There are several options available to Proctor and Gamble, which you might have come up with. An obvious solution is to use a manufacturer rep's firm, these are the most widely used type of agents for physical products. They're typically used by manufacturers, who lack a sales force or when a manufacturer needs additional service push behind a new product or the market is not fully developed. So these type of agents, are also good when the sales potential of a product may not justify the cost of using the company salesforce. Another option would be to sell to retailers or wholesalers on consignment, or dropship the inventory. In this way, Procter and Gamble maintains ownership of the product as long as possible, but still once ownership is transferred, the problem is still there. The most common solution is to use a MAPP or a Minimum Advertised Pricing Policy. Now, this is a unilateral statement by the manufacturer of the minimum advertised price for a specific stock keeping unit or SKU. Of course, the definition of advertise needs to be determined whether that's the everyday retail price or promotional price. Importantly, the manufacturer must put clear penalties in place in the case that the policy is violated. This might include but not be limited to the loss of the SKU, or all of the manufacturers SKUs, if the entire product line has pulled power. Penalties might even be as severe as the reseller or retailer losing its authorized status, and this can matter a lot. Say for example, car dealers and retailers, it's hard to sell BMWs when you are not BMW authorized. MAPP policies have no power if they're not enforced, it's like raising kids. If you tell them that there's a consequence for a poor choice, but you never enforce it, your system is a sham, and they don't take you seriously. So it's critical that the manufacturer has some type of monitoring system in place. This may mean that you have secret shoppers or you serve a customers or you use some sort of technology that gives you insight into their transactions and process. Remember the Tovolo ice maker CEO who conducts bitests on Amazon to see what Amazon is shipping customers? That's an example. Of course, there's a lot of research on MAPP policies and what it basically shows is that there are strong social effects. And by this I mean that authorized resellers will violate the policy if they see other authorized resellers violating it as well. Authorized resellers will also violate the policy if they see an authorized resellers violating it. But authorized resellers will violate to a lesser degree than when they observed authorized resellers violating. So I'm often asked, well how do these unauthorized resellers get their hands on the goods? And unfortunately, it's often from the authorized reseller. So when I was a doctoral student, I was doing some research with Kroger in their buying group in Cincinnati and my house was introducing me to the various members of the group. But when he got to one office, he said, this is Frank, he's our diverter, shh. What Kroger was doing was taking advantage of volume buys from suppliers then with the excess goods they would sell those products to other non consumer markets like smaller retailers, or these days it might include online retailers. These unauthorized retailers create what is known as a gray market and they sell the goods at even lower prices, because they're able to take lower margins and their goal is to turn product. Their money is made in volume sales. Now, manufacturer's gray markets are almost always the result of a bubble in the pricing policies and the most effective way to solve it is for the manufacturer to change its pricing policy. Procter and Gamble dealing with gray markets is a separate issue from how it manages its authorized resellers. For these guys, the authorized resellers control is critical, in other words, deal with the gray market issues separately. Let's move on to the second major challenge in channel pricing, and this is the problem of double marginalization. You cannot be a bona fide channel strategists, if you do not understand the concept of double marginalization, it's a sign of a pedigree. So double marginalization is essentially the cumulative effect of myopic or monopolistic behavior. So an intuitive way to think about this is to imagine the Rhine River in Germany. If you ever have the opportunity to take a boat or a train ride along the river, I would highly recommend it, I did this at dusk, just as all the castle lights were going on and it was amazing. There are beautiful castles along the path of the river and they were not just there for blocking pleasure, in the past, they would actually collect tolls from boats passing through. Each castle had a different owner and was probably passed down over generations within a family or a city. If you are a castle owner, what price do you set for the boats to pass? Well, the answer's the highest price that you can, right? So imagine that everyone near the top of the river does exactly that. What happens to traffic on the river? It dries up. And what happens to castles downstream? Well, if you're an upstream castle, you really don't care. So this monopolistic pricing practice on the part of each castle owner is myopic because of the total traffic is killed, then you essentially shoot yourself in the foot. You lose your revenue stream, but on the other hand, if everyone charged a lower toll, they would collectively make more money over time because of the volume of boats that would pass through. Or if there was one monopolist castle owner, that one castle would charge a single monopoly price. And more money would be made as throughput falls, but not by as much as when there are multiple monopolists with multiple monopolist prices facing travelers. So put differently, the cumulative effect of all of these monopolists is much worse and all the monopolist as a group are worse off than if they can coordinate. Two monopolists are much worse, in other words, more than twice as bad is the moral of the story. So why does this happen? Well, let's take a general look. I'm going to use Wal-Mart and 3M to help illustrate the idea, but this insight generalizes to any upstream downstream set of firms. So we know from basic economics that firms generally face a downward sloping demand curve, such as this one. In other words, the higher the price, the less you sell and the lower the price, the more you sell. So we see here that at a price of $10, you will only sell 3 units. If Wal-Mart lower its price to let's say $3, it will then sell 11 units. Now, the slope of this demand curve reflects how much incremental revenue the retailer is gaining for each additional unit sold. So notice that the slope is changing along the range of the curve, if we were to plot that slope, it would look something like this. It's higher at lower quantities and decreases as you sell more and more. So this is Walmart's marginal revenue curve and this curve is critical because it helps to determine Wal-Mart's profit maximizing position. So let's move on, every firm also faces a marginal cost which reflects the change in the total costs from producing one more unit. In other words, this is the additional class required to produce the next unit. So for now, let's simplify this to be a constant, although for most firms it's a curve and non-linear. The retailer wants to keep producing as long as the price that consumers pay is greater than their marginal costs. So Wal-Mart always wants to produce until the point at which its marginal revenue equals its marginal costs. And this point determines Wal-Mart's profit maximizing price in quantity, which in this case is 5 units at $9. So all sales above the marginal cost line translates into profits for Wal-Mart. So I want you to notice something important here and that is this area in which consumers are willing to pay for products above the retailer's marginal costs, now in yellow. The problem is that Wal- Mart is not willing to sell to these consumers because to do so requires that it lowers its price and that lowers its profits. So we can think of this area as Deadweight loss. Now let's take a supplier or manufacturer's point of view, Wal-Mart's marginal cost can also be thought of as the price they pay 3M for every unit that Wal-Mart purchases. So if 3M sets a price of $4, this tells us that quantity that 3M will sell is 5, which is Wal-mart's profit maximizing quantity. So another way of saying this is that Wal-Mart's marginal revenue curve is essentially 3M's demand curve. If 3M raises its price to Wal-Mart to $6, what's going to happen to the quantity that Wal-Mart purchases, it will fall to 4 units, so whatever price 3M sets, reveals the quantity demanded by Wal-Mart. Let's get rid of that and let's instead consider the question of what price will 3M want to set. It will want to set its price where its marginal revenue equals marginal costs. So let's add in a marginal revenue curve for 3M, which is two times the slope, similar to what we had before. 3M faces of marginal cost and this produces a price to Wal-Mart of $8 which is its marginal cost. Since Wal-Mart now faces a higher input cost, it finds the location where its marginal revenue is equal to its marginal costs, and this leads to the profit maximizing quantity of 3, that is now sold at a price of $10.50. So it's important to notice that Wal-Mart's profit here is much lower than before, and some of the profit has been claimed by the wholesaler, but notice that overall, the total amount of profit is now less than before. And how do we know that? Well before the retailer's profit area was five times five or 25, but now the retailer and wholesalers combined area is six and a half times three, which is equal to 19.5. How else do we know this? Because Wal-Mart could have set a higher price of 10.50 before, but it didn't, because its profit maximizing price was 8. So total profits have fallen when two intermediaries are used, 3M and Wal-Mart both. Another way to think about this is that if 3M and Wal-Mart had combined, that is if they were vertically integrated, they would have collectively set a lower price. Because that is the point at which their profits would have been maximized, but they don't, because each is self interested it acts as a monopolist would. And it would take effort to negotiate a split or a bargain that satisfies both parties. Notice too, that the deadweight loss has increased dramatically under this scenario, clearly everyone is worse off, firms and customers. Quantity falls dramatically, prices rise and consumers lose options. And this pattern continues as more and more intermediaries are added, so this is the problem of double marginalization. As each successive intermediary adds its margins, the products prices raised above each channel members marginal costs. Clearly, in this scenario, everyone is much worse off with two intermediaries as opposed to one single vertically integrated intermediary. The cumulative effect of all of this is a distortion in channel pricing, in other words, prices are too high for customers in quantity drops by a lot. And this is why economists say that two monopolists are much worse than one, each additional intermediary adds an exponentially bad effect, it's like saying one plus one equals three. So this is led some to conclude the monopolies aren't necessarily bad for consumers, in fact, vertical integration of two monopolies could improve social welfare. Monopolies aren't great, but if you're going to have them better one vertically integrated than two independent monopolies. A classic example is Microsoft, Microsoft was accused of leveraging its monopoly in operating systems in order to gain a monopoly in browsers. But would you rather have Microsoft with a monopoly ini operating systems and let's say, Netscape with a monopoly in browsers, or Microsoft with a monopoly in both? It's better for consumers when Microsoft has a monopoly in both, because you will have lower prices, increased outputs and from Microsoft's point of view higher profits. So vertical integration can be an effective way to solve the double marginalization problem. But what can the channel strategists do if vertical integration is not an option?
