make their whole- in (2) and choose Qi such that Qi 6 Qj. Further, when Q j 6 awbi0mi ,
i
sale price and promotion decisions. Next, the retailers observe the problem in (3) also becomes feasible and the retailer has the
the manufacturers’ decisions and simultaneously make their or- additional option of choosing Qi such that Qi P Qj. Hence, in this
der/sales quantity decisions. (The timing of decisions is similar to case, retailer i’s profit is equal to the higher of the two profits
those in several papers analyzing competition in two-stage supply Pe Do i ðQ i ; Q j Þ and P
b Do i ðQ i ; Q j Þ. Let Po ðQ i ; Q j Þ be retailer i’s profit
D;i
chains, e.g., Boyaci and Gallego, 2004 and Kim and Staelin, 1999.) when the retailers choose the joint strategy (Qi, Qj). Then,
In other words, simultaneous decision games are embedded in a
PoD;i ðQ i ; Q j Þ
Stackelberg framework with the manufacturers acting as the lead- 8
ers and the retailers as the followers, where the manufacturers <Pe o ðQ i ; Q j Þ if Q j P awbi0mi ;
D;i
i
anticipate the retailers’ responses while making their own deci- ¼
: maxf P
e o ðQ i ; Q j Þ; P
b o ðQ i ; Q j Þg ¼ P
b o ðQ i ; Q j Þ otherwise:
sions. Note that the order of decisions imply that the manufactur- D;i D;i D;i

ers are assumed to hold relatively greater channel power ð4Þ

compared to their retailers (Bichescu and Fry, 2009 and Pan We state the retailers’ best responses in Proposition 1, where
et al., 2010), which can be considered reasonable in the auto indus- we let Q i ðQ j Þ be the best response function of retailer i correspond-
try. We are interested in subgame-perfect Nash equilibrium (SPNE) ing to each quantity/sales decision of retailer j. (For notational clar-
outcomes where none of the firms has an incentive to deviate from ity we suppress the dependence of Q i on wi and wj.)
their decisions in the two-stage game.
In analyzing the game between the players, we first solve the Proposition 1. Given the manufacturers’ wholesale prices (wi, wj),
retailers’ problems and find the equilibrium (if any exists) as a the best response of retailer i to the order/sales quantity of retailer j is
function of the manufacturers’ decisions. In the next step, we solve as follows:
the manufacturers’ problems by embedding the retailers’ best re-
sponses into the problem formulations. We solve for the SPNE 8 aw m
< bi0 i if Q j P awbi0mi ;
explicitly when possible and use iterative algorithms to find equi-
Q i ðQ j Þ ¼ i i

librium outcomes (if any exists) otherwise. In both cases, we pro- : awi mi  bic Q j otherwise:
bio bio
vide observations through numerical examples.
We show the proof of Proposition 1 and other results in Supple-
mentary Appendix A.
3.1. No promotion
Using the best response functions, we can characterize the
We first consider the case where the manufacturers do not offer retailers’ equilibrium, which is stated in Proposition 2. Note that
any promotions, therefore they only make wholesale price deci- for a given set of problem parameters and the manufacturers’ deci-
sions and the retailers set their order/sales quantities. Although sions, the retailers’ equilibrium is unique. For illustration, see
this is a special case of later models, we study it separately to Fig. 2, where part (a) shows the equilibrium when
awi mi aw m
exploit the structure of problems for closed-form equilibrium b0
6 bj0 j and part (b) shows the equilibrium when
i j
outcomes. We first define the strategy spaces of supply chain awi mi awj mj
b0i
P b0j
.
members. From the discussion in Section 3, the manufacturers’
strategies are such that ci 6 wi 6 a  mi, i = 1, 2 for nonnegative
Proposition 2. The retailers’ unique equilibrium in response to the
profits. Retailer i’s order/sales quantity can take its maximum
manufacturers’ wholesale prices is given by
value when retailer j selects Qj = 0. Further, to ensure that retailer
i satisfies the reservation price requirement in this case, his

order/sales quantity is bounded above by awbi mi . Hence, the Q 1 ; Q 2
io 8  
retailers’ strategies are such that 0 6 Q i 6 awbioi mi ; i ¼ 1; 2. We start >
< awb10m1 ; awb2 m2  bb2c awb10m1 if 0 6 awb10m1 6 awb20m2 ;
2o 2o
with the analysis of the game between the retailers. ¼  1
  1
 1 2

>
: awb1 m1  bb1c aw20m2 ; aw20m2 aw2 m2
if 0 6 b0 aw1 m1
6 b0 :
1o 1o b 2 b 2 2 1
Step 1. The retailers’ order/sales quantity decisions: Given the
manufacturers’ wholesale price decisions, the retailers
simultaneously decide how much to order/sell. Recall that Step 2. The manufacturers’ wholesale price decisions: The man-
the retailer i’s demand depends on whether he sells more ufacturers simultaneously choose their wholesale prices to
or less units than retailer j. Hence, for a given Qj, retailer i maximize own profits anticipating the best responses of
can choose Qi such that either Qi 6 Qj or Qi P Qj holds. Each the retailers. Using the retailers’ equilibrium in Proposition
of these cases leads to different optimization problems for 2, we can write the payoff function of manufacturer i for a
retailer i and are shown in Eqs. (2) and (3), respectively. given choice of (wi,wj) by the manufacturers:
Z Qi
e o ðQ i ; Q j Þ ¼ max 0

P D;i a  bi qi dqi  wi Q i ;
06Q i 6Q j 0
ð2Þ
a  wi  mi
s:t: Q i 6 0 ;
bi
Z Qj Z Qi
b o ðQ i ; Q j Þ ¼ max 0

P D;i a  bi qi dqi þ ða  bic Q j  bio qi Þdqi  wi Q i ;
Q i P0 0 Qj

a  wi  mi bic
s:t: Q j 6 Q i 6  Q:
bio bio j
ð3Þ
Fig. 2. Retailers’ equilibrium under no promotion.
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280 273

PoM;i ðwi ; wj Þ Table 2

8    The SPNE with no promotion.
> awj mj
< u1 ðwi ; wj Þ ¼ ðwi  ci Þ awbi mi  bbic 0
bj
if ci 6 wi < ci ;
io io Feasible Region (F. R.) SPNE
¼  
>
: u ðw ; w Þ ¼ ðw  c Þ awi mi (a) F.R.1 \ F.R.2 0
SPNE.1
2 i j i i b0
if ci 6 wi 6 a  mi ;
i (b) F.R.10 \ F.R.2 SPNE.2
ð5Þ (c) F.R.1 \ F.R.2 SPNE.1, SPNE.2
0
b0i
2b1 a02 > ðb2c þ 2b2o Þa01
where ci ¼ maxðci ; a  mi  ða  wj  mj ÞÞ. We establish the conti-
b0j SPNE.1 (F.R.1)
nuity of PoM;i ðwi ; wj Þ by noting that limwi !cþ PoM;i ðwi ; wj Þ ¼ w1 aþc1 m1
2
i
limwi !ci PoM;i ðwi ; wj Þ ¼ 0, when ci = ci, and limwi !cþ PoM;i ðwi ; wj Þ ¼ w2 2b01 ðam2 þc2 Þb2c a01
0
i 4b1
ððawj mj Þb0i a0i b0j Þðwj þmj aÞ
limwi !ci PoM;i ðwi ; wj Þ ¼ ðb0j Þ2
, when ci ¼ a  mi  Q o1 a01
0
2b1
b0i
Q o2
0
ða  wj  mj Þ. Manufacturer i’s best response to the wholesale
b0j
2b1 a02 b2c a01
4b2o b01
price decision of manufacturer j is determined by solving the opti- 0
2b2 a01 > ðb1c þ 2b1o Þa02
o
mization problem max  i PM;i ðwi ; wj Þ. Then, a pair of whole-
 ci 6wi 6am SPNE.2 (F.R.2)
w1 2b02 ðam1 þc1 Þb1c a02
sale price decisions wi ; wj constitutes a Nash equilibrium if 0
4b2
neither of the manufacturers can improve profits by unilaterally w2 aþc2 m2
  2
Q o1
0
2b2 a01 b1c a02
changing their own decision, i.e., PoM;i ðwi ; wj Þ P PoM;i wi ; wj ; 0
4b1o b2

Q o2 a02
8wi 2 ½ci ; a  mi , and PoM;j ðwi ; wj Þ P PoM;j wi ; wj ; 8wj 2 ½cj ; a  mj . 2b02

To investigate the existence of an equilibrium in the game, we ana-

lyze the payoff functions of the manufacturers. Cachon and Netes-
sine (2004) mention several methods for proving the existence of
Nash equilibrium, all of which require either (quasi-) concavity or
supermodularity of the payoff functions. Unfortunately,
mined a priori by the system parameters. From Table 2, when there
is no impact of the competitor on manufacturer i’s demand (bic = 0),
it trivially follows that manufacturer i achieves the monopoly prof-
ð a0 Þ
2

its of PM;i ¼ 4bi io (Caliskan Demirag et al., 2010), where

PoM;i ðwi ; wj Þ is neither quasi-concave nor supermodular in general
(see Example 1), hence these methods are not applicable in our set-
ting. On the other hand, it is easy to verify that the functions
u1(wi, wj) and u2(wi, wj) are concave, hence the payoff function is
piecewise concave (or concave when ci = ci). This structure allows
us to characterize the manufacturers’ equilibrium outcomes, which
are shown in Proposition 3.
Example 1. Consider an instance with a = 50, mi = mj = ci = cj = 10,
bio = 2 bjo = 3, and bic = bjc = 1. In Fig. 3, we plot PoM;i ðwi ; wj Þ for
wj = 17, where the function is not quasi-concave (or concave). For
 
supermodularity the following must hold: PoM;i w1i ; w1j 
   
PoM;i w2i ; w1j P PoM;i ðw1i ; w2j Þ  PoM;i w2i ; w2j , for all w1i P w2i and
w1j P w2j . Note that for the following pair of wholesale prices

 
w1i ; w2i ¼ ð25; 20Þ; w1j ; w2j ¼ ð20; 17Þ, the condition reduces to
675
showing that 8  325 285
4 P 75  4 , which is not satisfied.
Proposition 3. When there is no promotion offered by the manufac-
turers, the SPNE is as shown in Table 2.
The results show that a unique equilibrium is attained in each of
the regions denoted by (a) and (b), whereas two equilibria may ex-
ist in region (c). Note that the entire space of feasible parameters is
completely partitioned by the feasible regions, which are deter-
a0i ¼ a  mi  ci ; i ¼ 1; 2. This may be seen in practice when the
manufacturer has a loyal customer base such as for certain luxury
vehicles in the auto industry. When bic > 0, i = 1, 2, both manufac-
turers obtain lower profits when there is competition than when
they are monopolies.
In Observation 1(i), we determine the market leader corre-
sponding to the different SPNE. In part (ii), we identify a sufficient
condition for a unique equilibrium and analyze the sensitivity of
the manufacturers’ profits to the system parameters.
Observation 1.
(i) When the supply chain members are at the unique equilib-
rium denoted with SPNE.1 (SPNE.2), manufacturer 2 (1) is
the market leader in terms of sales.
(ii) When the manufacturers have identical net market poten-
0
tials, i.e., a01 ¼ a02 , and 2b2 < b1c þ 2b1o , then SPNE.1 is the
unique equilibrium, and manufacturer 2 is the market leader
in terms of sales and profits. Manufacturer 2’s profit changes
at a faster rate in response to changes in b2o, m2, and c2 com-
pared to the changes in b2c, m1, and c1, respectively, which
implies that the market leader’s profit is more sensitive to
her own parameters than to those of the competitor. Table 3
illustrates the comparative statics for the manufacturers’
profits when SPNE.1 is the unique equilibrium. All results
are symmetric for SPNE.2.

Recent observations from practice may suggest some relations

between price sensitivity and sales similar to Observation 1(ii).
In the U.S., the sales of the American auto manufacturers show a
declining trend while the non-American manufacturers have in-

Table 3
The impact of parameters on the manufacturers’ profits where a0 1 = a0 2 and
2b0 2 < b1c + 2b1o. . (%) implies decreasing (increasing) profits with increasing values
of the parameters, and ‘‘–’’ implies no impact.

b1o b1c b2o b2c m1 m2 c1 c 2

PoM;1 . . – – . – . –
PoM;2 % % . . % . % .
Fig. 3. PoM;i as a function of wi (Example 1).
274 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
creased their market shares in recent years (MSNBC News, 2007).
We also find from our data sets that the new vehicle registrations
of the compact and midsize vehicles by the American manufactur-
ers totaled 4.5 M and 6 M, respectively, versus 5.2 M and 7.4 M by
the Japanese manufacturers during 2000–2003. Although this can
be due to several reasons, one empirical work shows that the
American auto manufacturers face higher price sensitivity in their
demands for the compact and midsize car segments (Keskinocak
et al., 2009), potentially leading to smaller market shares. Manu-
facturers may benefit from lowering their customers’ price sensi-
tivities, e.g., by increasing the (perceived) quality of the products.
We obtain further observations from numerical examples in
Section 4. The no-promotion case provides a benchmark for ana-
lyzing the effects of promotions on firms’ sales and profits in the
following sections. Our analysis also gives insights on the equilib-
rium outcomes of interactions between first-degree price discrim-
inating and competing firms in two-stage supply chains, which
have not been studied in the literature.
3.2. Customer rebates
In this section, we analyze the case where the manufacturers of-
fer customer rebates. Rebates increase the purchasing power of the
customers, thus increase the maximum price dealers may charge
or the market potential if sensitivity is fixed. However, as Keskino-
cak et al. (2009) find from empirical evidence, rebates offered by
one manufacturer may reduce the competitor’s sales and profits
in a linear fashion. One reason for this may be the customers’ re-
duced willingness to pay for a manufacturer’s product when the
competitor is offering a rebate, which can be facilitated by the fact
that such promotions are advertised widely in the auto industry.
Correspondingly, we adjust the demand function as shown in Eq.
(6).
P i ðQ i ; Q j ; Ri ; Rj Þ
(
ða þ Ri  dj Rj Þ  ðbio þ bic ÞQ i if Q i 6 Q j
¼ i; j 2 f1; 2g; i – j:
ða þ Ri  dj Rj Þ  bio Q i  bic Q j otherwise
A manufacturer’s own rebate increases the customers’ purchas-
ing power and willingness to pay, while the rebates offered by the
competitor have a negative effect, the degree of which is captured
by the parameter di, where 0 < di 6 1. The decisions of manufac-
turer i are wi and Ri, where wi  Ri P ci, i = 1, 2, should hold for non-
negative profits. Further, we restrict the strategy spaces such that
a + Ri  djRj P wi + mi, which satisfies the reservation price require-
ment for retailer i when Qi = 0 and also implies Rj 6 amd i ci . The
retailers’ equilibrium in response to the manufacturers’ decisions
j
is identical to that in the no-promotion equilibrium as stated in
Proposition 2, except that the term a  wi  mi is replaced with
a + Ri  djRj  wi  mi, i, j 2 {1, 2}, i – j, in the existence of rebates.
In Proposition 4, we identify equilibrium pairs of wholesale prices
and rebate values–the points at which neither manufacturer can
increase profits by changing own decisions if the other manufac-
turer’s decisions remain fixed.
Proposition 4. When both manufacturers offer customer rebates, any
(wi, Ri) and (wj, Rj) are continuum of equilibrium pairs satisfying
amj cj adi Ri mj þcj
Ri 6 , wi  Ri = ci, Rj ¼ amdji ci , and wj  Rj ¼
di
i; j 2 f1; 2g; i–j, where the points wi = ci and Ri = 0 lead to an outcome
of zero profits and sales for manufacturer i, and no-promotion
ða0j Þ2 a0j
monopoly profit and sales for manufacturer j, and the points
4bjo 2bjo
amj cj
Ri ¼ di and wj  Rj = cj lead to an outcome of zero profits and
sales for both manufacturers.
If manufacturer j offers a large rebate, Rj ¼ amdji ci , then, due to
the manufacturer i’s nonnegative profit constraint and retailer i’s
reservation price requirement, this forces manufacturer i to select
the only feasible set of decisions wi  Ri = ci, and drives the sales
and profits of manufacturer i to zero. On the other hand, manufac-
turer j’s profit is sensitive to the specific values of wi and Ri, and de-
am c
creases in Ri. If manufacturer i offers Ri ¼ dij j , both
manufacturers obtain zero profits; whereas if manufacturer i can-
not afford to give any rebates, this benefits manufacturer j by effec-
tively reducing the threat of competition and allowing
manufacturer j to act as a monopoly. Similar results have been
found in other models where competition may drive one or all
firms out of business (e.g., Pekgun et al., 2008). Caliskan Demirag
et al. (2010) show in the monopolistic setting that customer re-
bates are not effective in increasing the manufacturer’s sales and
profits when demand is deterministic. However, Proposition 4 sug-
gests that there exist outcomes where rebates can be profitably
used by a manufacturer under competition.
In the auto industry, it is likely that the rebate amounts are lim-
ited by a practical upper bound, e.g., a percentage of the wholesale
price or the production cost. The existence of such bounds on the
rebate values is supported empirically by our data sets and can also
be expected when the manufacturers are concerned about poten-
tial negative effects of large rebate values on customers’ perception
of their brand quality. In the case with bounded rebates, we are not
able to find analytical results on the equilibrium decisions. Corre-
spondingly, we use numerical methods based on exhaustive search
procedures to find equilibrium decisions and generate insights
(Section 4).
3.3. Retailer incentives
In this section, we look at the case where manufacturer i offers a
lump-sum incentive Ki to retailer i, i = 1, 2. Retailer i seeks to max-
imize profits while satisfying the reservation price requirement for
all units sold. The main role of incentives is to enable the retailers
to reach customers they would not be able to otherwise. More spe-
cifically, for customers who are not willing to pay at least wi + mi,
ð6Þ the retailer can make a sale by passing through the incentive to
compensate the difference between his reservation price and the
price that the customer pays. While doing this, the retailer ensures
that the total incentive used for such sales does not exceed Ki. On
the other hand, there is no need to pass through any incentive to
the buyers who are willing to pay at least wi + mi. Similar to Sec-
tion 3.1, we assume that wi 6 a  mi since the retailer cannot sell
any units without an incentive otherwise.
In our analysis, the retailer incentives are offered as lump-sum
payments with no conditions on the performance or sales quantity.
Under these circumstances, the retailer is free to pocket the incen-
tives, i.e., not transfer to the end customer. Although auto manu-
facturers may not have direct control or visibility over how
dealers use these, empirical studies show that dealers indeed pass
through some part of the incentives to the end customers (Busse
et al., 2006). Some reasons for the retailers’ voluntary participation
in transferring the incentives include better status in the turn-and-
earn system for inventory allocation and an opportunity for receiv-
ing a better selection of vehicles in the future, which is facilitated
by a high volume of sales by the dealers. This observation is also
supported in our model setting, where we find that the manufac-
2 ;
turers can take advantage of their higher channel power, i.e.,
first-mover position, and enforce equilibrium outcomes where
the incentives are indeed passed through to the end buyers rather
than pocketed by the retailers.
First, we analyze the game where the retailers simultaneously
decide how much to order/sell to maximize their own profits given
the manufacturers’ wholesale price and incentive amount deci-
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280 275

sions. In Fig. 4, we illustrate how the retailers can use the incentive Z Q Ij
0
I
under different scenarios. Note that retailer i passes through the max a  bi qIi dqi
aw m b
Q Ij 6Q Ii 6 bi i b ic Q Ij 0
incentive to the sales with prices below his reservation price io io

wi + mi. In Fig. 4(a), we show the case with Q Ii 6 Q Ij , where retailer Z Q Ii  

I
i is selling entirely on the first segment of his demand function and þ a  bic Q Ij  bio qIi dqi  wi Q Ii þ K i : ð10Þ
Q Ij
uses the incentive only on this segment for the sales between the
points denoted by A–B. In Fig. 4(b) and (c) we show the cases with Finally, when Q Ij P awbi0mi , the retailer passes through the incentive
Q Ii P Q Ij . In Fig. 4(b), retailer i uses the incentive on the second seg- i
on both segments of his demand function (Fig. 4(c)) and solves the
ment of his demand function for the sales between the points de- following problem:
noted by C–D, and in Fig. 4(c), he passes through the incentive on   R Q Ij 0
I
both segments of his demand function to the sales between the PID;i Q Ii ; Q Ij ¼ maxQ I PQ I 0 a  bi qIi dqi
i j
points denoted by E–G. Each of these scenarios implies a different R Q Ii I
optimization problem for retailer i, which we formulate next. þ Q Ij
ða  bic Q Ij  bio qIi Þdqi  wi Q Ii þ K i ;
For a given Q Ij , if retailer i selects Q Ii 6 Q Ij , then the relationship R Q Ij 0

I
ð11Þ
between Q Ij and awbi0mi determines whether the retailer transfers s:t: awi mi wi þ mi  a  bi qIi dqi
i b0
the incentive. When Q Ii 6 Q Ij 6 awbi0mi , no units are sold at prices i
i R Q Ii   
I
below wi + mi, hence the retailer does not use any incentive to- þ QI
wi þ mi  a  bic Q Ij  bio qIi dqi 6 K i :
j
wards sales. This situation corresponds to the retailer’s pocketing
of the incentive. He determines the optimal Q Ii decision by solving For any given set of values for Q Ij ; K i ; wi ; wj , the problems in (7)–(10)
the following problem: are feasible, but the problem in (11) is not always feasible. For
Z Q Ii
example, when Q Ij is ‘‘large’’ and Ki is ‘‘small’’, it may be infeasible
0
I for the retailer to set Q Ii P Q Ij due to insufficient incentive. We de-
max a  bi qIi dqi  wi Q Ii þ K i : ð7Þ
06Q Ii 6Q Ij 0 rive a lower bound on Ki from the reservation price requirement

When Q Ij P awbi0mi , the retailer transfers the incentive to the units by evaluating the corresponding constraint in (11) at Q Ii ¼ Q Ij and
i 2
with prices below wi + mi (Fig. 4(a)). In this case, the optimal Q Ii find that K i P
ðawi mi b0i Q Ij Þ
for feasibility.
2b0i
decision is found from the problem in (8).
  Having formulated retailer i’s problems, we can now derive his
R Q Ii I
e I Q I ; Q I ¼ max
P 0
ða  bi qIi Þdqi  wi Q Ii þ K i ; payoff function, which is found by solving the problems in (7)–
D;i i j I I 0
06Q i 6Q j (11). In regions where multiple problems are feasible, the retailer
ð8Þ
R Q Ii 0

I selects the solution that generates the highest profit. We can prove
s:t: awi mi wi þ mi  a  bi qIi dqi 6 K i :
b0
dominance relationships between the retailer’s problems in (7)–
i
(11) and simplify the payoff function as shown in Proposition 5.
If retailer i selects Q Ii P Q Ij , then retailer i’s optimal Q Ii decision is (For notational clarity we do not show the dependence of the pay-
found by analyzing the cases illustrated in Fig. 4(b) and (c). When off function on the manufacturers’ decisions, wi, wj, Ki, and Kj).
Q Ij 6 awbi0mi , the retailer does not pass through the incentive on
i
the first segment of his demand function but can transfer it to the Proposition 5. When both manufacturers offer retailer incentives,  
sales with prices below wi + mi on the second part of the demand retailer i’s profit corresponding to the retailers’ joint strategy Q Ii ; Q Ij
function, i.e., when Q Ii P awbioi mi  bbioic Q Ij (Fig. 4(b)). In this case, the is given by
retailer’s optimization problem is:

b I ðQ I ; Q I Þ ¼
R Q Ij 0
I  
P D;i i j max 0 a  bi qIi dqi PID;i Q Ii ; Q Ij
Q Ii PQ Ij ; 8  
awi mi bic I
Q Ii P b Q j >
> b I QI; QI
P if Q Ij 6 awbi0mi ;
bio >
> D;i i j
io >
<
i

R QI  
I ð9Þ e I ðQ I ; Q I Þ I awi mi ðawi mi b0i Q j Þ
2

þ Q Ii a  bic Q Ij  bio qIi dqi  wi Q Ii þ K i ; ¼ P

>
> D;i i j if Q j P b i0
and K i 6 2bi0
;
j >
>
   >
: maxf P e I ðQ I ; Q I Þ; PI ðQ I ; Q I Þg if Q I P awi mi and K i P ðaw m b 0
Q Þ 2
R Q Ii I
i i i j
:
wi þ mi  a  bic Q Ij  bio qIi dqi 6 K i :
D;i i j D;i i j j b0 2b 0
s:t: awi mi bic I
i i

b Q j
bio io Retailer i’s best response to retailer j’s sales/order
 quantity
 deci-
On the other hand, when Q Ii 6 awbioi mi  bbioic Q Ij , the retailer does not sion is found by solving the problem maxQ I P0 PID;i Q Ii ; Q Ij , which
i
pass through the incentive on any part of his demand function requires solving the subproblems in the regions identified by Prop-
and solves the following problem: osition 5. Note that the objective functions of the subproblems are
 
concave. Further, P e I ðQ I ; Q I Þ ¼ PI Q I ; Q I only when Q I ¼ Q I .
D;i i j D;i i j i j

Fig. 4. Retailer i’s pass-through of incentives under different scenarios. Ki is passed through to sales: (a) on the first segment of the demand function, (b) on the second
segment of the demand function, (c) on both segments of the demand function.
276 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
Hence, retailer i’s best response is unique for a given wi, wj, Ki, Kj,
and Q Ij . When an equilibrium exists in the retailers’ game, we let

Q Ii be the equilibrium sales/order quantity decision of retailer i
and formulate manufacturer i’s problem as follows: PIM;i ¼

max ðwi  ci ÞQ Ii  K i .
wi Pci ;K i P0
We have analytically derived the equilibrium in the no-promo-
tion and customer-rebate cases (with unrestricted rebate values);
however, in the case of retailer incentives, we are not able to
explicitly characterize the equilibrium or show its existence due
to the complex structures of the players’ payoff functions and best
responses. The competitive interactions at both stages of the sup-
ply chain complicate the analytical characterization of the equilib-
ria considerably. This is also mentioned by Boyaci and Gallego
(2004), where the authors study a setting similar to ours in terms
of supply chain structure and timeline of decisions. While the
authors analytically derive the retailers’ unique equilibrium, they
numerically compute the wholesalers’ Nash equilibrium decisions
and thus the overall equilibrium. In our analysis, we use numerical
methods to find the retailers’ and manufacturers’ equilibrium (if
any exists) using the manufacturers’ payoff functions and the
retailers’ best response functions from Proposition 5.
4. Numerical examples
We numerically investigate the impact of system parameters
and competition on the supply chain members’ decisions, and
the resulting sales/profits. Our examples aim to explain some
observations in the auto industry and to generate managerial in-
sights useful for the firms’ promotion decisions in competitive
environments. Although our focus is on understanding retailer
incentives and customer rebates, we also show observations for
the benchmark case of no promotion, which help us compare the
two promotions.
In simultaneous-move games, similar to the manufacturers’ and
retailers’ competitive interactions in our analysis, Fudenberg and
Tirole (1991) discuss an iterative adjustment process where play-
ers take turns to make their decisions, and each player makes a
decision that is a best response to the opponent’s decision one iter-
ation before. Unfortunately, there is no guarantee that this process
will converge; however, if it converges to a stable point, then the
point is a Nash equilibrium. We develop an iterative algorithm
similar to the one discussed in Fudenberg and Tirole (1991). Table 8
in Supplementary Appendix B outlines the pseudo-code for the re-
tailer-incentive case, where we iteratively search for the manufac-
turers’ equilibrium wholesale price and retailer incentive
decisions, and we find the retailers’ equilibrium in an embedded
iterative sub-procedure, where we also check the existence of mul-
tiple equilibria. (See Supplementary Appendix B for details.)
In our computational tests for the retailer-incentive case, we
have always been able to achieve convergence. However, we also
observed that the algorithm can converge to two different equilib-
ria in the manufacturers’ game with alternative manufacturers as
the market leader in sales. Unlike the manufacturers’ game, we ob-
served in the retailers’ game that for any given set of manufactur-
ers’ decisions a unique equilibrium is found. Both of these
observations are consistent with the analogous results proved in
the no-promotion case (Proposition 2). However, since we cannot
analytically rule out the possibility of multiple retailers’ equilibria,
we also check for the existence of such outcomes. Based on our
extensive computational experiments, we conjecture that the
retailers always achieve a unique equilibrium in response to a gi-
ven set of manufacturers’ decisions, and there are at most two dif-
ferent manufacturers’ equilibria, and hence the overall equilibria,
where alternative manufacturers can be the market leader depend-
ing on the problem parameters. In the case of bounded customer
rebates, we use an iterative procedure similar to the one outlined
for the retailer-incentive model. We have observed in our experi-
ments that there exists a continuum of equilibria, as in the case
of unbounded rebates (Proposition 4).
In the rest of this section, we present examples to answer a
number of questions of managerial interest, such as: (a) Can we
find any conditions on the problem parameters to identify the mar-
ket leader in profits or sales? (b) How do the retailers’ reservation
prices affect the manufacturers’ incentive amounts, sales, and prof-
its under competition? (c) Does competition have an impact on
which promotion achieves higher equilibrium profits for a manu-
facturer? We also provide observations for the cases with bounded
rebates and different types of promotions offered by the
manufacturers.
(a) Determining the market leader in profits or sales: In our
models, the manufacturers’ and retailers’ payoff functions
and equilibrium profits are complex functions of the prob-
lem parameters. Hence, it is difficult to characterize general
relationships between the parameters and the manufactur-
ers’ performance. Nevertheless, the no-promotion case pro-
vides insights to explain some observations from practice.
For example, we are able to identify a sufficient condition
under which the manufacturer with a higher profit is also
the market leader in sales (Observation 1). In general cases,
however, different combinations of parameters may lead to
varying results on the market leader’s performance. In
Example 2(i), we show that the market leader in sales quan-
tity (manufacturer 2) can make less profit than the compet-
ing manufacturer, since the competing manufacturer’s
production cost and the retailer’s reservation price are
lower. In Example 2(ii), we show that lower production cost
and retailer’s reservation price do not guarantee higher prof-
its for a manufacturer. Here, although manufacturer 1’s pro-
duction cost is lower, she sells fewer units than
manufacturer 2 partly due to higher own- and cross-price
sensitivities, and she ends up with a lower profit.
Example 2
(i) When a = 150, b1o = 3, b1c = 1, b2o = 1.5, b2c = 1, c1 = 2, c2 = 10,
m1 = 5, m2 = 35, SPNE.1 is the unique equilibrium with the
following decisions: w1 ¼ 73:6; w2 ¼ 53:6; Q o1 ¼ 17:9; Q o2 ¼
29:0, where PoM;1 ¼ 1278:0; PoM;2 ¼ 1265:1.
(ii) When a = 50, b1o = 6, b1c = 1.5, b2o = 2, b2c = 1, c1 = 15, c2 = 20,
m1 = 10, m2 = 15, SPNE.1 is the unique equilibrium with the
following decisions: w1 ¼ 27:5; w2 ¼ 26:7; Q o1 ¼ 1:7; Q o2 ¼
3:3, where PoM;1 ¼ 20:8; PoM;2 ¼ 22:2.
The examples suggest that manufacturers should not only focus
on reducing production cost but also consider reducing their deal-
er’s reservation price and customers’ price sensitivity in order to
gain competitive advantage.
(b) The effect of retailers’ reservation prices: We use the retai-
ler-incentive case to investigate how the retailers’ reserva-
tion prices affect the manufacturers’ equilibrium decisions.
We design our experiments by selecting the following
parameter values: a = [25, 50, 100] (corresponding to low,
medium, and high market potentials), m1 = [6, 10, 15, 30],
m2 = [8, 13.5, 20, 32], c1 = [12, 20, 30], c2 = [10, 16.5, 25],
[b1o, b1c] = [[3, 2], [2, 1]], and [b2o, b2c] = [[2.5, 1], [3,2]]. These
sets of parameters result in 510 instances after discarding
the combinations that violate the assumption a P mi + ci,
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
i = 1, 2, which is needed for nonnegative profits in our anal-
ysis. Without loss of generality, we present common obser-
vations from all experiments by using some representative
instances and give the complete results for these instances
in Supplementary Appendix B (Table 10). Using the same
sets of parameter values, we also investigate the case where
the incentive is paid per vehicle ordered/sold and find con-
sistent results with the lump-sum incentives.
In Example 3, we analyze the impact of mi on the equilibrium
values of the lump-sum incentives, sales, and profits. The observa-
tions suggest that manufacturers can use incentives to counteract
the retailers’ high reservation prices, but they must also be careful
in selecting the incentive amount to avoid any pocketing.
Example 3. We see in Fig. 5 that as mi increases, retailer i first
receives a higher incentive from the manufacturer, who is interested in
maintaining sales levels. As also observed in the monopoly case
(Caliskan Demirag et al., 2010), an increase in the incentive amount
is accompanied by an increase in the wholesale price to ensure that
the retailer uses the incentive towards sales rather than pocketing
it. However, when mi further increases, this forces manufacturer i to
choose wi = a  mi in equilibrium, which is the upper bound on wi (see
Section 3). With reduced wi, manufacturer i also lowers the incentive
amount since any further increase in the incentive leads retailer i to
pocket a portion of it. We also see in Figs. 5 and 6 that the
competing manufacturer’s and retailer’s sales and profits are not
largely affected by increasing mi in the region where Ki also
increases since manufacturer i selects the values for the pair (wi, Ki)
appropriately to maintain own sales and profits. However, when a
further increase in mi causes Ki to decrease, manufacturer i and
retailer i, respectively, are negatively affected due to reduced wi
and Ki, while their competitors are positively affected.
Fig. 5. Incentive amount and sales with increasing mi (a = 50, c1 = 12, c2 = 10, b1o = 3, b1c = 2, b2o = 2.5, b2c = 1).
Fig. 6. Profits with increasing mi (a = 50, c1 = 12, c2 = 10, b1o = 3, b1c = 2, b2o = 2.5, b2c = 1).
277
(c) The effect of competition on the manufacturer’s prefer-
ence of promotions: Caliskan Demirag et al. (2010) show
analytically in the monopoly setting that retailer incentives
are always preferred over customer rebates in terms of sales
and profits when demand is deterministic. We now numer-
ically investigate whether this result extends to a competi-
tive setting.
Observation 2.
(i) The manufacturers are simultaneously better off with retai-
ler incentives than no promotion when both manufacturers
offer incentives.
(ii) The impact of customer rebates on the manufacturers’ sales
and profits depends on the realized equilibrium outcome: in
some equilibrium outcomes only one manufacturer is better
off and in others both manufacturers are worse off than no
promotion when both manufacturers offer rebates.
(iii) Unlike the monopoly setting where a manufacturer is
always better off with retailer incentives under determinis-
tic demand, there are some equilibrium outcomes in the
competitive setting where a manufacturer prefers customer
rebates over retailer incentives.
We first discuss Observation 2(i). We observed in our computa-
tional experiments that when both manufacturers offer retailer
incentives they consistently obtain higher profits and sales com-
pared to the case where they do not offer promotions. See, for
example, the representative instances in Table 4. (Additional in-
stances can be found in Table 10 of Supplementary Appendix B.)
This observation numerically extends the analytical result by Cal-
iskan Demirag et al. (2010), stating that retailer incentives always
improve a monopolistic manufacturer’s profits and sales as well as
278 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280

the channel’s. In the same study, authors find mixed results for the Table 5
incentive’s impact on the retailer’s profits. We can see from Table 4 Equilibrium decisions and profits with customer rebates, CR: Customer rebate (a = 50,
b1o = 3, b1c = 2, b2o = 2.5, b2c = 1, c1 = 12, c2 = 10, m1 = 6, m2 = 8, d1 = 0.5, d2 = 0.5).
and 10 that a parallel observation carries over to the competition
case: the manufacturers obtain higher sales and profits by offering w1 R1 Q R1 PRD;1 PRM;1
retailer incentives, whereas the retailers achieve higher profits (w2) (R2) (Q R2 ) (PRD;2 ) (PRM;2 )
only when the market potential is ‘‘low’’ or alternatively the gap 12 0 0 0 0
between a and mi + ci, i.e., net market potential is ‘‘small.’’ This CR Equilibrium 1 (90.0) (64.0) (6.4) (85.3) (102.4)
observation is mainly due to the manufacturers’ first-mover posi- 92.0 64.0 5.3 89.6 85.3
tion in the channel, which allows them to dictate the wholesale CR Equilibrium 2 (10) (0) (0) (0) (0)
pricing/promotion terms and take advantage of favorable market
situations, e.g., those with large net market potential. In particular,
when the market potential increases, the incentive values are non-
decreasing and the manufacturers select higher wholesale prices.
Initially, the retailers pass through the incentives making all par-
ties better off; however as the market potential further increases,
the retailers’ objectives become misaligned with their channel
partners’ objectives since pocketing the incentive can be more
profitable. To prevent this outcome and ensure the incentives are
passed through, the manufacturers’ incentives start leveling off.
Consequently, with the increased wholesale prices and constant
incentive amounts at high values of the market potential, the
retailers capture a lower percentage of total profits in their respec-
tive channels and become worse off compared to the no-promotion
case. In a competitive setting, Bruce et al. (2005) study a different
kind of dealer promotion that is in the form of wholesale price-cuts
based on sales. They find that while the manufacturers are better
off with trade promotions, the retailers are worse off when both
manufacturers offer them even though retailers’ participation in Fig. 7. Customer-rebates equilibria. ⁄
denotes the equilibrium.
the promotion is voluntary.
Next, we explain Observation 2(ii). Proposition 4 characterizes
the structure of a continuum of equilibria, which can lead to an To understand whether a manufacturer benefits from a cus-
outcome where manufacturer i generates no sales and profits tomer rebate, we can compare the equilibrium results under
due to the rebate by manufacturer j who is able to achieve the prof- customer rebates with those in the no-promotion case. Unfortu-
it of a monopolistic firm offering no promotion. We give an exam- nately, the answer to the preceding question depends on which
ple in Table 5 to illustrate such outcomes. of the possible equilibria is observed as the outcome of the interac-
The outcomes in Table 5 are only two extreme points (with tions between the players. See, for example Table 5, and the
R1 = 0 or R2 = 0) out of the continuum of equilibrium values, no-promotion results in Table 4. Furthermore, comparing the
which, without loss of generality, can be illustrated by selecting equilibrium results under retailer incentives and customer rebates,
w1, R1 such that w1  R1 = c1 and R1 P 0. (See Fig. 7.) Note that, Tables 4 and 5 reveal that manufacturer 1 prefers customer rebates
while any combination of (w1, R1) brings zero profit to manufac- over retailer incentives when the realized equilibrium outcome is
turer 1 (driving her out of business), manufacturer 1’s specific given by equilibrium 2. This is stated in Observation 2(iii), and it
choices of w1 and R1 impact her competitor’s sales and profits. is different from the manufacturer’s absolute preference of retailer
For example, any R1 > 0 reduces manufacturer 2’s profit as dem- incentives which was found in Caliskan Demirag et al. (2010),
onstrated in Fig. 7, where w1  R1 = c1 results in PRM;1 ¼ 0 on all implying that competition has an effect on which promotion is
curves, and PRM;2 decreases as R1 increases. When R1 gets suffi- better for the manufacturers.
ciently large, PRM;2 becomes lower than PoM;2 . In this outcome, We proceed to investigate some cases which have practical rel-
both manufacturers are worse off with rebates than with no evance and can be addressed numerically by our models. First, we
promotions. In the economics and game theoretical literature, look at the case with bounded rebates, next we analyze situations
this is an example of a situation called the prisoner’s dilemma. with alternative promotion choices by the manufacturers.
An analogy could be made with practice: Auto manufacturers Bounded rebates: A closer look at Table 5 shows that rebates
may prefer that no promotions are offered in the industry but can be as high as 71% of the wholesale price at the extreme out-
none is willing to stop giving them unless their competitors also come with one of the manufacturers out of business, which may
discontinue offering promotions at the same time (Smith et al., not be realistically expected in practice. To gather empirical infor-
2004). mation about the rebate percentages offered in practice, we

Table 4
Comparison of equilibria when no promotion is offered versus when both manufacturers offer retailer incentives, NP: No promotion, RI: Retailer incentive (b1o = 3, b1c = 2,
b2o = 2.5, b2c = 1, c1 = 12, c2 = 10, m1 = 6, m2 = 8).

w1 w2 K1 K2 Q1 Q2 PD;1 PD;2 PM;1 PM;2

NP 53.0 46.9 – – 8.2 14.8 217.3 424.0 336.2 544.6
a = 100 RI 56.0 50.6 3.6 12.8 8.8 16.2 197.2 381.2 383.6 646.5
NP 28.0 24.4 – – 3.2 5.8 44.8 92.7 51.2 82.9
a = 50 RI 31.0 28.0 3.6 12.8 3.8 7.2 39.7 85.5 68.6 118.2
NP 15.5 13.2 – – 0.7 1.3 5.4 12.3 2.5 4.0
a = 25 RI 18.5 17.0 3.6 8.5 1.3 2.3 7.8 18.2 4.9 7.3
 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
analyzed our secondary data which recorded the number of trans-
actions from the dealers of major car manufacturers in the U.S.
domestic market during June 2000 - May 2003. Focusing only on
the cash rebates provided from the manufacturers directly to the
end customers and using 3,426,605 transactions, we found that
the average rebate percentage, which is the ratio of the cash rebate
to the vehicle cost to the retailer (i.e., the wholesale price) is 5.52%.
(Instances with averages less than 0.01% are excluded.) In Table 6,
we resolve the instance in Table 5 by using this percentage value as
an upper bound and show two equilibrium outcomes that are use-
ful to illustrate our observations. In equilibrium 1, manufacturer 2
is the market leader obtaining higher sales and profits with the
customer rebate than with no promotion. Similar to the observa-
tion with unbounded rebates, the sales and profits of manufacturer
1 are below the no-promotion equilibrium values; however, in this
case, manufacturer 2 cannot drive the competitor completely out of
business since the rebate values are bounded. Further, there exist
alternative outcomes, e.g., equilibrium 2, where manufacturer 2’s
profits and sales are adversely affected by a rebate offered by man-
ufacturer 1. If the supply chain members reach equilibrium 2, then
both manufacturers become worse off compared to no-promotion
case, again resulting in a prisoner’s dilemma situation similar to
the unbounded-rebates case.
Manufacturers’ different promotions: We consider a case
where manufacturers offer different types of promotions. In prac-
tice, the American auto manufacturers are well-known for their
frequent and deep customer rebates, whereas the non-American,
especially Japanese auto manufacturers seldom offer those and in-
stead may give incentives to their dealers. We analyze a scenario
where we characterize manufacturer 1 with high production cost
and total price sensitivity and manufacturer 2 with low production
cost and total price sensitivity; note the intended correspondence
between the former (latter) with the American (Japanese) auto
manufacturers. To understand which promotion is preferred by a
manufacturer, we compare the manufacturers’ equilibrium profits
under different combinations of promotions. We summarize our
observations with a representative instance in Table 7. (Complete
results for this instance are given in Table 11 of Supplementary
Appendix B.) We note that in the cases with bounded rebates, we
restrict the manufacturers’ rebate values to 5.52% of their whole-
sale prices (as revealed from our data sets). Further, in the case
of a continuum of equilibria, we assume the most efficient out-
come will take place.
When rebates are unbounded, if one manufacturer offers a re-
bate, the other manufacturer obtains no profits with a retailer
incentive but can obtain positive profits with a customer rebate,
hence prefers customer rebates. When manufacturer 1 offers a re-
tailer incentive, manufacturer 2 is generally better off with a retai-
ler incentive also, and both manufacturers obtain higher profits
Table 6
Equilibrium with bounded rebates (a = 50, b1o = 3, b1c = 2, b2o = 2.5, b2c = 1, c1 = 12,
c2 = 10, m1 = 6, m2 = 8, d1 = 0.5, d2 = 0.5).
w1 w2 R1 R2 Q1 Q2 PM,1
NP 28.00 24.40 – – 3.20 5.76 51.20
CR Equilibrium 1 27.62 25.91 0 1.43 3.13 5.76 48.94
CR Equilibrium 2 29.07 25.55 1.45 1.41 3.13 5.60 48.98
Table 7
Comparison of equilibria in different cases; manufacturer 1 (M1) has higher production cost and total price sensitivity than manufacturer 2 (M2) (a = [50, 75, 100], b1o = 3, b1c = 2,
b2o = 2.5, b2c = 1, c1 = [12, 20, 30], c2 = 10, m1 = 6, m2 = 8, d1 = 0.5, d2 = 0.5).
M2 offers M1’s profit is highest with
Rebate (unbounded) Rebate (unbounded)
Incentive Rebate (unbounded)
Rebate (bounded) Incentive
279
than those in the no-promotion case. The preceding observations
are also seen in practice, where manufacturers follow each other’s
promotion very closely and offer the same type of promotion. For
example, Ford Motor Co. chairman William Clay Ford Jr. mentioned
that ‘‘[Ford] will match General Motors Corp. dollar-for-dollar in
cash and financing incentives (March 6, 2002).’’ Similarly, Auto-
channel.com cites a Chrysler executive who stated that ‘‘continued
soft sales this month had forced the automaker to match increased
rebates from General Motors Corp.’’ On the other hand, if manufac-
turer 2 offers a retailer incentive, then manufacturer 1 obtains the
highest profit with a customer rebate if she can offer large rebates;
otherwise, retailer incentive is preferred. This observation is also
consistent with practice, where manufacturers with high produc-
tion cost and price sensitivity (e.g., American auto manufacturers)
often prefer large customer rebates while their competitors (e.g.,
non-American auto manufacturers) choose retailer incentives
(Henderson, 2005). Finally, we see that when one manufacturer of-
fers a customer rebate that is restricted to 5.52% of the wholesale
price, the other manufacturer obtains the highest profit with a re-
tailer incentive. Retailer incentives help manufacturers increase
profits and lead to equilibrium outcomes with smaller difference
in profits compared to customer rebates, where manufacturers’
profits can vary from zero to the monopoly profits under different
equilibria.
5. Conclusions
In this paper, we study a two-stage supply chain with duopoly
competition between manufacturers and price-discriminating
retailers at each of the two stages. The analysis is motivated by
the perspective of automotive manufacturers, where one of our
primary goals is to understand how manufacturers’ promotions
such as customer rebates and retailer incentives are affected by
competition. A key difference between these promotions is that re-
bates are given to all customers purchasing at that point in time,
while retailer incentives can be directed by dealers to customers
with low reservation prices.
We use game theory to analyze the interactions between the
supply chain members. We model competition at both stages of
the supply chains, where the retailers observe the manufacturers’
decisions and compete in sales, and the manufacturers simulta-
neously determine their wholesale prices and promotion amounts
by predicting the retailers’ equilibria. Although modelling compet-
itive interactions at both stages complicates the analytical charac-
terization of the equilibria considerably, it allows us to capture
more realistic situations and generate practical insights.
We find that retailer incentives of the form lump-sum pay-
ments can be effective in improving the manufacturers’ sales and
profits under competition but not necessarily those of the retailers.
When the market conditions are favorable, e.g., when the market
potential is large, incentives may hurt the retailers’ profits. With
the objective of maximizing one’s own profit, we also find that cus-
PM,2
tomer rebates can be used by one manufacturer to increase her
own profit while reducing the competitor’s profit compared to that
82.94
83.33
in the benchmark case of no promotion. We observe with numer-
79.20 ical examples that a manufacturer prefers to offer the same type of
promotion as that of her competitor although in some cases she
M1 offers M2’s profit is highest with
Rebate (unbounded) Rebate (unbounded)
Incentive Incentive
Rebate (bounded) Incentive
280 O.C. Demirag et al. / European Journal of Operational Research 215 (2011) 268–280
obtains higher profits with a customer rebate when the competitor
is offering a retailer incentive.
There are a number of areas where further research could ben-
efit the study of promotions in a competitive setting. In this anal-
ysis we have focused on promotions under deterministic demand;
Caliskan Demirag et al. (2010) show that demand uncertainty is
one factor that can make customer rebates a desirable promotion
for a manufacturer. A useful extension of our research would be
to consider both uncertainty and competition, although this would
add significant complexity to the analysis. Our models do not facil-
itate complete structural results for the equilibria in the retailer-
incentive and customer-rebate cases, which we investigate
through iterative algorithms. Due to the multiplicity of equilibrium
and analytical complexities in best responses, we are not able to
prove convergence properties or identify general conditions that
lead to a unique equilibrium. Alternative equilibrium outcomes
also present challenges in making meaningful comparisons be-
tween models since insights tend to be specific to which of the
equilibria is observed. Another limitation is that we model demand
in an aggregate fashion and do not consider individual customer
utility maximization. Alternative demand models could be devel-
oped to better understand the impact of competition. In this paper
we do not explicitly consider sales effort (which we incorporate
indirectly through retailer’s price discrimination and pass-through
of the incentive) or information asymmetry, each of which relates
to interesting questions and are worthy topics in their own right.
Finally, since the manufacturers’ promotion and capacity-utiliza-
tion strategies can be interlinked in some industries, it would be
useful to develop more complex models by relaxing the ample
capacity assumption and by considering production costs which
depend on capacity utilization.
Acknowledgements
This research was supported by NSF grants SBE-0624269 and
DMI-0093844. The authors thank the editors and reviewers for
their valuable comments and suggestions, which helped improve
the content and the presentation of this article.
Appendix A. Supplementary data
Supplementary data associated with this article can be found, in
the online version, at doi:10.1016/j.ejor.2011.04.006.
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