Product Match Disclosure in a Distribution Channel

Transcription

1 Product Match Disclosure in a Distribution Channel Monic Sun Boston University July 9, 2015 Comments are welcome: [email protected]. I would like to thank Yi Luan and Ying Lei for providing excellent research assistance. I am also grateful to Rajeev Tyagi, Anthony Dukes, Barbara Bickart, Carey Moorwedge, Sherif Nasser, Shuba Srinivasan, Feng Zhu, participants at the UTD FORMS conference and the INFORMS marketing science conference, and seminar participants at Boston University, Columbia Business School and University of Rochester for helpful discussions and comments.

2 Product Match Disclosure in a Distribution Channel Abstract Sellers in today s marketplace have increasing abilities to facilitate consumers learning about their match with her product through prepurchase disclosure. We investigate how a seller s incentive to disclose product match information is affected by the structure of her distribution channel. Our model suggests that, while selling through a monopolistic retailer typically decreases manufacturer disclosure, selling through competitive retailers could increase such disclosure. Furthermore, retailers often have stronger disclosure incentives than the manufacturer, especially for products with a strong quality reputation. We collect data on web-only fast-fashion brands in India and find evidence that is consistent with the model predictions. We also discuss how product returns and a continuum of product types affect disclosure incentives. Keywords: Information Disclosure, Product Match, Distribution Channel 1

3 1 Introduction With about 250,000 new products launched globally each year, 1 consumers constantly need to evaluate their potential fit with a product. 2 Sellers, as a result, are adopting many costeffective prepurchase disclosure strategies, such as posting detailed product descriptions online and circulating product pictures and videos. For magazines, books, movies, software and video games, sellers can also provide a free version online. Warby Parker, a popular brand of eyeglasses and sunglasses, allows a consumer to virtually try on multiple pairs of glasses. 3 Similarly, Land s End and Pearle Vision both offer software programs allowing the consumer to envision himself in their products (Shulman et al. 2009). As prepurchase disclosure becomes popular due to the development of digital technologies, it plays an increasingly important role in a firm s overall marketing strategy and may interact with other elements of the marketing mix. In particular, manufacturers may have different disclosure incentives depending on how they distribute their products. Jabong.com, a leading fast-fashion online retailer in India, posts multiple pictures of each clothing item on their site to help consumers evaluate their potential fit with the item. Many items are from web-only brands with no physical distribution channels so that pictures are the primary source of product match information. Interestingly, many items have a different number of pictures on Jabong than on their brands own e-commerce sites. When asked why a consumer may not see the same pictures on the retailer site, a Jabong employee responds that a brand decides how many pictures to give us. 4 It seems that brands are making a conscious decision on what they want consumers to see on 1 accessed in July Recent research at Cisco shows that digital content from the Internet is the most powerful influence in buying decisions for the majority of shoppers in all channels. See , accessed in April The survey suggest that 78% of all shoppers use the Internet to research and purchase products. 3 accessed in April Interview conducted with Jabong s customer service on December 4,

4 their retailers websites. Many brands in the U.S. adopt similar strategies. Angela & Roi, an emerging handbag brand that sells exclusively online, posts multiple pictures for each bag on the brand s own website but only offers one picture for each bag on Bluefly, a leading online retailer that typically displays multiple pictures for each item. To complicate matters, the disclosure decision is not always up to the manufacturer. Gilt, for example, has its own in-house photo studio set up in Brooklyn offices where it shoots models wearing items it carries. 5 Some online retailers offer sales assistance such as live chat to given detailed answers to consumers questions about each of their products. Some incorporate customer reviews into their websites. Casper.com, an online retailer of mattresses, identifies reviewers with real names, locations, and sleeping habits so that a potential consumer could evaluate his fit with a mattress by seeking out a like-minded reviewer. 6 As retailers often have first-hand knowledge on consumers attitudes and behavior, they can sometimes be in a better position than the manufacturer to disclose product match information. To better think about the relationship between product match disclosure and channel structure, we set up a game theoretic model to answer the following questions. First, how does a manufacturer s optimal disclosure strategy change with her distribution channel? When she distributes through competitive retailers, in particular, how does the intensity of downstream competition affect upstream disclosure? Second, when retailers are in charge of digital information disclosure, how would their optimal strategy be different from that of the manufacturer? Our model features a monopolist manufacturer who can costlessly disclose truthful information about her product. 7 At the core of the disclosure decision is a seller s tradeoff 5 is-in-the-navy-yard-which-is-actually-quite-advantageous-for-photo-shoots-1, accessed in April accessed in April See Moorthy (2005) for a general theory of pass-through with multiple manufacturers and retailers. 3

5 between a product s margin and demand (e.g., Anderson and Renault 2006, 2009). Disclosure is typically aligned with a margin-driven strategy, as the consumers willingness to pay is more heterogeneous and the product is optimally targeted at well-matched consumers at a premium price. Nondisclosure, on the other hand, is aligned with a demand-driven strategy, as the willingness to pay is more homogeneous and the product is optimally targeted at the mass market at an average price. As the model focuses on an experience good whose match value can only be learned through prepurchase disclosure or post-purchase consumption, it is more applicable to products that cannot be returned once purchased (e.g., meals, movies, software, spa services, vacation packages) or products whose price is low when compared to the hassle of a return so that consumers often keep an ill-matched product rather than returning it (e.g., magazines, books, fast-fashion clothing). A common features of these products is that repeat purchase is limited so that disclosure plays an important role in the purchase decision. A baseline result we find is that the manufacturer chooses to disclose product match information when her quality reputation is weak. 8 Intuitively, when quality reputation is weak, disclosure helps secure demand from well-matched consumers with a positive margin. As her quality reputation strengthens, she is attractable to a larger portion of the market. Serving uninformed consumers is more profitable in this case as she can price to the average, rather than the marginal, consumer (e.g., Xie and Shugan 2001; Anderson 2002). As a result, there exists a reputation threshold for nondisclosure: the manufacturer chooses not to disclose product match information if and only if her quality reputation exceeds this threshold. Our key results center around how this reputation threshold changes when a directselling manufacturer switches to distributing her product through retailers. We find that, if the manufacturer sells through a monopolistic retailer or two differentiated retailers, the 8 To ease exposition, we refer to the consumer as he and the manufacturer as she. 4

6 reputation threshold decreases. In other words, she is more likely to practice nondisclosure. As nondisclosure increases the elasticity of demand, it benefits the manufacturer by putting downward pressure on the retail markup and final price. On the other hand, the reputation threshold increases when the manufacturer sells through highly competitive retailers. As retail competition effectively limits retail markup, the manufacturer barely loses any demand when compared to the case when she sells directly to consumers. Therefore, the reduction in her demand is less significant than the reduction in her margin, and she chooses disclosure in order to restore the margin. Putting the two scenarios together, we find that although selling through dominant retailers tends to inhibit upstream disclosure, selling through competitive retailers may increase upstream disclosure. It is striking that when retailers are in charge of disclosure, they may adopt a nonmonotonic strategy and choose disclosure only if the manufacturer s quality reputation is either very low or very high. When the manufacturer s quality reputation is low, as before, disclosure helps ensure demand from well-matched consumers. For products with a high quality reputation, on the other hand, the market is almost fully covered and the profit gain from quality improvement goes mostly to the manufacturer under nondisclosure: consumers willingness to pay is homogeneous and retail markup is limited. By choosing disclosure, the retailers could obtain a larger share of the profit gain from quality improvement. When the manufacturer s quality reputation is mediocre, the dominant effect of disclosure is to alienate ill-matched consumers, which makes it less preferable to nondisclosure for all channel members. This middle range of quality reputation for nondisclosure shrinks as retailer competition intensifies: as the downward pressure on retail markup increases, the retailers can choose disclosure to restore their margins. To demonstrate the managerial implications of our model, we collect data on 1,434 clothing items from 53 web-only brands in the fast-fashion industry in India. As these brands sell only through online channels, product pictures and descriptions are the primary source 5

7 of product match information. We record the number of pictures for these clothing items across different distribution channels including the brand s own website and two leading fastfashion online retailers in India, Jabong.com and Myntra.com. Consistent with the model predictions, if the item is carried by only one retailer, the number of its brand pictures is on average smaller on the retailer s site than on its brand site. If the item is carried by both retailers, however, the number of its brand pictures is greater on a retailer s site than on its brand site. When a retailer uses its own pictures for the item, the number of such pictures is higher than the number of brand pictures on its brand site, regardless of whether it is carried by one or both of the retailers. We discuss two extensions of the model. First, we incorporate the possibility of product returns, which can also help consumers learn their match. Consistent with the literature (Anderson et al. 2009a), the option to return a product in our model may either increase or decrease the final demand of a product: the option expands initial demand by putting a cap on the potential loss from the purchase, while the realized returns from mismatched consumers reduce the final demand. Based on this intuition, we derive conditions for nondisclosure to be optimal for the manufacturer when returns are relatively easy for consumers. We find that while there is still a reputation threshold for nondisclosure, the impact of channel structure on this threshold changes. In particular, the threshold is now the highest (i.e.,. the manufacturer is the most likely to choose disclosure) when she sells through a monopoly seller and the lowest when she sells directly to the consumers. The extension hence highlights the importance of considering the possibility of product returns when the manufacturer crafts her optimal prepurchase disclosure policies. We also examine the possibility of a continuum of product types. The analysis becomes more involved in this case as the privately-informed manufacturer may have an incentive to pool product types into multiple subsets. A key observation is that a disclosing type should always make at least the profit of a nondisclosing type, as the latter can always costlessly 6

8 deviate to choosing disclosure. Using this observation, we characterize the equilibrium in which the pooling product types all charge the same price and show that the range of nondisclosing types in this equilibrium increases with the quality reputation of the manufacturer. The finding is consistent with our result that a strong quality reputation suppresses the manufacturer s incentive to disclose product match information. The remainder of the paper is organized as follows. In the next section, we discuss related literature. Section 3 then presents our main model of costless disclosure of truthful product match information, Section 4 offers empirical evidence on web-only fast-fashion brands in India that is consistent with the predictions of our model, Section 5 discusses the implications of product returns and continuous product types, and Section 6 concludes. 2 Literature Review The vast literature on product information disclosure starts with a focus on the disclosure of vertical product quality. In their seminal papers, Grossman (1981) and Milgrom (1981) establish the unravelling result: all levels of quality will be revealed in equilibrium, as the highest quality type in any pooling equilibrium would want to separate from the other types in the pool. Subsequent studies often characterize a quality threshold above which the seller would choose to disclose the quality of the product, and document how this threshold changes with factors such as disclosure costs (Jovanovic 1982; Guo 2009b; Guo and Zhao 2009), consumer s uncertainty about their preference for quality and asymmetry in firms quality levels (Kuksov and Lin 2010), whether disclosure is simultaneous or sequential (Guo and Zhao 2009), and whether disclosure is made directly to consumers or through downstream retailers (Guo 2009b). 9 Rather than focusing on the disclosure of vertical product 9 There is also an important literature (e.g., Gal-Or et al. 2008; Guo 2009a; Guo and Iyer 2010; Guo et al. 2014) that studies the sharing of information on demand shocks between channel members. Studies in this literature often assume that retailers and/or manufacturers are privately informed of the real time demand levels of the product and decide strategically whether to share this information with other members of the 7

9 quality, the current paper assumes that quality of the product is common knowledge and investigates channel members incentives to disclose the horizontal match between the product and individual consumers with heterogeneous tastes. The paper is hence more applicable to product categories in which a major source of the uncertainty around a consumer s valuation of a product comes from the idiosyncratic match. Following the literature on quality disclosure, research on match disclosure has accumulated quickly in the past decade. Unlike papers on quality disclosure, studies in this literature typically assume that product quality is common knowledge and focus on the seller s incentives to disclose product match information. Chen and Xie (2008) explore the relationship between consumer reviews and seller disclosure, both of which deliver information on consumer s match with the product, and find that the two forms of disclosure can be either substitutes or complements depending on the cost of the product and the sophistication of product users. Sun (2011) models multiple product attributes and shows that the unravelling result may breakdown when disclosure reveals information on both quality and match. Mayzlin and Shin (2011) and Branco et al. (Forthcoming) explore the interaction between a seller s information provision and the consumers information search and highlight equilibria of partial disclosure. Recently, there are also studies that explore the effect of competition on the disclosure of product match information (e.g., Shaffer and Zettelmeyer 2004; Anderson and Renault 2009; Gu and Xie 2013). 10 While the current paper also focuses on truthful disclosure of product match information, it is the first study in the match-disclosure literature to investigate the impact of downstream competition on upstream disclosure. distribution channel. Unlike papers in this literature, the current paper assumes that the manufacturer is better informed than the manufacturer on the product attributes that would affect how well it matches with consumers with heterogeneous tastes. 10 Fay and Xie (2008) study probabilistic goods: offers that involve a probability of getting any one of a set of multiple distinct items. While probabilistic selling (PS) is similar to nondisclosure in that both make the consumers willingness-to-pay more homogeneous and enable the seller to broaden market coverage by catering to consumers with weak preferences, the two strategies are conceptually different in that the disclosure decision modeled in the current paper does not require the existence of multiple (component) products. 8

10 A key intuition in the literature, shared by the current paper, is that unlike disclosure of quality information which typically shifts the demand curve up or down, disclosure of match information tends to rotate the demand curve (Johnson and Myatt 2006). 11 Rotation of demand curve could happen for a variety of reasons and often changes how the total surplus gets distributed. Anderson (2002), for example, shows in the context of product design that firms may choose to assemble the product fully even if it is Pareto-efficient for the consumers to carry out part of the assembly: a fully completed product is associated with a more elastic demand curve, which allows the seller to capture a greater share of the total surplus. The current paper goes beyond demand curve rotation, however, by showing that disclosure may either increase or decrease depending on the intensity of downstream competition. An important contribution that relates fit revelation to the structure of a distribution channel is Gu and Liu (2013), who characterize the optimal shelf layout and find that whether competing products should be displayed together depends on the difference in the products ex-ante fit probabilities as well as the intensity of retail competition. While they model search goods so that consumers always learn the match before making a purchase, we focus on experience goods with which consumers may not know their match until after the purchase. Therefore, there is a possibility for consumers in our model to be stuck with an ill-matched product that is absent from their model. Another closely related stream of literature is the one on product returns. Prepurchase disclosure and post-purchase product returns could both serve as effective ways to disclose product match information. The two strategies differ significantly, however, for two reasons. First, prepurchase disclosure typically incurs lower marginal cost to firms than product returns, which cost the U.S. companies more than $100 billion annually ( Shulman et al. 2010, 2011). As mentioned above, prepurchase disclosure is often implemented through digital 11 See Renault and Koessler (2012) for a discussion on the necessary and sufficient conditions on consumers preference structures in order for the unravelling result to hold. 9

11 technologies, and the marginal cost of disclosing match information for an additional product is often negligible once the fixed cost of the disclosure technology is incurred. On the other hand, firms typically have to incur substantial restocking costs for each returned item. Second, prepurchase disclosure also tends to be less costly to the consumers when compared with product returns, which are often associated with the hassle of packing and shipping, and sometimes hefty restocking fees. Given the significant marginal cost of product returns to both the sellers and consumers, studies in the returns literature focus on the relationship between the return rate and the price that consumers paid for the product (Anderson et al. 2009b), the value of returns to consumers and how sellers can optimally balance it against the operational costs of returns (Anderson et al. 2009a), the optimal reverse channel structure, including who handles returns and how much the manufacturer should refund the retailers for returned products ( Shulman et al. 2010), and the optimal restocking fees in monopoly and duopoly settings ( Shulman et al. 2011). Shulman et al. (2009), in a related study where a multi-product manufacturer sells directly to consumers, investigate the interaction of prepurchase disclosure and post-purchase returns. Consistent with the current paper, they find that the seller has an incentive to target the well-matched consumers when reservation utility for the category is low. Moreover, it is not always optimal to choose prepurchase disclosure even if it could eliminate all uncertainty around match. In a more recent paper, Shulman et al. (forthcoming) model prepurchase information that partially resolves the uncertainty around match and find that when consumers are reference dependent, such information may increase, rather than decrease, the instances of product returns. While these important studies focus on the effect of information disclosure on the likelihood of returns, the current paper focuses on the impact of the channel structure on prepurchase disclosure. Although we exclude the possibility of product returns in the main model, our extension in Section 5.1 suggests that as an im- 10

12 portant form of information disclosure, product returns would indeed change the impact of channel structure on prepurchase disclosure. Overall, while there is a large body of literature on information disclosure, we make a distinct contribution by showcasing the impact of a downstream distribution channel on costless upstream disclosure of product match information. Our findings that the manufacturer should decrease disclosure when selling through a monopolistic retailer, but increase disclosure when selling through competitive retailers, and that retailers may have different disclosure incentives from the manufacturer, all have immediate implications for marketing managers. 3 The Model We use an augmented Hotelling model (Hotelling 1929) to capture consumers heterogeneous tastes for the product and the store at which they make a purchase. 12 Formally, suppose a unit mass of consumers are distributed uniformly in the unit square. The x-axis represents consumers ideal store types, and the y-axis represents their ideal product types. A consumer s preference for the product is independent of his preference for the store. This assumption suits real-world situations in which the store carries a large array of products and one single product does not have a significant impact on the consumers preference for the store. There are many factors that go into a store type, such as product layout, name of the store, style of service, store ambience and store location. For online stores, store types can be influenced by factors such as the color theme, page layout and shipping methods. The two stores in our model are located at x s = 0 and x s = 1, and these locations are common knowledge. They can be jointly owned by the manufacturer or a monopolistic 12 We obtain similar results with a circular model (Salop 1979) if consumers tastes differ only with respect to the product. When tastes differ also with respect to the stores, it is more intuitive to incorporate the second dimension of differentiation with the augmented Hotelling model. 11

13 retailer, or separately owned by two different retailers. The product s type, captured by its location, is a random variable that takes the value of y p = 0 or y p = 1 with equal probability. A consumer located at (x, y) buys at most one unit of the product and gains utility U(x, y) = v p t x x t y y from the purchase, where v > 0 is the manufacturer s quality reputation. 13 The consumer is willing to pay v if his matches with the product and the store are both perfect. One way to interpret v is to think of it as the product s quality. An alternative interpretation of v is the relative weight that a consumer puts on (a fixed level of) product quality. With this alternative interpretation, a weak reputation does not necessarily come from a low quality level. Rather, it could be due to other factors such as the newness of the manufacturer. Other parameters in the utility function above are p, the price of the product, x (resp. y), the consumer s store (product) mismatch which equals the distance between the consumer s ideal store (product) location and the actual store (product) location, and t x (resp. t y ), the weight that is placed by the consumer on the store (product) mismatch. While other variables in the consumer s utility function are common knowledge, the product s type is not known to the consumers without manufacturer or retailer disclosure. This assumption reflects our observation that it may be harder for consumers to learn their match with a particular product (e.g., Adobe Photoshop) than to learn the manufacturer s general quality reputation, as information on the latter can often be found online. We assume that if the manufacturer or retailers choose disclosure (e.g., offer a free trial for Adobe Photoshop), the disclosed information is truthful and all consumers observe the product s type. 14 Otherwise, the consumers cannot observe the product s location and keep their prior 13 In the event that the manufacturer offers multiple product lines that are vertically differentiated, then v should be thought of as the quality reputation of the product line that includes the focal product that the consumer is considering. 14 See Shaffer and Zettelmeyer (2004) and Iyer et al. (2005) for in-depth discussions of targeted advertising. 12

14 belief that the product is located at y = 0 or y = 1 with equal probability. 15 As we model preference heterogeneity on two dimensions (store and product) in a continuous framework, certain modelling assumptions are necessary to keep the game well defined and tractable. For example, the linear mismatch costs along both dimensions enable us to analyze all possible demand scenarios. With quadratic mismatch costs, for example, optimal disclosure can only be characterized for the extreme cases of local monopolies and complete market coverage. 16 Also, by fixing the stores at the two ends of the Hotelling line, we can sidestep discontinuous demand functions that tend to emerge when firms are located inside the Hotelling interval (d Aspremont et al. 1979; Tirole 1988). Finally, by restricting the product s location to be either 0 or 1, we can avoid getting into the analysis of multiple equilibria, an issue we discuss further in Section Equal Weights on Product and Store Mismatch To highlight the key forces behind disclosure, we first characterize the manufacturer s optimal disclosure strategy in a benchmark model where the consumers have equal weights on their store and product mismatch: t x = t y = A nondisclosing manufacturer could use her price to signal the product s location. However, in an equilibrium where the two types choose nondisclosure and charge different prices, at least one of them can profitably deviate to disclosure. Therefore, the two types always charge the same price under nondisclosure. We assume that this price is profit maximizing. An off-equilibrium-path belief that supports this assumption is that consumers believe that the product is located at 0 when a different price is charged. 16 If demand falls in between these two cases, the shape of demand for each store becomes the area of a triangle plus a circular sector, making the derivation of optimal prices intractable. For example, if the utility of consumer (x, y) is v p x 2 y 2, we can obtain that under disclosure (nondisclosure), the two retailers 1 remain local monopolies in equilibrium if v 1 (resp. 4 < v 5 4 ), in which case the manufacturer s profit is 1 16 πv2 π (resp. 8 (v 1 4 )2 ). She prefers to choose disclosure if v < 0.85, which is consistent with our intuition that lower importance of quality triggers disclosure of product match information. On the other hand, the retailers will compete head to head and cover the entire market under disclosure (nondisclosure) if v 9 4 (resp. v 7 4 ), in which case the manufacturer s profit is v 9 4 (resp. v 7 4 ). She prefers nondisclosure in this case, consistent with our upcoming result that high importance of quality leads to nondisclosure of product match information. 13

15 3.1.1 Selling Directly to Consumers When the manufacturer owns both stores and sells directly to consumers, the game proceeds as follows: First, the manufacturer learns the product s location (y p = 0 or y p = 1) and decides whether to disclose it to consumers. She then sets a price p and consumers each decide whether to buy the product. We solve the game backward by comparing the manufacturer s profit levels in the disclosure and nondisclosure subgames. As a tie-breaking rule, we assume throughout the paper that a channel member chooses disclosure when it is indifferent between disclosure and nondisclosure. The Disclosure Subgame. Suppose that the manufacturer discloses the product s location. Without loss of generality, let y = 0. The utility of consumer (x, y) is then v p x 1 y, and the three demand scenarios are shown in Figure 1. Correspondingly, 2 Figure 1: Demand Scenarios in the Disclosure Subgame: Selling Direct v-p v-p Note: The shaded areas indicate demand for the product. The three panels above demonstrate that as v p increases, demand also increases. the manufacturer s profit is 14

16 π D = 4 27 v3 if 0 < v < 3, 4 1 (v )2 if 3 v < 7, 4 4 { 1 [ 6 + 4v + g(v)] 1 [ } 1 1v + 1g(v)] 2 if v 7, where g(v) = 21 12v + 4v 2 and D stands for disclosure. It is intuitive that the manufacturer s profit increases with her quality reputation. Interestingly, however, the market is never fully covered under disclosure: with full market coverage, the manufacturer would have to charge an extremely low price so that the marginal consumer who has the worst match with both the product and the store would still purchase, and this is never profitable in equilibrium. The result is consistent with our intuition that disclosure is a niche strategy for the manufacturer to target well-matched consumers. The Nondisclosure Subgame. When the manufacturer does not disclose the product s 1 location, expected product mismatch is the same for all consumers: (y 0) + 1 (1 y) = 2 2 1, y [0, 1]. Therefore, nondisclosure of product match information tends to make con- 2 sumer preferences more homogeneous and the demand more elastic. The utility of consumer (x, y) now becomes v p x 1 1. As a result, there is no demand if v < 1. For v 1, the manufacturer s demand is 2(v p 1 ) as consumers purchase decisions depend entirely 2 on their match with the store, and her profit is 2(v p 1 )p. In sum, the manufacturer s 2 maximum profit is π N = 0 if 0 v < 1 2, 1 (2v 8 1)2 if 1 v < 3, 2 2 v 1 if v 3 2. Comparing the manufacturer s profit in the disclosure and nondisclosure subgames, we obtain the following result (see all proofs in the Appendix). 15

17 Lemma 1 The manufacturer chooses disclosure iff her quality reputation is low (v 1.10). The intuition is the following: disclosure allows the manufacturer to charge a high price to well matched consumers, while nondisclosure tends to increase demand. When the manufacturer s quality reputation is weak, targeting a market niche is critical as the average willingness to pay is too low. As her reputation strengthens, it becomes attractive to sell across the board and nondisclosure allows the manufacturer to target the average, rather than the marginal, consumer. As a result, nondisclosure is the preferred strategy when the manufacturer s quality reputation is strong Selling through a Monopolistic Retailer Suppose now the manufacturer distributes her product through a monopolistic retailer who owns both stores. Similar to the consumers, the retailer has to learn the product s type through manufacturer disclosure. As before, the manufacturer first decides whether to disclose her product location and then sets a wholesale price w. Next, the retailer sets a final price p and consumers each decide whether to buy the product. As before, we compare the manufacturer s profit levels in the disclosure and nondisclosure subgames to obtain the reputation threshold for nondisclosure, and then compare this threshold to that under selling direct. 17 Lemma 2 When selling through a monopolistic retailer, a manufacturer discloses her product location less often (v 1.06) than when she sells direct (v 1.10). Lemma 2 suggests that, as before, there exists a reputation threshold for nondisclosure. This threshold decreases, however, as the manufacturer starts to sell through a monopoly retailer, making disclosure less likely to occur in equilibrium. Intuitively, when the manufacturer sells through a retailer, she has to share the total margin with the retailer, which 17 Expressions of the equilibrium price and profit in each subgame an be found in the proof of Lemma 2 in the Appendix. 16

18 makes the margin-driven disclosure strategy less attractive. On the other hand, nondisclosure makes demand more elastic and effectively limits retail markup. As a result, the manufacturer chooses nondisclosure more often Selling through Duopolistic Retailers Suppose now the manufacturer distributes her product through two retailers, each owning one of the two stores. Without loss of generality, suppose retailer A owns the store located at x s = 0 and retailer B owns the one located at x s = 1. The game remains the same as before except that the two retailers now choose their final prices simultaneously. To keep the analysis tractable, we focus on the symmetric equilibrium in which they choose the same price. 18 The Disclosure Subgame. Consider first the optimal retail prices in the disclosure subgame. Denote the wholesale price by w and the two retailers prices by p A D and pb D, the following lemma can be obtained from the retailers optimal-response functions. Lemma 3 In the disclosure subgame, the retailers optimal retail prices are p A D = p B D = v+2w if 0 v w < 3, 3 4 (v w 1 2 )2 + 3 if 3 v w < 3, v+w v+w if 3 2 v w < 5 2, 1 + w if v w 5 2. The retailers margin, demand, and profit all increase with the highest potential margin, v w. The two retailers are local monopolies when the highest potential margin, v w, is low. As this margin increases, more consumers are served in equilibrium, and the retailers start to 18 Interesting channel dynamics may occur when one retailer is more dominant than the other (Geylani et al. 2007) or when one retailer operates an online arm while the other does not (Ofek et al. 2011). 17

19 compete with each other. When choosing the optimal wholesale price w D, the manufacturer maximizes her profit given the retailers pricing strategies above. Lemma 4 In the disclosure subgame, the optimal wholesale price is w D = v if 0 < v < 9, 3 8 v 3 4 if 9 8 v < 19 16, v + 3.4( 13.7+v)(2.2+v) f(v) f(v) 1 3 if v < 5 2, v 3 if 5 v < 3, 2 2 ( ) v + 1 (v ) if v 3, where f(v) = v v v (5 + v) (3 + v)(6 2v + v 2 ). Correspondingly, her profit is πd M = v3 if 0 < v < 9, 8 1 (v 3) if 9 v < ( ) v w w D D (v w 2 2 D 1 2 )2 + 3 if 19 v < 5, (v 3) if 5 v < 3, w D ( v w D )( 9 4 v w D 2 ) if v 3. 16, The profit strictly increases with her quality reputation v. The top portion of Figure 2 demonstrates that retail competition intensifies and the total demand increases as the manufacturer s quality reputation strengthens. As before, the manufacturer never induces full market coverage when she chooses disclosure. The Nondisclosure Subgame. We now derive the manufacturer s equilibrium profit under nondisclosure. There are only two possible demand scenarios here: either the two retailers are local monopolies or they split and cover the entire market. Given a wholesale price w, 18

20 Figure 2: Demand Scenarios in the Disclosure and Nondisclosure Subgames Note: The shaded areas indicate demand for the product. As v increases, more consumers purchase the product in both the disclosure and nondisclosure subgames. the optimal retail price is p A N = p B N = 1 (v 1 + w) if 1 v w < 3, v 1 if 3 2 v w < 2, 1 + w if v w 2. As demand is always zero if v w < 1 2 (consumers willingness to pay cannot cover their expected mismatch), the optimal retail price is not well defined in this region. Given the optimal retail price above, the manufacturer decides whether to induce retail competition by charging a low wholesale price. Lemma 5 The optimal wholesale price is w N = 1 (v 1) if 1 v < 5, v 3 2 if v

21 The manufacturer s profit is, correspondingly, πn M = 0 if 0 < v < 1 2, 1 (v )2 if 1 v < 5, 2 2 v 3 2 if v 5 2. Comparing the manufacturer s profit under disclosure and nondisclosure, we find that the reputation threshold is the same as before: v = This result may appear surprising at first, but a closer look reveals that it occurs only because the retailers are not competing at this quality level: they remain local monopolies in both the disclosure and nondisclosure subgames at v = Essentially, as consumers assign the same weight to store and product mismatch, the powerful retailers find it optimal to stay local monopolies. To identify the impact of downstream competition on upstream disclosure, we next allow the relatively weight of store mismatch to decrease. 3.2 Flexible Weights on Product and Store Mismatch We now consider the general setup in which t x and t y can be different. To ease interpretation, we rewrite the consumers utility function so that results can be discussed in terms of the relative importance of quality reputation and store mismatch: u(x, y) U(x, y) t y = v p t x x t y y t y v p t x y, where v = v t y p = p t y is the relative importance of quality reputation vis-à-vis product mismatch, is the normalized price, and t = t x ty is the relative importance of store mismatch. Without loss of generality, we normalize the importance of product mismatch t y to 1 so that v = v, p = p and t = t x. When t y is different from 1, the consumer s utility, as well as the channel members margins and profit, can all be obtained by multiplying the current 20

22 equilibrium outcomes by t y, and results on prepurchase disclosure would remain the same. One way to interpret t is to think of it as the transportation cost parameter in the industrial organization literature (Tirole 1988), as a higher transportation cost increases the relative weight that consumers put on their distance from a store. The lower is t, the less consumers care about the difference between retailers, and the more intense is downstream competition. We assume t (0, 1] so that retailers may find it optimal to compete in equilibrium. As a first step, we examine how manufacturer disclosure changes with t. Proposition 1 Suppose the manufacturer sells through two retailers. As store mismatch becomes more important, the manufacturer is more likely to disclose her product type. Two effects drive this result. First, consumers net willingness to pay for the product, v t x y, decreases as t increases. As the willingness to pay becomes lower, the manufacturer has more incentive to use disclosure to increase her margin. Second, consumer preferences become more homogeneous as t decreases. In the extreme case of t = 0, for example, all consumers have the same willingness to pay under nondisclosure and the two retailers enter Bertrand competition. As demand becomes more elastic, nondisclosure becomes more effective in expanding demand. To elicit the impact of downstream retailers on manufacturer disclosure, we solve the game for the other two channel structures and summarize the comparison below. Proposition 2 The manufacturer s reputation threshold for nondisclosure is the lowest when she sells through a monopolistic retailer. When 0 < t 0.85, reputation threshold is the highest with duopolistic retailers and when 0.85 < t 1, the threshold is the highest with selling direct. The first part of the proposition suggests that exclusive dealing tends to minimize manufacturer disclosure. Across the three channel structures, double marginalization is the most 21

23 severe when the manufacturer sells through a monopolistic retailer, and the manufacturer has the strongest incentive in this case to use nondisclosure to limit retail markup. For an example on the implication of this result, consider a manufacturer of cat food who sells her product exclusively on Amazon. If she switches to selling directly on her own website, our result suggests that she is more likely to disclose product match information (e.g., cats of what breeds, sizes and ages would enjoy her product the most) as without Amazon, the manufacturer can now fully reap the margin-enhancing benefit of disclosure. Compared to selling direct, the manufacturer incurs a loss in both her margin and demand when retailers are present. When the transportation cost is low, retailers compete heavily in price and the manufacturer barely incurs any loss in her demand. As she lowers the wholesale price to induce better market coverage, the reduction in her margin becomes more significant than the reduction in her demand, and disclosure in this case could help restore her margin. As a result, she chooses disclosure more often than when she sells direct. When the transportation cost is high, the retailers charge a high markup and the reduction in the manufacturer s demand becomes more significant. As nondisclosure helps expand demand, she chooses it more often than when she sells direct. In reality, the magnitude of transportation cost depends on many factors. The cost may be lower, for example, when consumers shop online and do not have to physically travel to the store. Under this interpretation, the magnitude of t would depend on the penetration of ecommerce for the particular product category. 3.3 Retailer Disclosure of Product Match Information Compared to the manufacturer, sometimes retailers are in a better position to provide product match information. Bestbuy, for example, labels itself the ultimate showroom and offers in-store demonstrations of many electronic products. Car dealers often learn consumers preferences on spot and offer individual consultation regarding their match with a 22

24 particular car. As mentioned before, retailers could also circulate their own pictures of the products they carry. For situations like these, we are interested in how retailers optimal disclosure strategy may differ from that of the manufacturer. We set up the retailers disclosure game as follows. First, the two retailers 19 learn the product s location and choose whether to disclose it to consumers. The manufacturer then sets the wholesale price. Next, retailers simultaneously set retail prices and consumers decide whether to purchase one unit of the product. An important feature of the timeline is that the disclosure decision is made before pricing decisions. The assumption reflects our observation that retailers often need to commit to a particular disclosure technology (e.g., virtual try-on, demo versions, professional shooting of product pictures) before wholesale and retail prices are chosen. To acknowledge the fact that consumers often engage in comparison shopping across retailers, we also assume that disclosure from a single retailer is sufficient for all consumers to learn the product s location. We start the analysis with the benchmark case of t = 1 and obtain the following result. Lemma 6 The retailers chooses nondisclosure when the manufacturer s quality reputation is in an intermediate range (1.28 < v < 3.77) and disclosure otherwise. Based on our analysis in Section 3.1.3, the manufacturer in this case chooses disclosure if and only if 0 < v < 1.10, which contrasts sharply with the retailers bell-shaped disclosure strategy in Lemma 6. We explain the difference in the channel members optimal disclosure strategies by looking at different ranges of the quality reputation. First, when quality reputation is weak (0 < v 1.10), all channel members prioritize the need to secure positive demand from well-matched consumers. As a result, they all prefer disclosure. As quality reputation increases (1.10 < v 1.28), the optimal demand under nondisclosure begins to exceed that under disclosure (see Figure 3). The retailers margin is higher under disclosure, while the manufacturer s wholesale prices are close in the 19 Analysis with a monopolistic retailer yields the same qualitative conclusions. 23

25 two subgames. As a result, the retailers prefer disclosure while the manufacturer prefers nondisclosure. Figure 3: Retailer Margin, Demand and Profit under Disclosure and Nondisclosure v v v Note: The dashed curves correspond to market outcomes in the nondisclosure subgame, and the solid curves correspond to those in the disclosure subgame. The kinks in the curves correspond to corner solutions: the second and fourth demand scenarios under disclosure in Figure 2, and the third scenario under nondisclosure. As quality reputation further increases (1.28 < v < 3.77), the manufacturer and retailers all prefer nondisclosure, as the increase in demand starts to outweigh the loss in their margins. Finally, when quality reputation is very strong (v 3.77), the market is almost completely covered in both subgames. The retailers could obtain a significant margin under disclosure while the manufacturer has to cut the wholesale price significantly for retailers to compete for the ill-matched consumers. Under nondisclosure, on the other hand, the manufacturer 24

26 can extract most of the consumer surplus as retailers compete heavily in price given the elastic demand curve. As a result, the retailers in this case again prefer disclosure while the manufacturer prefers nondisclosure. The following proposition shows that the retailers bell-shaped disclosure strategy carries over to the more general setting with flexible weights on product and store mismatch. Proposition 3 When t [0.043, 1], the retailers choose nondisclosure for an intermediate range of quality reputation, and disclosure otherwise. When t (0, 0.043), they always choose disclosure. Figure 4 illustrates the proposition above. The intuition for the bell-shaped strategy is similar as before. When the transportation cost is extremely low, retailers compete fiercely in price and disclosure helps them restore the margin by making demand more inelastic. Proposition 3 has important implications for mandatory disclosure policies (e.g., labeling requirements for textile and food) and voluntary word of mouth among consumers (e.g., third-party review and discussion forum sites). As channel members have different disclosure incentives, these disclosure initiatives could affect channel members in different ways. When the manufacturer s quality reputation is high, they may benefit retailers and hurt the manufacturer. When her quality reputation is mediocre, they may hurt all channel members. When her quality reputation is low, they may benefit all channel members. 4 An Application: Web-Only Brands To demonstrate the managerial implications of the model, we collect data on 1, 434 clothing items from 53 web-only fast-fashion brands in India, including the price and number of pictures posted on each item s brand site and two leading fast-fashion online retailers in India, Myntra.com and Jabong.com (Myntra and Jabong henceforth). We choose this application 25

27 Figure 4: Reputation Thresholds for Retailer Disclosure v t Note: The vertical segment in the top curve corresponds to a corner solution (the fourth scenario in the top panel of Figure 2) in which the manufacturer makes the same profit in both subgames. for several reasons. First, our main model suits product categories in which individual match is important and often learned through prepurchase disclosure. The fast-fashion industry, besides its own economic significance and fast growth, fits our model well. The value of a clothing item to a consumer depends critically on the match and consumers often rely on product pictures to estimate this match. The relatively low price point of clothing items in our data (INR 1,338 or USD 21) also means that consumers would often choose to keep a product even if the realized match is less than ideal (Anderson et al. 2009b), as they may 26

28 need to incur significant costs when returning a product. 20 Second, we focus on web-only brands that do not sell in brick-and-mortar stores so that pictures are the consumers primary source of match-related product information. While the ideal empirical setup would be one in which we can exogenously vary the channel structure for a brand and see how it would change the number of pictures accordingly, it is impossible to conduct this experiment in reality. As a second-best alternative, we compare the numbers of pictures for the same item across different distribution channels. If the manufacturer offers, for example, 4 pictures on its own site for the item but 6 pictures on the retailer s site, we would take this as evidence that the manufacturer has a stronger incentive to disclose product match information when she sells through the retailer. The ability to conduct the comparison within an item helps us control for the impact of unobserved brand or item characteristics on disclosure. Finally, Myntra and Jabong are leading Indian e-tailers that specialize in fast fashion. The two companies compete head to head and are similar in many ways. 21 With an annual revenue of INR 4.42 billion (USD 69.0 million) in 2014, Myntra partners with over 1,000 leading fashion and lifestyle brands in the country to offer a wide range in latest branded fashion items. 22 Its biggest competitor, Jabong, has an annual revenue of INR 4.38 billion (USD 68.4 million) in 2014 and carries more than 1,500 brands and over 150,000 styles. While many product pictures on the two retailers websites are offered by the product s 20 A summer dress in a fast-fashion chain store such as Zara or H&M costs INR 2,135 on average, according to Numbeo ( accessed in June 2015). While both retailers and many brands in our data offer the option to return a product, most of the time a consumer has to initiate the return by calling the customer service or submitting a request online, put together a return information sheet with the order number, repack the product with this sheet, and either schedule a pick up or ship the item back. See Myntra and Jabong s return policies at https: //secure.myntra.com/faqs and both accessed in June The option to return a product is also further discussed in Section See an interesting article on the competition between the two dominant e-tailers at forbesindia.com/article/cross-border/myntras-big-leap-forward/34871/1, accessed in June See -lag-myntra.html, accessed in June

29 manufacturer, there are also some pictures that are taken by the retailers with their own models. The setting hence offers us a unique opportunity to look at both the manufacturer s and retailers choices of pictures. Our model suggests that brands that sell through an exclusive retailer should be less likely to choose disclosure than when they sell directly to consumers. 23 Therefore, we expect such brands to post more pictures, on average, for the same item on their own sites than on the retailer site. Similarly, we expect brands that sell through both retailers to post fewer pictures for an item on their own sites than on a retailer site. Finally, when the retailers are using their own pictures, we expect more pictures to be posted for an item on the retailer sites than on the item s own brands site, as our model suggests that the retailers should have strong disclosure incentives given the intense competition (low t). Although our model does not formally consider the possibility of the manufacturer selling directly and through retailers at the same time, the predictions should hold as long as there exist consumers who would shop only on the brands own sites. In the extreme case that consumers always comparison shop across all the sites, no retail margin is possible even when the manufacturer sells only through one retailer, which is not what we observe from the data. 24 To collect data, we first compile a list of web-only brands by looking at all brands carried by Myntra or Jabong, and then select brands that meet two conditions: (1) the brand is sold exclusively through online channels, which can be verified by statements on the brand s own e-commerce site or its official social media outlets; (2) the brand sells directly to consumers on its own website. For a brand that is carried by only one of the two retailers, we look for items that are offered on the brand s own site as well as the retailer site, and search the Internet to make 23 The range of quality reputation for disclosure in equilibrium is smaller under exclusive dealing than that under selling direct. Therefore, for each item, the likelihood of disclosure is higher under selling direct. 24 Jabong, Myntra and many brands in our data offer free shipping for purchased merchandise, so a consumer s total cost of buying a product is simply its price on the site. 28

30 sure that the item is not carried by e-tailers other than Myntra and Jabong. For each of these items, we record its price and number of pictures on both the brand s site and the retailer site. For brands that are carried by both retailers, we look for items that are offered on all three sites (brand s site and the two retailer sites) and record each item s price and number of pictures on each site. As there can be many qualified items for certain brands, we limit our selection to the 50 random items for each brand. This procedure ensures that our results are not driven by a few dominant brands that offer a huge selection on their own sites as well as on the retailer sites. Following this procedure, we are able to identify 7 brands carried only by Jabong, 8 brands carried only by Myntra and 38 brands carried by both retailers. 25 There are a total of 1,434 items in our data. For each item, we look across all the sites to identify the source of its pictures on each site. Table 1: Summary Statistics of Web-Only Brands Variable Obs. Mean St. Dev. Min Max # Pictures on Brand Site 1, # Pictures on Myntra 1, # Pictures on Jabong 1, Price on Brand Site 1,434 1,338 1, ,930 Price on Myntra a 1,236 1,261 1, ,930 Price on Jabong 1,179 1,425 1, ,930 a The average price on Myntra is lower than that on the brand sites because the items are not the same. For the 1,236 items that are offered on Myntra, the average price on the brand sites is 1,244 INR, lower than the average price of the same items on Myntra. Table 1 presents summary statistics of clothing items in our data. As one can see, there are a total of 1,434 items with an average price of INR 1,338 (USD 21) on their brand sites. 25 The list of brands is available upon request. One brand that is carried by Myntra (Wear Your Opinion) has items with manufacture pictures as well as items with Myntra pictures. Four brands that are carried by both retailers (MEIRO, Monte Carlo, Uptown Galeria, Famella) also have items with manufacturer pictures on both sites and items with retailer pictures on both sites. 29

31 While the average number of pictures and price is similar across the different selling channels, there is significant variation in both of these variables across items. We compare an average item s number of pictures and price across the different sites in Table 2. Consistent with our observation of the intense competition between Myntra and Jabong, the two retailers are charging the same price as the brand site for items carried by both retailers (p > 0.01 for all price comparisons in 2-retailer scenarios in Table 2). On the other hand, a retailer often charges a higher price than the brand site for items carried by one retailer (p < 0.01 for three out of the four price comparisons in 1-retailer scenarios in Table 1). The only exception occurs for Myntra for items with brand pictures. With only 18 observations, the p-value in this case is 0.04 and the average price on Myntra is higher than that on the brand sites. Also consistent with the model predictions, Table 2 shows that when an item is carried by only one retailer and that retailer uses its brand pictures, there are more pictures available on the brand site (p < 0.01 for both retailers). On the other hand, when an item is carried by both retailers and they both use pictures from the brand, there are fewer pictures available on the brand site (p < 0.01 for both retailers). Finally, when retailers use their own pictures, the item on average has a higher number of pictures on the retailer site, regardless of whether the brand is carried by one or both of the retailers (p < 0.01 for all four comparisons). While the results are highly consistent with our predictions, our analysis is not without limitations. For example, the list of web-only brands comes from the two dominant retailers so if a web-only brand does not sell through either retailer, we would have missed it. Also, brands may differ on factors such as their visibility on social media, advertising, and other factors that are not captured in our data. Nonetheless, our goal here is to demonstrate the managerial relevance of our model and show that prepurchase disclosure indeed seems to vary with the structure of the distribution channel. Through this simple application, we hope to inspire future empirical work that examines prepurchase disclosure more comprehensively. 30

32 Table 2: Number of Pictures and Product Price on Brand and Retailer Sites Scenario R #Items #Brands BPic b RPic p-value c BPrice RPrice p-value BP, 1R a M J BP, 2R RP, 1R M J M J RP, 2R M J a BP (RP): brand (retailer) pictures are used on retailer sites. 1R (2R): brand is carried by 1 (2) retailer(s). b BPic (RPic): number of pictures on brand (retailer) site. BPrice (RPrice): price on brand (retailer) site. c All p-values are from paired, two-tailed t-tests. 5 Discussion of Model Assumptions 5.1 Product Returns and Prepurchase Disclosure While product returns are not allowed in our main model, it is common for sellers to accept returns for a period of time after the product is purchased. As pointed out in the literature (e.g., Anderson et al. 2009a; Shulman et al. 2009), consumers often have to incur different forms of cost when returning a product: they may have to make a trip to the store, pay for shipping, schedule and wait for pick-up, and in some cases pay a hefty restocking fee. If return costs are formidable compared to the value of the product itself (e.g., magazines, fast-fashion clothing) or the product is not returnable (e.g., vacation packages, spa services, meals), our analysis remains unchanged and the predictions are the same as before. When returns are easier, it becomes better for consumers to return an ill-matched product than keeping it. This may occur, for example, with durable products such as furniture, mattresses and household electronic appliances. One may wonder, in this case, if prepurchase 31

33 disclosure would still play a significant role in the consumers purchase decisions. In theory, if the cost to return a product is zero, then a consumer could always learn the type of the product before committing to a final purchase, and even the nondisclosure decision would become equivalent to the disclosure decision. In reality, however, returns almost always incur positive costs to consumers. To highlight the impact of product returns on our results, we analyze below a situation where return costs are small but positive. To focus on the match-revealing effect of product returns, we abstract away from sellers considerations of the operational costs associated with returns and assume that returned products can be handled efficiently (e.g., a returned product can be easily resold as a new product). Incorporating positive operational costs of returns would, intuitively, lower the channel members profits under nondisclosure and make disclosure more attractive. 26 Formally, consider the main model with flexible weights on product and store mismatch in Section 3.2, and suppose that a consumer incurs cost h 0 when returning a product, where h captures the cost of hassle. The disclosure subgame would remain the same as in our main model, while the nondisclosure game changes in the following manner. Consider a consumer with y 1 2 without loss of generality, as demand is symmetric around y = 1. A good match is realized if the product type turns out to be y 2 p = 0, and a bad match is realized if y p = 1. A consumer in this case falls in one of three scenarios. First, he would gain positive utility from the purchase even if the product turns out to be a bad match: v p t x (1 y) > 0. In this case he buys the product and never returns it. Second, the consumer would gain negative utility from the purchase even if the product is a good match: v p t x y < 0. in this case, he does not buy the product. Third, the consumer gains positive utility if the product is a good match, and negative utility otherwise. Denote his utility upon a bad match by z v p t x (1 y). If z < h, he returns 26 We also abstract away from exchanges and restocking fees as these factors are specific to product returns and outside the scope of the current paper. 32

34 the product, which is consistent with Anderson et al. (2009b) in that a higher price tends to trigger more returns. Otherwise, he is stuck with a product that he has to keep. A forward-looking consumer can anticipate these decisions and buys the product if and only 1 if his expected utility from a trial is positive: (v p t x y) + 1 max{z, h} One can easily verify that when h = 0, nondisclosure becomes equivalent to disclosure as all consumers can costlessly learn the product type before committing to the purchase. When h > 0.5, we are back to the main model as none of the consumers would ever return a product. As h decreases, product returns become a real possibility. Consistent with the product-returns literature (e.g., Anderson et al. 2009a), the option to return a product in our setting may either increase or decrease final demand. Lemma 7 Suppose the manufacturer sells directly to consumers and chooses not to disclose the product s type. Allowing product returns increases final demand if the demand without returns is lower than.5. Essentially, the option to return a product expands initial demand by putting a cap on the potential loss for consumers, while the realized returns from mismatched consumers decrease the final demand. When initial demand without returns is low, the manufacturer s quality reputation is low and the dominant effect of returns is to expand demand. On the other hand, when initial demand is already high, the manufacturer s quality reputation is high and many consumers would try the product even without the return option. The dominant effect of returns in this case is to give ill-matched consumers an option to withdraw from the purchase. Therefore, allowing product returns would increase final demand if and only if the initial demand level is low. It is interesting to explore what happens when returns are almost costless to the consumers, as in this case the match-revealing effect of product returns is the strongest. To answer this question, we allow the consumer s cost of return to approach zero, and charac- 33

35 terize the manufacturer s optimal disclosure strategy. 27 Proposition 4 Suppose a consumer can return the product at the cost of h 0 +. (a) Nondisclosure increase total channel profit if and only if demand under disclosure is higher than.5. (b) The manufacturer s reputation threshold for nondisclosure increases with t under all three channel structures. (c) The threshold is the highest when the manufacturer sells through a monopoly retailer and the lowest when she sells directly to consumers. Proposition 4(a) suggests that, when compared to the full disclosure benchmark, having consumers learn their match through trying the product can be a double-edged sword for the seller. On one hand, for consumers who decide to try the product, there is a positive probability for them to be stuck with an ill-matched product, which may help increase final demand. On the other hand, the uncertainty of match prior to purchase means that the price needs to be lowered in order to motivate consumers initial purchases. When demand uner disclosure is high (low), the manufacturer s quality reputation is high (low), many (few) consumers would be interested in the product, the demand (price) effect dominates and nondisclosure leads to greater (smaller) total channel profit than disclosure. Proposition 4(b) suggests that, an increased relative weight on store mismatch (higher t) induces manufacturer disclosure. As before, consumers net willingness to pay for the product becomes more heterogeneous when retailers are more differentiated, which makes the demand-expansion effects of nondisclosure less significant. Proposition 4(c) shows that the effect of channel structure on prepurchase disclosure changes significantly when product returns are easy. When returns are easy, using a distribution channel always makes disclosure more attractive to the manufacturer, regardless of the intensity of downstream competition. The difference between the results here and 27 It would be nice to solve the generalized model with a fully flexible h. However, the model becomes intractable in this case as consumers are differentiated along two dimensions and demand is not differentiable everywhere with respect to price. 34

36 those from the main model stems from the fact that when return costs are negligible, the elasticity of demand barely changes with the disclosure decision. As a result, the manufacturer s margin stays almost the same and the main effect of disclosure comes from changes in her demand. Given Proposition 4(a), demand under disclosure has to reach.5 in order for nondisclosure to be profitable. Due to double marginalization, it is the easiest for the manufacturer to reach this demand threshold when she is selling direct. When consumers cost of return h is high, on the other hand, the elasticity of demand is significantly higher under nondisclosure. As a result, the price under nondisclosure is significantly lower than that under disclosure, and the disclosure decision has to be made by considering changes in both demand and margin. As the intensity of downstream competition directly affects both of these factors, the impact of channel structure on manufacturer disclosure becomes more delicate. Overall, Proposition 4 suggests that predictions from our main model rely on the costs of return being relatively high, and are more applicable to product categories such as magazines and fast-fashion clothing, or services. 5.2 A Continuum of Product Types For tractability of the analysis, our main model assumes that there are two symmetric product types. As a result, the equilibrium disclosure decision is not a function of the actual product type. In a more general setting with a continuum of product types, the disclosure decision may become a function of the actual product type. Formally, suppose that the product s type y p is uniformly distributed on [0, 1] and keep other aspects of the baseline model in Section 3.1 unchanged. A first observation of this new setting is that there may exist multiple Perfect Bayesian Equilibria. In particular, there always exists a separating equilibrium in which every type of manufacturer discloses her type and charges the optimal price under disclosure. In this equilibrium, consumers are able to infer the product type whenever the manufacturer deviates to nondisclosure, making the 35

37 deviation profit for this type the same as or even lower than its equilibrium profit. There may exist other equilibria in which some types of the manufacturer pool together by choosing nondisclosure. Theoretically speaking, a nondisclosing manufacturer could charge different prices depending on her actual product type, so that the price could serve as a signal of the product type. All these nondisclosing types, however, must be earning the same profit, as otherwise a low-profit type could profitably deviate to charging a high-profit type s price. Given the equal profit, we focus on the highest-profit equilibrium in which all nondisclosing types charge the same price, which maximizes their profit given the consumers belief. Given that the profit under disclosure decreases with the distance between the product and the central location, y 0.5, and that all nondisclosing types earn the same profit, there exists an f [0, 0.5] so that the manufacturer chooses disclosure when y p (f, 1 f) and nondisclosure otherwise. 28 While the generalized model is too complex to be analytically tractable, we can find f through numerical analysis for the case of selling direct. In particular, for a given level of quality reputation v > 0, we can find f by plotting two profit curves. The first curve plots how profit under disclosure changes with location l, and the second curve plots the profit under nondisclosure when firms in [0, l] [1 l, 1] choose nondisclosure and charge the corresponding optimal price. The intersections of these two curves would then give us the values of f and 1 f. We replicate this procedure for different levels of v and see how f changes with v. As shown in Figure 5, f increases with v, which means that more types choose nondisclosure as quality reputation increases. As f approaches.5, the manufacturer almost always chooses nondisclosure in equilibrium. These results are consistent with our main model in that prepurchase disclosure reduces with the manufacturer s quality reputation A similar result is shown in Sun (2011). 29 When the manufacturer sells through a distribution channel, even the numerical analysis becomes intractable, although we expect the intuition behind our main results to remain robust. 36

38 Figure 5: Equilibrium Disclosure Strategies with a Continuum of Product Types f v Note: As the manufacturer s quality reputation v increases, f also increases, meaning that the range of nondisclosing types [0, f) (1 f, 1] enlarges in equilibrium. 6 Conclusion This paper explores truthful, costless prepurchase disclosure of product match information in the context of a distribution channel. Our model suggests that optimal disclosure indeed depends on whether the manufacturer distributes her products through retailers and the intensity of downstream competition. When the manufacturer sells through only one retailer or two differentiated retailers, she is less likely to choose disclosure when compared with selling direct. On the other hand, when the manufacturer sells through two competitive retailers, she is more likely to choose disclosure when compared with selling direct. Interestingly, when retailers are in charge, they often choose disclosure for products with 37

39 either a very high or very low quality reputation. With intense downstream competition, in particular, the retailers may choose disclosure for all levels of quality reputation. In general, our results suggest that retailers may benefit more from an informative marketing campaign than the manufacturer when the product s quality reputation is high, or when downstream competition is intense. We identify a unique setting, Indian web-only fast-fashion brands, and collect primary data to find evidence for the model. Through comparing the numbers of pictures across different channels, we find that a brand would provide fewer pictures to a retailer than it has on its own site if the item is carried only by that retailer. On the other hand, a brand would provide more pictures to the retailers than it has on its own site if the item is carried by both retailers. When retailers use their own pictures for an item, they tend to use more pictures than what is available on its brand site. Notably, the possibility of easy product returns could change our results qualitatively. In particular, the manufacturer in this case may have the strongest disclosure incentives when selling through a monopolistic retailer and the weakest incentives when selling direct. Our analysis hence suggests that manufacturers should be mindful of both the prevalence of product returns and the structure of the distribution channel when crafting their prepurchase disclosure strategies. 38

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42 Appendix Proof of Lemma 1. Consider first the disclosure subgame. Start with the case where demand is lower than 1 4. The demand for the product, under price p, is (v p)2. Hence, the profit is maximized at p = v 4, and the equilibrium profit is 3 27 v3. The condition on quality for the demand to fall into this region is v 3. Next, consider the case where demand is 4 in ( 1 4, 3 4 ], the demand in this case is v p 1 4. The profit is maximized at p = 1 2 (v 1 4 ), and the equilibrium profit is 1 4 (v 1 4 )2. The condition on quality is 3 4 < v 7 4. When demand is in ( 3 4, 1], the demand can be written as 1 ( 3 2 v + p)2. The optimal price is 1 ( 6 + 4v v + 4v 6 2 ), and the optimal profit can be obtained by substituting the optimal price into the demand expression. Whenever v > 7, the equilibrium falls into this 4 demand scenario. Under nondisclosure, if the market is not completely covered, the demand is 2(v p 1 2 ), the optimal price is 1 4 (2v 1) and the equilibrium profit is 1 8 (2v 1)2. The condition on quality for is v 3. Otherwise, if v > 3, the market is completely covered, and 2 2 the optimal price and profit are both v 1. Given the profit levels, the manufacturer finds it optimal to disclose product information if and only if v Proof of Lemma 2. Consider the disclosure subgame. Start with the case when demand is strictly lower than 1 4. The retailer s profit function is (p w)(v p)2 and the optimal price is thus p = v+2w 3. Substituting this optimal price into the manufacturer s profit function, which becomes w (v v+2w 3 ) 2, we obtain that the manufacturer would charge w = v 3 and her equilibrium profit is v3. The condition on quality for demand to fall into this scenario can be derived, by substituting in the optimal retail and wholesale prices into the demand, as v < 9. Similarly, when 9 v < 5, the optimal retail price is v 1, the wholesale price is v 3, and the manufacturer s profit is 1(v 3). When 5 v < 13, the optimal retail price is v+w 2 1 8, the wholesale price is v 2 1 8, and the manufacturer s profit is 1 8 (v 1 4 )2. When 13 4 v < 35 8, the optimal retail price is v 1, the wholesale price is v 7 4, and 41

43 the manufacturer s profit is 3(v 7). Finally, when v 35, the optimal retail price is v + w + 1 (v w )2 + 3 and the wholesale price and the manufacturer s profit can be obtained by substituting this price into the demand function. The manufacturer never induces complete market coverage, by a similar logic as that in the proof of Proposition 1. Consider now the nondisclosure subgame. When the market is not fully covered, demand is 2(v 1 2 p), and the optimal retail price is 1 2 (v w). Plugging this price into the demand and writing out the manufacturer s profit, we obtain that the optimal wholesale price is 1 2 (v 1 2 ). The equilibrium profit for the manufacturer is hence 1 4 (v 1 2 )2. The condition for incomplete market coverage is v < 5. When v 5, the market is fully covered, 2 2 the retailer s equilibrium price and profit is v 1, and the manufacturer s profit is v 3 2. Under complete market coverage in the nondisclosure subgame (v > 5 ), we know that 2 v w N = 3 2, while in the highest demand scenario in the disclosure subgame (v > 35 8 ), v w D > 3 2. Therefore, when v > 35 8, w D < w N. Since both wholesale price and demand are higher under nondisclosure for the manufacturer, her profit is higher under nondisclosure. We can numerically compare the profit levels under disclosure and nondisclosure for the other regions of quality. From this comparison, we can see that the manufacturer prefers to disclose product information if and only if v Proof of Lemma 3. Consider first the case where the two retailers are local monopolies. Suppose that, without loss of generality, the product is located at y = 0. A consumer (x, y) would buy the product from retailer A (located at x = 0) if v x y p A 0, which is equivalent to x+y v p A. As the density of consumers is one in the unit square, demand for retailer A is 1 2 (v pa ) 2. Therefore, retailer A s profit is 1 2 (pa w)(v p A ) 2, and the optimal retail price is p A D = 1(v + 2w). By symmetry, 3 pb D = 1 (v + 2w). The corresponding demand 3 of each retailer, at this optimal price, is 2 9 (v w)2. The resulting profit is 2 27 (v w)3, which increases with the total potential margin, v w. To ensure that the two retailers remain local monopolies, we need the demand for each retailer to be less than 1 8, which implies v w <

44 Suppose now that the two retailers start to compete and market demand falls into the second scenario Figure 6. Figure 6: Retail Market with Wholesale Price w D v-w In this scenario, given the retail price of retailer B, the indifferent consumer who expects ( ) p zero utility from a purchase with either retailer is (x, y) = B p A +1, v p A pb p A ( ) Therefore, retailer A s demand is pb p A +1 2v 2p A pb p A +1 and his profit is (p A w) 4 2 ( p B p A v 2p A pb p A +1 2 ). Equating the first-order derivative of this profit to zero, ensuring a negative second-order derivative, and then equating p A to p B, we obtain that the optimal retail prices are p A D = pb D = 3 + v+w (v w ) At this price, the demand for each retailer is v w (v w 1 2 )2 + 3, and the profit is ( v w 1 ) ( (v w 1 v w ) ) (v w ) The retailer s margin, demand and profit all increase in v w. For the demand to fall into this scenario, we need 3 4 v w < 3 2. When the competition gets more intense and demand falls into the third scenario in [ ] Figure 6, given p B, retailer A s demand is 2(v p A ) pb +1 p A pb +1 p A 1(v pa 1) 2. Multiplying this demand with the retailer s margin, setting the first-order derivative to zero, and then equating the two retailers prices, we find the optimal prices p A D = pb D = v+w

45 The corresponding demand of each retailer is 1 2 (v pa D ) (v pa D ) 5, which increases with 8 v p A D and thus with v w. For the demand to fall into this region, we need 3 2 v w < 5 2. Since the retailers margin also increases with v w, their profit also increases with v w. Finally, when v w 5, all consumers purchase a unit of the product and demand 2 falls into the last scenario of Figure 6. The retailers charge 1 + w to consumers, and have a demand of 1 2 each. Their profit is also 1 2. Proof of Lemma 4. Start with a high level of product quality v. The manufacturer can induce any of the four possible retail market scenarios discussed above. If she decides to induce complete market coverage, given the retail prices obtained earlier, the wholesale price must satisfy v w 5. The highest profit the manufacturer can get in this scenario 2 is hence w 4 = v 5 2. If the manufacturer induces second scenario in Figure 6, the wholesale price must satisfy 3 v w < 5. The manufacturer s profit is w [ (v p A 2 2 D )2 + 3(v p A D ) 4] 5, where p A D is given in Lemma 3. There is always an interior w that maximizes this profit when v 3, which ( ) is w 3 = v + 1 (v ) Whenever this interior solution exists, it brings the manufacturer a higher level of profit than under complete market coverage. Therefore, w 4 never occurs in equilibrium when v 3. When 3 2 v < 3, this interior solution does not exist; instead, there is a corner solution that corresponds to the boundary between the second and third scenarios in Figure 6, w 23 = v 3. The corresponding total demand at this 2 corner solution is 3, and the manufacturer s profit is 3(v 3 ). The manufacturer s profit with this corner solution is higher than that under w 4 whenever both solutions can be sustained. Therefore, w 4 and the corresponding complete market coverage never occur in equilibrium. If the manufacturer induces the second scenario in Figure 6, 3 v w < 3. The optimal 4 2 wholesale price can be obtained by setting the first-order derivative of the manufacturer s profit to zero: w 2 = v + 3.4( 13.7+v)(2.2+v) f(v) f(v), where f(v) = (976, , 768v 301, 056v 2 8, 192v 3 +85, 134(5+v) (3 + v) (6 2v + v 2 )) 1 3. The corresponding 44

46 ( ) v w manufacturer profit is 2w (v w ) By imposing the requirement above on v w, we find that the interior solution can be obtained when v < 5 2. When v 5 2, manufacturer profit is the highest if she charges the corner solution w 23 and when 4 v < 19, the manufacturer s profit is the highest if she induces the boundary case between 3 16 the first and second scenarios in Figure 6. In this case, the wholesale price is w 12 = v 3 4, the total demand is 1 4, and the corresponding manufacturer profit is 1 4 (v 3 4 ). If the manufacturer induces the first demand scenario in Figure 6, in which the two retailers are local monopolies, the interior solution is w 1 = v. The corresponding total 3 market demand is v2, and profit is v3. This solution is feasible when the quality is low, 0 < v < 9. When 9 v < 19, the manufacturer finds it more profitable to charge the corner solution w 12. We next compare manufacturer profit at all the attainable, scenario-wise optimal wholesale prices for different ranges of quality. The two regions of quality in which there is more than one optimal price are 4 3 v < 9 8 and 3 2 v < 5 2. In the first region, both w 1 and w 12 are feasible but the manufacturer s profit is higher at w 1. In the second region, both w 2 and w 23 are feasible but the manufacturer s profit is higher at w 2. Unsurprisingly, whenever an interior solution exists, it is more profitable than a corner solution. Putting all quality ranges together, we obtain Lemma 2. Proof of Lemma 5. Consider first the optimal retailer prices. With local monopolies, the demand for each retailer is v p A 1 2 and a retailer s profit is (pa w)(v p A 1 2 ). Maximizing this profit, we obtain that the optimal retail price is p A N = 1 2 (v w). For the two retailers to remain local monopolies, we need the equilibrium demand to be positive and less than 1 2, which implies 1 2 v w < 3 2. When the two retailers compete with each other, retailer A s profit becomes (p A w) 1 2 (1 + pb p A ), 45

47 and her optimal response is p A = 1 2 (1 + pb + w). Given p A = p B, the optimal price in this case is p A N = pb N = 1 + w. For the two retailers to compete and cover the entire market, consumers located right in the middle of the two retail stores need to expect positive utility from the purchase: v p A Putting in the optimal retail price above, this condition reduces to v w 2. When 3 2 v w < 2, there is no interior solution for either scenario above and we arrive at corner solution where the middle consumers have exactly zero utility: v p A 1 = v p B 1 = 0, which implies p A N = pb N = v 1. Taken together, we can obtain the optimal retailer prices as presented in the text. Given the optimal retail price, there is no retail competition if v w < 3 2 and the manufacturer s profit in this case is w(v 1 2 w). The interior solution for the optimal wholesale price is w N = 1(v 1) and the condition on v w implies v < 5. At this optimal price, manufacturer profit is 1 4 (v 1 2 )2. With complete market coverage, on the other hand, we can obtain that the optimal wholesale price is w N = v 3 and the corresponding manufacturer 2 profit is v 3 2. Proof of Proposition 1. Consider the first scenario under disclosure in which the two retailers are local monopolies. Given wholesale price w, a retailers demand is 1 2t (v p)2, his margin is p w, and his optimal price is 1 (v + 2w). The manufacturer maximizes her 3 profit and charges w D = v. For the retailers to remain local monopolies, the demand for 3 each retailer must be smaller than t 4 can obtain the other boundaries in the first panel of Figure 7. 9t, which implies v <. Following the same steps, we 8 To show that the market is never fully covered under manufacturer disclosure, consider, for any given level of wholesale price w, the manufacturer s incentive to deviate by increasing the wholesale price when the market is indeed fully covered. Note that v w D = 7+3t 4 in equilibrium under full market coverage. If the manufacturer increases the wholesale price by a small number, Δw, the retail market would move into the fifth scenario from the bottom in the first panel of Figure 7. By looking at the first-order condition on the retailer s profit in 46

48 Figure 7: Reputation Threshold and Transportation Cost v v v t t t Note: The manufacturer sells through two retailers in this figure and the shaded areas indicate demand. The first panel shows how demand changes in the disclosure subgame for different ranges of v and t. The second panel shows how demand changes in the nondisclosure subgame. The third panel shows how the reputation threshold for nondisclosure changes with t. the fifth scenario, p w = t (v p 1 0.5t)2, we can see that the equilibrium retail margin, p w, 1 (v p 1 0.5t) increases with v p. Therefore, as demand and v p decrease (i.e., p increases) from complete market coverage into the fifth scenario, p w decreases, implying that 0 < Δp < Δw. The change in the manufacturer s profit, (w + Δw)(1 Δp2 ) w = (w + Δw) Δp2 + Δw, is hence t t positive when both Δp and Δw approach 0. Now consider the nondisclosure subgame. Without retail competition, the optimal retail price is 1(v + w 1), the optimal wholesale price is 1(v 1 ), and the constraint for non competition is given by v < 2t + 1. When quality is higher than this threshold, the market 2 47

49 is completely covered and the optimal wholesale price is v t 1 2. Given the manufacturer s profit functions under both disclosure and nondisclosure, we can compare the two profits and derive the condition under which she would choose disclosure. We do this for all scenarios except the top one in the first panel of Figure 7, and obtain the nonreputation threshold in the third panel. For the top scenario, the manufacturer induces complete market coverage under nondisclosure and it is sufficient to show that the equilibrium wholesale price under disclosure is less than or equal to that under nondisclosure. Recall that the optimal wholesale price under nondisclosure is v t 1 2. For t [0, 1], this price is higher than w = v 4+6t t2 4+2t and it is sufficient to show that w is higher than the optimal wholesale price in the top scenario under disclosure. In the fourth demand scenario under disclosure, w would be the optimal wholesale price. By continuity, it is sufficient to show that when demand is in the top scenario, v w increases with v in equilibrium. To see this, note that the optimal wholesale price in the fifth scenario is determined by the first order condition: D(v p) wd (v p) p (w) = 0. Note also that the optimal retail price is p = 1 3t + 3v + 1w + 1 (v w t)2 8(1 t). Suppose v w remains unchanged in equilibrium as v increases, then w increases but given the retail price above, v p and p (w) remain unchanged. As a result, the first-order derivative above becomes negative, and w has to decrease. Therefore, v w increases with v. Proof of Proposition 2. It is straightforward to solve for and compare the disclosure and nondisclosure profits except for the case when v is high (the top scenario in the first panel of Figure 7). We provide a proof here that the manufacturer s profit in the disclosure subgame is lower than that in the nondisclosure subgame for this top scenario. When the manufacturer sells directly to consumers, she enters the top scenario when v > 2 t. In this scenario, her profit is p[1 t( 1 v p 1 ) 2 ]. Suppose that the manufacturer 4 2 t covers the entire market by charging p = v 1 t, the first-order derivative of the profit 2 48

50 is 1 at this price and she finds it profitable to increase the price. That is, the manufacturer never induces complete market coverage under disclosure. If v > 2 t, the manufacturer would cover the entire market under nondisclosure and 4 charge v 1 t. At this price, the first-order derivative of the disclosure profit is negative 2 2 and a disclosing manufacturer would find it profitable to decrease the price. Therefore, the equilibrium price in the disclosure subgame is smaller than v 1 t. Since both price and 2 2 demand are lower under disclosure, the manufacturer chooses nondisclosure. When the manufacturer sells through a monopolistic retailer, the proof is similar to that of Proposition 1. Proof of Lemma 6. In the disclosure subgame, a retailer s profit is the product of his margin and demand: πd R = MD D R D R = 2v 9 8v2 81 = 16v3 729 if 0 < v < 9 8, 1 1 = 1 if 9 v < ( ) ( ) 3 + x 1 (x ) x + 1 (x )2 + 3 if 19 v < 5, = 3 if 5 v < 3, [ ] [ h(v) h(v)2 + 3h(v) ] 5 if v 3, , where MD R = p D w D, x = v w D = v v 3.4( 13.7+v)(2.2+v) 0.01f(v), f(v) ( f(v) = 976, , 768v 301, 056v 2 8, 192v , 134(5 + v) (3 + v)(6 2v + v 2 ) (v 5 2 ) and h(v) = v w D = 1 6 v 1 6 A retailer s profit, in the nondisclosure subgame, is πn R = (p N w N ) DN R = 1 (v 1) 1(v 1) = 1 (v )2 if 1 < v < 5, = 1 if v ) 1 3, By comparing the two profit curves, we find that the retailers profits are higher under 49

51 disclosure if 0 < v 1.28 or v Proof of Proposition 3. When demand is in one of the bottom four scenarios in the first panel of Figure 7, we can simply plot retailer profits under disclosure and nondisclosure and obtain the reputation thresholds. When demand is in the top scenario, retailer profit equals t under nondisclosure. Meanwhile, under disclosure, as quality goes to infinity, retailer profit 4 monotonically increases and approaches t 2 in the limit. Therefore, there exists v so that the retailers would choose disclosure when v > v. Proof of Lemma 7. The demand function with the option to return the product at cost h, under nondisclosure, can be found in the proof of Proposition 4 below. Comparing this demand with the nondisclosing, direct-selling manufacturer s demand function without this option, D N = 0 if v p 1 2, 2 (v p 1) if 1 < v p 1+t, t if v p > 1+t 2, we can obtain the lemma. Proof of Proposition 4. When returns are allowed and consumers cost of returning the product is h > 0, demand under nondisclosure is D H = 0 if v p < h, (v p h) 2 (max{v p h t 2,0})2 t if h v p < 1 2, 2(v p 1 2 )+(max{1 h (v p),0})2 (max{v p h t 2,0})2 t if 1 2 v p < t 2, 1 (1+ t 2 h v+p)2 (max{1 h (v p),0}) 2 t if t 2 v p < 1 h + t 2, 1 if v p 1 h + t 2. This demand function is the same as the one under disclosure when h = 0. To show Proposition 4(a), realize that by the Envelope theorem, the change in the total channel 50

52 profit when h increases from zero is equal to the change in the total demand. Given the demand function above, we can obtain Proposition 4(a). To show (b) and (c), note that again, by the Envelope theorem, the change in the manufacturer s profit is equal to the change in her demand when h increases from zero. As a result, the reputation threshold for nondisclosure is given by the curve in the v-t plane along which demand under disclosure is.5. This curve is defined by v = 1 + t 4 when the manufacturer sells direct, v = 2 + t 4 when she sells through a monopoly retailer, and an increasing curve between these two lines when she sells through two retailers. 51