Managing Competing Channels through Nonlinear Contracts

An upstream supplier constrained by downstream competition and the threat of demand-side substitution faces a trade-off between maximizing overall joint-profit and extracting surplus. By inducing more intra-brand competition through lower wholesale prices, the supplier makes it less attractive for downstream firms to switch to alternative sources of supply. This insight yields various implications that are strikingly different from those of extant models of vertical contracting: (1) Though the supplier can control competing channels through non-linear supply contracts, marginal wholesale prices and final goods' prices both decrease when either down- stream competition intensifies or the supplier becomes more constrained by the threat of demand-side substitution. (2) It may be optimal for the supplier to "balance" his sales across competing channels through disadvantaging more efficient downstream firms, thereby smoothing out differences in market shares.