Strategic Impact of Internet Referral Services on Channel Profits

Abstract

Internet Referral Services, hosted either by independent third-party infomediaries or by manufacturers serve as “lead-generators” in electronic marketplaces, directing consumer traffic to particular retailers. In a model of price dispersion with mixed strategy equilibria, we investigate the competitive implications of these institutions on retailer and manufacturer pricing strategies as well as their impact on channel structures and distribution of profits. Offline, retailers face a higher customer acquisition cost. In return, they can engage in price discrimination. Online, they save on the acquisition costs, but lose the ability to price discriminate. This critical tradeoff drives firms’ equilibrium strategies. The establishment of a referral service is a strategic decision by the manufacturer, in response to a third-party infomediary. It leads to an increase in channel profits and a reallocation of the increased surplus to the manufacturer, via the franchise fees. Further, it enables the manufacturer to respond to an infomediary, by giving itself a wider leeway to set the unit wholesale fee to the profit maximizing level. We discuss implications of referral services on channel coordination issues, and whether a two part tariff can be successfully used to maximize channel profits. Contrary to prior literature, we find that when retailers can price discriminate among consumers, the manufacturer may not set the wholesale price to marginal cost to coordinate the channel. Consistent with anecdotal evidence, our model predicts that while it is optimal for an infomediary to enroll only one retailer, it is optimal for a manufacturer to enroll both retailers. Finally, our results show that under some circumstances, the manufacturer even benefits from the presence of the competing referral infomediary and hence, will not want to eliminate it.