European Journal of Operational Research 233 (2014) 114–124

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European Journal of Operational Research

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

Production, Manufacturing and Logistics

Product variety and channel structure strategy for a retailer-Stackelberg

supply chain
Tiaojun Xiao a, Tsan-Ming Choi b,⇑, T.C.E. Cheng a,c
a
School of Management Science and Engineering, Nanjing University, Nanjing 210093, China
b
Business Division, Institute of Textiles and Clothing, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong
c
Department of Logistics and Maritime Studies, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong

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

Article history: Motivated by the observations that the direct sales channel is increasingly used for customized products
Received 25 January 2013 and that retailers wield leadership, we develop in this paper a retailer-Stackelberg pricing model to inves-
Accepted 27 August 2013 tigate the product variety and channel structure strategies of manufacturer in a circular spatial market.
Available online 5 September 2013
To avoid channel conflict, we consider the commonly observed case where the indirect channel sells stan-
dard products whereas the direct channel offers custom products. Our analytical results indicate that if
Keywords: the reservation price in the indirect channel is sufficiently low, adding the direct channel raises the unit
Supply chain management
wholesale price and retail price in the indirect channel due to customization in the direct channel.
Product variety
Customization
Despite the fact that dual channels for the retailer may dominate the single indirect channel, we find that
Dual channels the motivation for the manufacturer to use dual channels decreases with the unit production cost, while
Game theory increases with (i) the marginal cost of variety, (ii) the retailer’s marginal selling cost, and (iii) the cus-
tomer’s fit cost. Interestingly, our equilibrium analysis demonstrates that it is more likely for the manu-
facturer to use dual channels under the retailer Stackelberg channel leadership scenario than under the
manufacturer Stackelberg scenario if offering a greater variety is very expensive. When offering a greater
variety is inexpensive, the decentralization of the indirect channel may invert the manufacturer’s channel
structure decision. Furthermore, endogenization of product variety will also invert the channel structure
decision if the standard product’s reservation price is sufficiently low.
Ó 2013 Elsevier B.V. All rights reserved.

1. Introduction
With the development of e-commerce and Internet technologies,
increasing numbers of manufacturers that previously sold their
products indirectly through third-party retailers have established
sales channels to sell to customers directly. Some well-known
examples are Compaq, Hewlett–Packard, IBM, Eastman Kodak, Nike,
Mattel, and Apple, among others (Mukhopadhyay et al., 2008; Tsay
and Agrawal, 2004; Wilder, 1999). The U.S. Department of Com-
merce reported that total U.S. e-commerce sales jumped by 14.8%
in 2010 to about US$165.4 billion (Brohan, 2011). To cater for a
broader (more heterogeneous) mix of consumer groups, supply
chains are increasingly providing a higher product variety to attract
customers (Dekimpe et al., 2011). Product variety here refers to the
number of variants within a specific product group. Customization
is an important value-adding service of the direct channel (which
is more effective compared with the indirect channel) because it
can better satisfy the heterogeneous demands of customers for
product attributes. It is well known that there exists channel conflict
between the indirect channel and the direct channel because both
channels compete for customers.1 Hence, the manufacturer must
cautiously avoid channel conflict and make a careful trade-off be-
tween product variety and customization. In fact, incorporating this
trade-off to address whether and when the manufacturer has an
incentive to use dual channels is a main objective of this paper.
Consider the sales channel of Nike, an international brand for
footwear and apparel, in Hong Kong. Since Hong Kong is a market
in which retail brands mainly rely on bricks-and-mortars stores to
sell their products, Nike’s standard products are only available in
physical retail stores. At the same time, Nike launches its
renowned NIKEiD mass customization programme online.
Consumers in Hong Kong can select and buy a pair of customized
shoes with their names printed via this online sales channel.
Obviously, Nike’s dual channel strategy is one designed to avoid
channel conflict, which is the exact business model that we
examine in this paper.

⇑ Corresponding author. Tel.: +852 2766 6450. 1

A classic example of channel conflict is Levi’s case (Laudon and Laudon, 2002, p.
E-mail addresses: xiaotj@nju.edu.cn (T. Xiao), jason.choi@polyu.edu.hk 130), in which Levi’s had to give up its online direct sales channel because of a fierce
(T.-M. Choi), Edwin.Cheng@polyu.edu.hk (T.C.E. Cheng). channel conflict with its indirect channel.

0377-2217/$ - see front matter Ó 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.ejor.2013.08.038
 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
Dual channels, as a part of the popular concept of multi-channel
retailing, are usually associated with the Internet direct sales chan-
nel. The recent literature has explored dual channels from various
perspectives. Perspective one assumes that the dual channel struc-
ture of a manufacturer is given and explores the corresponding
operational issues. There is no consideration of the strategic action
of adding the direct channel in the pure indirect channel strategy
(e.g., Cattani et al., 2006;Mukhopadhyay et al., 2008). Perspective
two considers the strategic choice as to whether there are incen-
tives for manufacturers to add a direct channel (e.g., Bernstein
et al., 2008). For both perspectives, customer acceptance and pref-
erence for the direct channel relative to traditional stores (the indi-
rect channel) undoubtedly influences the success of dual channels
(see, e.g., Chiang et al., 2003 for some more arguments and exam-
ples). Moreover, the difference in marginal cost between the two
channels plays an important role in determining the existence
and configuration of dual channels. For instance, Tsay and Agrawal
(2004) pointed out that in the personal computer industry, direct
selling facilitates the ‘‘assemble-to-order’’ strategy that typically
entails less inventory risk than the ‘‘make-to-stock’’ approach of
retail distribution. Dumrongsiri et al. (2008) found that the manu-
facturer is likely to be better off using dual channels than using the
single channel when the retailer’s marginal cost is high, and the
wholesale price, customer valuation, and demand variability are
low. Hendrikse and Jiang (2011) studied dual distributions in fran-
chising based on incomplete contract. In this paper we follow per-
spective two in the above reviewed literature on dual channels and
examine the strategic challenge from adding the direct sales chan-
nel. We consider the case where the two channels sell different
products (the indirect channel sells a standard product while the
direct channel sells a custom product) and customers have differ-
ent reservation prices for the products in different channels.
Chiang et al. (2003) argued that reducing double marginalization
effect is a main incentive for adding the direct channel. However,
as we shall show in later sections, we find that adding the direct
channel may strengthen double marginalization effect, which has
a negative effect on the indirect channel’s profitability and weak-
ens the motivation to use dual channels.
Using dual channels for the business model as adopted by Nike
Hong Kong, the manufacturer has two revenue sources, which
would increase the manufacturer’s profit. However, the presence
of the reservation price disadvantages of the direct channel over
the indirect channel and probable channel conflict between the
two channels together reduce the manufacturer’s profit. In partic-
ular, when the retailer (i.e., the indirect channel) is a Stackelberg
leader of the supply chain channel, the counter-force for the devel-
opment of the direct channel and channel conflict can be large. As a
consequence, it is unclear whether the manufacturer in a retailer-
Stackelberg (RS) supply chain should use the dual channel strategy.
In the literature, in view of the emergence of retail giants such as
Wal-Mart and Hudson’s Bay, there is a growing body of studies
on exploring the effect of downstream power shifting in supply
chains (see, e.g., Geylani et al., 2007). To be specific Geylani et al.
(2007) studied how a manufacturer strategically reacts to a domi-
nant retailer to decide the unit wholesale price for the weak retai-
ler and advertising investment, where the bargaining power is
described by the (exogenous) unit wholesale price for the domi-
nant retailer. Since the effect of adding a direct channel on the unit
wholesale price plays an important role in making the channel
structure decision, unlike Geylani et al. (2007), we consider the
endogenous wholesale price case. Notice that recently a number
of studies have examined the RS supply chain (Choi and Fredj,
2013; Gerchak and Wang, 2004; Pan et al., 2010;Wang and Liu,
2007). Based on the observed industrial trend and the literature
on RS supply chain management, we focus on examining the
probable existence of dual channels in a RS supply chain in this
115
paper. The channel leadership structure (sequence of decisions)
affects the equilibrium outcome (Choi and Fredj, 2013), which
further influences the channel structure strategy of the manufac-
turer. Some works are made in the effect of channel leadership
structure. For example, Pan et al. (2010) discussed different con-
tract strategies under both manufacturer-Stackelberg (MS) and
RS supply chains and identified the conditions under which the
leader is better off using a revenue-sharing contract. Edirisinghe
et al. (2011) studied the implications of channel power (capability
of being a leader) on supply chain stability for a two-supplier and
one-retailer supply chain. Choi et al. (2013) examined the closed
loop supply chain with different channel leadership. To the best
of our knowledge, the effect of channel leadership structure on
the channel structure decision of the manufacturer is still under-
explored. We try to fill this important research gap by comparing
the RS model with the MS model.
Increasing product variety is an effective business strategy be-
cause it can raise market demand. When a new product emerges,
firms often produce many variants. For example, in the automobile
industry, manufacturers differentiate their products according to
interior color, power specifications, and seat materials (Fisher
and Ittner, 1999). In the bicycle industry, manufacturers offer
different products according to frame material, frame size, frame
color, and components (Randall and Ulrich, 2001). In the literature,
product variety is well-regarded as an important factor that
influences customers’ buying decisions (Gaur and Honhon, 2006;
Hoffman and Novak, 1996; Xia and Rajagopalan, 2012). For
instance, Xia and Rajagopalan (2009) studied the standardization
and customization decisions of two firms in a competitive setting
and found interestingly that increasing product variety will not
intensify price competition if firm differentiation is sufficiently
high. Gaur and Honhon (2006) developed a location-choice model
to study an assortment planning and inventory management prob-
lem for a retailer under stochastic demand. However, increasing
product variety is not without drawbacks (Matsubayashi et al.,
2009). For example, it is well known that having a greater product
variety within a supply chain tends to increase the corresponding
operational costs (see, e.g., Randall and Ulrich, 2001 for more dis-
cussions). Furthermore, product variety alone (without proper cus-
tomization) may not well satisfy the heterogeneous demands of
customers. As a result, some firms offer customization service, such
as the popular mass customization service, to address this issue.
For instance, apparel brands adopting mass customization allow
consumers to select various customizable attributes such as color,
rise, front pocket style, leg, waist, inseam, and seat shape of their
pants (Mendelson and Parlaktürk, 2008). With the concepts of
mass customization and dual channels in mind, Dewan et al.
(2003) found that the simultaneous adoption of customization in
a duopoly game reduces differentiation between the players’
standard products but does not intensify price competition. In this
paper we consider product variety, mass customization, and dual
channels simultaneously. These factors affect the double marginal-
ization effect and market demand in the indirect channel, which in
turn influences the channel structure decision. Our scenario is sup-
ported by real-world cases (e.g., Nike) and obviously helps reduce
the pressure of channel conflict. In the literature, Randall and
Ulrich (2001) investigated the interaction between product variety
and supply chain structure by examining U.S. bicycle industry,
where supply chain structure is characterized by production effi-
ciency and facility location. Unlike Randall and Ulrich (2001), we
study whether the manufacturer has an incentive to add a direct
channel to the indirect channel. Thonemann and Bradley (2002)
studied how product variety affects the expected leadtime and
expected cost at the retailers. However, we explore how product
variety affects channel structure strategy. In addition, it is interest-
ing to study how the channel structure strategy affects product
116 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
variety decision through influencing the pricing and demand for
the indirect channel. In short, our objective is to understand how
product variety and customization affect the double marginaliza-
tion effect, and the interaction between the product variety deci-
sion and the channel structure decision.2 To the best of our
knowledge, these issues are still not addressed in the literature
and hence this paper attempts to address them. In particular, we fo-
cus on how the exogenization of product variety affects the channel
structure strategy. We find that this effect is essential because the
interaction between product variety and pricing is absent.
As a remark, our model in this paper is also related to the circu-
lar spatial market model (Balasubramanian, 1998; Dewan et al.,
2003; Salop, 1979). Essentially, Salop (1979) pioneered and intro-
duced a variant of the traditional Hotelling (1929) model, known
as the circular spatial market model, where the consumers are
modeled to be uniformly distributed on a circle and all the firms
are located evenly on the circle. Salop’s circular spatial market
model is influential and has been employed in many studies
(Soberman and Parker, 2006). For instance, Balasubramanian
(1998) considered the competition between a direct marketer
and conventional retailers in price with the behaviors of the sup-
pliers being ignored. Dewan et al. (2003) developed a duopoly
model where each firm first chooses a customization scope and
then optimally determines the conventional market price. Since
in the context of RS supply chain management, a consumer-utility
driven demand model can better capture the different demand pat-
terns of dual channels, we employ the circular spatial market in
developing our model.
In this paper, in order to address the research issues raised
above, we first develop a formal analytical RS supply chain model
in a circular spatial consumer market. In this ‘‘basic model’’, the re-
tailer is the Stackelberg pricing leader and the manufacturer is the
follower. In the indirect channel, the manufacturer sells a standard-
ized (standard) product with variety through the retailer; in the di-
rect channel, the manufacturer sells a mass customized (custom)3
product directly to consumers (cf: Nike). As a benchmark, we first
consider the dual channel strategy of a vertically integrated firm.
We find that when the product variety investment is very expensive,
the integrated firm inclines to use dual channels. We then study the
equilibrium decisions of the decentralized supply chain, with a focus
on the dual channel strategy of the manufacturer. We obtain the
closed-form conditions under which it is optimal for the manufac-
turer to use dual channels. We find that the decentralization of the
supply chain may invert the effect of channel structure on the equi-
librium product variety. Unlike the extant literature on dual channels
(Chiang et al., 2003), we show that adding the direct channel raises
the prices in the indirect channel if the (consumer) reservation price
of the standard product is sufficiently low, i.e., intensifying the dou-
ble marginalization effect, which weakens the motivation of using
dual channels. We analytically reveal why the manufacturer would
prefer and use dual channels even though adding the direct channel
intensifies the double marginalization effect. To examine the effect of
the channel leadership on the manufacturer’s decisions and the retai-
ler’s profit, we also develop an MS model and compare its results with
those of the RS model. We show that whether the retailer has an
incentive to act as a Stackelberg leader depends on whether the mar-
ket is fully covered. In addition, we examine how product variety and
exogenization of product variety affect the implementation of the
dual channel strategy. We find that endogenizing product variety
2
As a remark, both adding the direct channel and increasing product variety can
raise the total market demand. To a certain extent, the two approaches substitute
each other. However, both approaches incur different costs.
3 4
In this paper we follow the literature (Xia and Rajagopalan, 2009) to use ‘‘custom
product’’ and ‘‘standard product’’ for the terms ‘‘customized product’’ and ‘‘standard-
ized product’’, respectively.
may invert the channel structure strategy of the manufacturer. To
the best of our knowledge, our model and analysis are novel and dif-
ferent from the extant dual channel literature in two important ways:
(i) we examine how dual channel strategy relates to product variety
strategy, and channel leadership structure (RS and MS), and (ii) we
employ a consumer-utility driven ‘‘circular spatial market’’ model.
To enhance presentation, we put some technical propositions in
Appendix A and use Theorems and Corollaries to summarize the main
insights. Detailed proofs are relegated to an online supplementary
document.
2. The basic model
Consider a supply chain consisting of one manufacturer and one
bricks-and-mortar retail store (‘‘retailer’’ in short). The manufac-
turer sells the standard product through the retailer (indirect chan-
nel). Now, the manufacturer has an opportunity to consider
whether to add a direct (online) channel to supplement the indi-
rect channel, where the direct channel sells a fully customized
product to satisfy consumer requirements (custom product). If
deemed beneficial to add the online channel, the manufacturer
would use dual channels with both indirect and direct channels
as the channel structure strategy; otherwise, it only uses the single
indirect channel. In other words, we consider in this paper the case
where the manufacturer needs to select either the ‘‘single indirect
channel’’ or the ‘‘dual channels’’ strategy.
We construct the basic model based on the commonly adopted
circular spatial market in the literature (Balasubramanian, 1998;
Salop, 1979; Soberman and Parker, 2006). In the circular spatial
market, the preferences of consumers are uniformly distributed
on a circle of unit circumference (the locations represent their ideal
products) and n types of a standard product are evenly distributed
on the circle, i.e., the manufacturer evenly divides the unit circular
market into n segments such that the arc length of each segment is
1/n (see Fig. 1). Each consumer has a unitary demand in each per-
iod and the unit reservation price of the standard product is r. A
standard product at an arc distance y units away from the con-
sumer generates a gross utility of r  ty, where t is called the fit cost
per unit distance and reflects the attribute differentiation of the
standard product (Dewan et al., 2003). Gaur and Honhon (2006)
considered a location-choice model for a retailer under the uncer-
tain environment. To focus on the channel competition and the
channel structure decision, we assume that the market environ-
ment excluding consumers’ locations is deterministic. As a remark,
we adopt the circular spatial market because it can well describe
the effects of product variety and heterogeneity of consumers on
market demand for dual channels.
The retailer orders the standard product from the manufacturer.
In the basic model, we consider the supply chain as a RS channel
where the retailer is the pricing leader that first determines the
profit margin m and then the manufacturer determines the unit
wholesale price w for the standard product.4
Owing to symmetry of the locations of the different types of the
standard product, the equilibrium retail prices are identical, i.e.,
the manufacturer should charge the retailer the same unit
wholesale price such that the retailer offers the same retail price
p(= w + m) for all types of the standard product (Xia and
Rajagopalan, 2009). Thus, the (net) utility of the consumer that
buys a unit of the standard product from the retailer is
r  ty  (w + m), y 6 1/(2n).
Denote the reservation price of the consumer that buys the
custom product from the direct channel as rd and the (direct) retail
Notice that the case in which the retailer determines the profit margin is very
common in the literature and practice (see, e.g., Kadiyali et al., 1999; Sudhir, 2001;
Trivedi, 1998).
 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
Rn
Direct
channel’s
share
pd
R1 D p R Retailer’s
share
R2
Fig. 1. Circular spatial market.
price of the custom product as pd. rd may be different from r due to
a virtual inspection and a lead time (i.e., waiting time). The (net)
utility of the consumer that buys the custom product from the di-
rect channel is rd  pd. Here a consumer can save fit cost by buying
custom product to satisfy its requirements. However, buying stan-
dard product incurs a fit cost because this standard product may be
different from its preference. To prevent the retailer from buying
from the direct channel (the retailer’s arbitrage behavior), the
manufacturer charges the retailer a unit wholesale price lower
than the direct channel’s retail price, i.e., w 6 pd (Chiang et al.,
2003). Let the unit production cost of the manufacturer be c. The
retailer incurs a marginal selling cost of the standard product cr;
the direct channel incurs a marginal selling cost of the custom
product cd.5 Note that the retail prices in the two channels are higher
than the total marginal costs, i.e., w + m P c + cr and pd P c + cd. To
avoid the trivial cases, we assume throughout this paper that (i)
the total surplus of each channel is positive, i.e., r  c  cr > 0 and
rd  c  cd > 0 (otherwise, the channel with a non-positive value will
withdraw from the market because the manufacturer cannot make a
profit from the channel), and (ii) the indirect channel has a higher
total surplus than the direct channel (otherwise, the manufacturer
will sell all the products through the direct channel despite having
dual channels), i.e., r  cr P rd  cd. For a notational purpose, denote
(i) the total surplus of the indirect channel as A1 = r  c  cr(>0),
(ii) the total surplus difference between the two channels as
A2 = cd  cr + r  rd > 0. Since rd  c  cd > 0, we have A1 > A2.
Increasing product variety incurs costs to the manufacturer
(Xia and Rajagopalan, 2009). A higher variety level often raises
the difficulty of increasing variety such that a higher marginal vari-
ety cost is incurred. Thus, we extend the linear cost structure (nf) in
Xia and Rajagopalan (2009) to the case where product variety n in-
curs a cost gn2/2 + nf, including the product development cost and
the labor learning cost, and f, g > 0.6 This quadratic cost structure
means that the marginal cost of product variety increases with the
variety level, which is consistent with that in the literature on inno-
vation (e.g., Gupta, 2008). A similar cost structure with a quadratic
term is used by Dewan et al. (2003) who study product customiza-
tion. We call g the variable marginal cost coefficient (VC) and f the
constant marginal cost of product variety.
For the sake of convenience, in the basic model, we use the first
number suffix 1 to represent the case of using the single indirect
channel and 2 to represent the case of using dual channels.
5
cr includes costs like stocking, labor, and facility maintenance costs; cd includes
the costs of maintaining the website, the distribution system, and extra unit
production cost due to customization.
6
Notice that even though equilibrium analysis is still feasible for a more general
product variety cost function, in order to obtain closed-form analytical results, we
follow the literature by assuming that the product variety cost function is a quadratic
function.
117
From r  ty  (w + m) P 0 and y 6 1/(2n), we see that when the
manufacturer only uses the indirect channel, the market demand is

2nðr  w  mÞ=t; if w > r  m  t=ð2nÞ
x1 ¼ ; ð1Þ
1; if w 6 r  m  t=ð2nÞ
which means that the market is not fully covered if the retail price
is sufficiently high (w > r  m  t/(2n)). Furthermore, the manufac-
turer’s profit function is

pM11 ; if w > r  m  t=ð2nÞ
pM1 ¼ ; ð2Þ
pM12 ; if w 6 r  m  t=ð2nÞ
where pM11 = (w  c)  2n(r  w  m)/t  gn2/2  nf and pM12 =
(w  c) 1  gn2/2  nf. The retailer’s profit function is pR1 =
x1  (m  cr). The second number suffix j(= 1, 2) represents branch j.
Unlike Dewan et al. (2003), we consider the case that the man-
ufacturer sells the standard product through the indirect channel
and the custom product through the direct channel that can cus-
tomize the whole circle. We consider the market demand (x) for
the standard product. In dual channels, since the direct channel
can customize the product to meet consumers’ specifications, no
fit cost is incurred to consumers and each consumer obtains a sur-
plus rd  pd. If pd > rd, the manufacturer achieves a higher profit un-
der the single indirect channel than under dual channels because
the dual channels strategy is degenerated to be a single indirect
channel and incurs a positive fixed cost of adding direct channel.
Thus, the manufacturer should offer a direct retail price pd less than
the reservation price rd in dual channels such that a consumer that
buys the custom product will obtain a nonnegative surplus
rd  pd P 0. Furthermore, the market is fully covered and each
consumer buys from either channel in dual channels. Since the
effect of the fixed cost from adding direct channel to the channel
structure decision is well understood, we ignore it, which does
not impact our main results.
When the manufacturer uses dual channels and there is a posi-
tive demand for the custom product, the manufacturer’s profit
function is
pM2 ¼ 2nðr  w  mÞðw  cÞ=t þ ½1  2nðr  w  mÞ=t
ðpd  c  cd Þ  gn2 =2  nf ; ð3Þ
where the first term is the manufacturer’s gross profit coming from
the indirect channel and the second term is the manufacturer’s
profit coming from the direct channel. In dual channels, the retai-
ler’s profit function is
pR2 ¼ 2nðr  w  mÞðm  cr Þ=t: ð4Þ
The retailer should take the manufacturer’s wholesale price reac-
tion into consideration in order to maximize its profit function.
The sequence of decisions in the game in our basic model (the
RS model) is given as follows:
(i) The manufacturer chooses the single indirect channel (the
standard product) or dual channels (standard and custom
products), and then determines product variety n for the
standard product;
(ii) The retailer determines the (profit) margin m of the standard
product;
(iii) If the manufacturer uses dual channels, it determines the
unit wholesale price w of the standard product in the indi-
rect channel and the retail price pd of the custom product
in the direct channel; otherwise, it determines the unit
wholesale price w.
In the above RS game, we can derive the Subgame Perfect Nash
Equilibrium (SPNE) using the standard backward induction tech-
nique. This game does not result in a holdup issue because the unit
118 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
wholesale price affects the retail price as well as market demand.
In addition, we also develop an MS model to explore the effect of
channel leadership structure on the equilibrium channel structure
strategy.
3. Equilibrium analysis
To understand the economic force for dual channels, we
first consider in this section the channel structure strategy of
an integrated firm, and then consider the channel structure
strategy of a manufacturer that sells the standard product
through an independent retailer (i.e., a decentralized supply
chain).
3.1. The optimal decisions of the integrated firm
In this subsection the indirect channel is operated by an
integrated firm. When the integrated firm only uses the indirect
channel, it decides the retail price and variety to maximize
pind (= pM1 + pR1); and when the integrated firm chooses dual
channels, it decides the retail prices and variety to maximize
pI (= pind + pd = pM2 + pR2). Similar to Balasubramanian (1998) and
Xia and Rajagopalan (2009), we relax the integrality of variety n
to ease the exposition. Since the market is fully covered, the man-
ufacturer would like to raise the retail prices of the standard and
custom products to extract the consumer’s surplus until the
marginal consumer obtains zero surplus.7 Thus, the manufacturer
always offers the retail price rd of the custom product if the
manufacturer wants to sell the custom product, i.e., pdI ¼ r d .
Table 1 summarizes the optimal decisions and profits,
   
where g ^ I1 ¼ A1 A21  2ft =ð2t 2 Þ; g
^ I2 ¼ A2 A22  2ft =ð2t 2 Þ < g
^ I1 , and
nI1 is the unique positive root of 2gn3  2fn2 + t = 0. Here the suffix
I indicates the integrated setting.
From Table 1, A1 > A2 > 0 and rd  cd  c > 0, we derive Corollary
1.
Corollary 1. (i) When the variety cost is sufficiently large ðg > g ^ I1 Þ,
the integrated firm offers a higher retail price, provides a smaller
product variety, and produces a smaller quantity of the standard
product in dual channels than in the single indirect channel; and (ii)
when the variety cost is sufficiently small ðg < g
^ I2 Þ, the integrated firm
offers a higher retail price and provides a greater product variety in
dual channels than that in the single indirect channel.
Corollary 1 is intuitive. When the market is not fully covered by
the standard product ðg > g ^ I1 Þ, adding the direct channel, the inte-
grated firm can better extract the consumer’s surplus by raising the
retail price, providing less product variety to save the variety cost,
and attracting some consumers from the indirect channel to the di-
rect channel, which decreases the demand for the standard prod-
uct. Adding the direct channel raises the total market demand,
i.e., product customization acts as a substitution for variety for
attracting consumers. However, when the market is fully covered
by the standard product ðg < g ^ I2 Þ, adding the direct channel raises
the product variety in dual channels relative to that in the single
indirect channel because this increases the difficulty of attracting
consumers to the indirect channel.
Proposition 1 summarizes the optimal channel structure strat-
egy of the integrated firm.
7
When the manufacturer offers a second-degree discriminatory pricing scheme—a
scheme under which the manufacturer sets prices for its products, and among all the
product-price pairs, each consumer picks the one that maximizes its surplus (Dewan
et al., 2003), we find that the retail price of the custom product is also the reservation
price rd.
Proposition 1. The integrated firm uses dual channels if the variety
 2
cost satisfies g > g ^ I1 or (g ^ I1 and A22  2ft =ð8t2 gÞ
^ I2 < g 6 g
   2 
A2 þ t= 2nI1 þ g nI1 =2 þ fnI1 > 0); otherwise, the integrated firm
uses only the indirect channel.
Proofs of all the propositions are given in the online supplemen-
tary document. Proposition 1 is intuitive, for the integrated firm,
when the variety cost (f, g) is sufficiently high, the integrated firm
has an incentive to add the direct channel to the indirect channel to
save the variety cost; and when it is sufficiently low, the integrated
firm has no incentive to add the direct channel because the inte-
grated firm can always meet customers’ demand through the indi-
rect channel and dual channels cannot improve its profit. As a
result, we find that with the addition of the direct channel, the
manufacturer should take the variety cost into consideration in
determining whether adding the direct channel decreases product
variety depends on the variety cost. Moreover, the variety cost plays
an important role in determining the channel structure strategy for
the integrated firm.
3.2. Equilibrium outcome in a decentralized supply chain
In a decentralized supply chain, the players make their deci-
sions independently. We first consider the setting in which the
manufacturer only uses the indirect channel; then we consider
the dual channels setting; finally, we explore the channel structure
strategy of the manufacturer by comparing the two settings. Prop-
osition A.1 (Appendix A) summarizes the equilibrium outcome in
the single indirect channel.
Under the single indirect channel, we have the following find-
ings (i) When the variety cost (f, g) is sufficiently low (g 6 g ^ 1 Þ,
the manufacturer would like to offer a great product variety to cov-
er the market; otherwise, the manufacturer would only meet part
of the demand due to a high cost of variety. (ii) If the market is fully
covered, when the total surplus A1 increases, the retailer raises the
margin to share the benefit such that the manufacturer reduces
 
product variety n1 to save the variety cost because the market
has been covered. (iii) However, if the market is not fully covered,
the manufacturer no longer decreases product variety. It is now the
case where the manufacturer increases product variety. This
happens because the manufacturer can strategically raise price to
attain a higher unit profit and provide a greater variety to attract
consumers when the market is not fully covered. The manufacturer
shares the benefit of the increased total surplus in the indirect
channel with the retailer. Thus, they have full incentives to cooper-
atively raise the total surplus in the indirect channel by decreasing
costs or raising the consumer’s reservation price. (iv) When the fit
cost (t) increases, the profits of the two players decrease because
this discourages consumers if the market is not covered; if the
market is covered, the manufacturer’s profit decreases because
the manufacturer must invest more in variety to cover the whole
market while the retailer’s profit is unchanged.
Define A3 = r  cr  rd. Throughout this paper, we shall assume
A3 > 0 to ensure that the equilibrium outcome exists. From rd > c,
we have A1 > A3. For a convenience’s sake, we denote the case where
r < 2cd + cr + rd or where 2cd + cr + rd 6 r < 3cd + cr + rd and
pffiffiffi 
cd P 2  1 A3 as Case I, and the case where r P 3cd + cr + rd or
pffiffiffi 
where 2cd + cr + rd 6 r < 3cd + cr + rd and cd < 2  1 A3 as Case
II. Observe that Case I refers to the scenario in which the reservation
price r is sufficiently low and the marginal selling cost in the direct
channel cd is sufficiently high, whereas Case II refers to the case where
the reservation price r is sufficiently high and the marginal selling cost
in the direct channel cd is sufficiently low.
 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124 119

Table 1
The optimal decisions and profits of the vertically integrated firm.

Single indirect channel Dual channels

Cases g > g^ I1 g 6 g^ I1 g > g^ I2 g 6 g^ I2
   
pI 1
2 ðc þ c r þ rÞ
r  t= 2nI1 r  A2/2 r  t= 2nI2
   
nI A21  2ft =ð2t
gÞ nI1 ¼ maxft=A1 ; nI1 g A22  2ft =ð2t gÞ nI2 ¼ maxft=A2 ; nI1 g
   
xI A1 A21  2ft =ð2t2 gÞ 1 A2 A22  2ft =ð2t2 gÞ 1
 2  
pind 2
gðnI1 Þ A22  2ft ð4A1 A2
2
gðnI2 Þ
A21  2ft =ð8t2 gÞ A1  2nt   2 

fnI1 A1  2nt   2

 fnI2
I1 I2
3A22  2ftÞ=ð8t 2 gÞ
pd n/a d  c  cd Þ½1  A2
ðr 0
 A22  2ft =ð2t2 gÞ
pI  2 2  2 2
gðnI1 Þ gðnI2 Þ
A21  2ft =ð8t2 gÞ A1  2nt   2  fnI1

A22  2ft =ð8t 2 gÞ A1  2nt   2

 fnI2
I1 I2
c  cd þ r d
Feasible range f < A21 =ð2tÞ f < A22 =ð2tÞ

Proposition A.2 (Appendix A) summarizes the equilibrium out-
comes of these two cases in using dual channels. From Propositions
A.1 and A.2, we know that, in Case I, when the variety cost is suffi-
ciently high, the retailer offers a lower margin and obtains a lower de-
mand while the manufacturer charges a higher unit wholesale price
and provides a smaller product variety in using dual channels than
using the single indirect channel. Furthermore, we have Corollary 2.
Corollary 2. In Case I: (i) if the reservation price r is sufficiently low
and the variety cost is sufficiently high, the effects of the channel
structure on the manufacturer’s decisions are similar to those in the
centralized setting (see Corollary 1); and adding the direct channel
decreases the retailer’s profitability. (ii) Since the manufacturer can
serve part of consumers through the direct channel, the manufacturer
decreases product variety to reduce the variety cost if VC is sufficiently
high. (iii) Adding the direct channel raises the unit wholesale price and
retail price in the indirect channel if the reservation price r is
sufficiently low, i.e., enhancing the double marginalization effect.
Notice that the finding of Corollary 2(iii) is different from that in
Chiang et al. (2003), who claimed that the wholesale and retail
prices are always lower when the manufacturer uses dual channels
than when it relies only on retail distribution. Specifically, in Case I,
the arbitrage constraint w 6 pd is nonbinding such that the nega-
tive effect of this constraint on the unit wholesale price does not
exist. Note that the retailer extracts most of the total surplus of
the indirect channel, and the reservation price for the direct chan-
nel relative to the indirect channel is not too low. Moreover, the
customization avoids the consumer’s fit cost (trip cost), which in-
creases market demand for the direct channel and decreases that
for the retailer. As a result, the manufacturer transfers some con-
sumers from the indirect channel to the direct channel through
raising the unit wholesale price.
In Case II, when the variety cost is sufficiently high, although
adding the direct channel decreases the retailer’s margin, the re-
sults on the unit wholesale price, product variety, and market de-
mand depend on the values of the parameters as summarized in
Proposition A.3 (Appendix A). Notice that in Case II, on one hand,
adding the direct channel can raise the control of the manufac-
turer over the unit wholesale price due to product customization
in the direct channel. On the other hand, the relative profitability
of the indirect channel to the direct channel is high and the unit
wholesale price constraint w 6 rd in dual channels is binding such
that the manufacturer leaves more profit to the retailer to prevent
the retailer from switching purchases to the direct channel. The
higher the reservation price r is, the higher the relative profitabil-
ity of the indirect channel will be. As a consequence, we have
Corollary 3.
Corollary 3. In Case II, if the reservation price r is sufficiently high
(r > cr  3c + 4rd), the manufacturer charges the retailer a lower unit
wholesale price in using dual channels than using the single indirect
channel; otherwise, it charges a higher unit wholesale price.
Corollary 3 means whether adding the direct channel decreases
the unit wholesale price directly depends on the reservation price.
By adding the direct channel, the manufacturer can decrease prod-
uct variety to save the variety cost. On the other hand, when the
marginal selling cost of the custom product cd increases, the man-
ufacturer increases product variety to stimulate the demand for
the standard product. In Case II, the manufacturer provides a greater
product variety in using dual channels than using the single indirect
channel if the marginal selling cost of the custom product (cd) is
sufficiently high regardless of VC, which is inconsistent with the
centralized setting (see Corollary 1). Thus, we can see that the
decentralization of the supply chain may invert the effect of channel
structure on product variety.
The custom product can substitute for the standard product
such that adding the direct channel negatively influences the de-
mand for the standard product in the indirect channel. On the
other hand, the market demand for the standard product positively
depends on product variety. Moreover, adding the direct channel
may decrease the unit wholesale price and the retailer’s margin
of the standard product, which increases the market demand due
to a lower retail price. As a result, when the variety cost is suffi-
ciently high ðg > maxfg ^1; g
^ 22 gÞ, adding the direct channel raises
the demand for the standard product if the marginal selling cost
of the custom product is very high ðcd > ^cd1 Þ. From Proposition
A.2 and Table 1, it is clear that in using dual channels, the inte-
grated firm offers a lower retail price and produces a larger quan-
tity of the standard product than in the decentralized supply chain;
and the product variety of the integrated firm is greater than that
in the decentralized supply chain. That is, decentralization raises
the retail price of the standard product due to the double margin-
alization effect and decreases product variety because the manu-
facturer only reaps part of the benefit from increasing product
variety, which decreases the demand for the standard product.
Proposition 2 summarizes the conditions under which the man-
ufacturer uses dual channels.
Proposition 2. (i) In Case I, the manufacturer uses dual channels if
g > g^ 1 ; and (ii) in Case II, the manufacturer uses dual channels if
2rd + cr  c < r < 4rd  3c + cr and g 6 minfg
^1 ; g
^ 22 g.
From Propositions 1 and 2, we know that the results on the
channel structure strategy in the decentralized setting may be
different from those in the integrated setting. Specifically, the man-
ufacturer may have an incentive to use dual channels even when
120 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124

the variety cost is sufficiently low ðg 6 minfg

^1; g
^ 22 gÞ, which differs M
from the findings in Proposition 1 because the manufacturer can 4.4
reduce the retailer’s profit margin by adding the direct channel.
Proposition 2(ii) implies that dual channels for the manufac-
M1
turer may be better than the single indirect channel even when 4.2
there is no demand for the direct channel because adding the direct
channel decreases the retailer’s profit margin. This finding is con-
sistent with that in Chiang et al. (2003). 4.0
M2

Proposition 3. A higher unit production cost c or marginal selling

cost cd decreases the manufacturer’s motivation to use dual channels. 3.8

From Proposition 3, we know that when the unit production

cr
cost increases, the manufacturer has a weaker incentive to use dual 2.5 3.0 3.5 4.0
channels. Specifically, when the unit production cost c increases,
the manufacturer’s profit decreases regardless of the channel Fig. 2. Manufacturer’s profit versus marginal selling cost for the standard product.
structure strategy. However, the negative effect of the higher unit
production cost on the manufacturer’s profit in using the single
M
indirect channel is smaller than that in using dual channels be- 4.5
cause the total demand in dual channels is higher than that in
the single indirect channel. This explains why the manufacturer 4.0
has a higher incentive to use dual channels when th unit produc- M2

tion cost decreases. When the marginal selling cost cd increases, 3.5
the demand for the standard product increases, which raises the
3.0
manufacturer’s profitability; on the other hand, the demand for
the custom product decreases and the variety cost increases due 2.5 M1
to a greater product variety, which decreases the manufacturer’s
profitability. Moreover, if the marginal selling cost of the custom 2.0
product cd increases, the manufacturer’s profitability in using the
1.5
direct channel will decrease. As a consequence, the manufacturer’s
profit in using dual channels decreases with the marginal selling r
cost cd because its negative effect outweighs its positive effect, 28 30 32 34
which further decreases the manufacturer’s motivation to use dual
channels. Theorem 1 below summarizes the core insights from the Fig. 3. Manufacturer’s profit versus reservation price for the standard product.

above discussions.
M
Theorem 1. (a) The effect of channel structure on product variety
may be inverted by the supply chain decentralization. (b) When the
5.5
variety cost is sufficiently low: the decentralization of indirect channel M1

may invert the manufacturer’s equilibrium channel structure strategy,

5.0
i.e., decentralization raises the motivation of using dual channels. (c) It
is more likely for the manufacturer with either a low unit production
4.5
cost or low marginal selling cost for the direct channel to use dual
channels. M2
4.0
Figs. 2–4 illustrate how the manufacturer’s profit depends on
some of the key parameters, the default values of which are as 3.5
follows:
t
c ¼ 5; cd ¼ 2; cr ¼ 3; f ¼ 0:1; r ¼ 34; r d ¼ 10; t ¼ 20; 12 14 16 18 20 22 24
and g ¼ 2:
Fig. 4. Manufacturer’s profit versus the fit cost.
In Figs. 2–4, the fine curve represents the manufacturer’s profit in
 
using the single indirect channel pM1 and the thick curve
  repre-
sents the manufacturer’s profit in using dual channels pM2 . to use dual channels decreases with the reservation price of
From Fig. 2, we know that a higher marginal selling cost of the standard product.
the standard product cr raises the incentive for the manufacturer Fig. 4 implies that a higher fit cost t strengthens the manufac-
to use dual channels due to a lower unit wholesale price in turer’s motivation to use dual channels. Specifically, if the market
using the single indirect channel. Fig. 3 indicates that a higher is fully covered by the standard product, the manufacturer in-
reservation price r weakens the manufacturer’s motivation to use creases product variety to cover the market as fit cost t increases;
dual channels. To be specific, when the reservation price r in- otherwise, the manufacturer reduces product variety to save the
creases, the manufacturer increases product variety to stimulate variety cost because it is more difficult to stimulate demand by
the demand for the standard product in using dual channels. increasing product variety. If the market is fully covered by the
However, in using the single indirect channel, the manufacturer standard product, the manufacturer offers a greater product vari-
can raise the unit wholesale price to extract the consumer’s sur- ety to react to the increased fit cost in using the single indirect
plus, which further induces a greater product variety to stimu- channel than using dual channels because adding the direct chan-
late demand. As a consequence, the manufacturer’s motivation nel decreases the retail price of the standard product, which means
 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
that using dual channels reduces the increased variety cost. If the
market is not fully covered by the standard product, the demand
advantage of using the single indirect channel over dual channels
decreases with the fit cost due to a smaller variety difference. As
a consequence, the manufacturer has a stronger incentive to use
dual channels as the fit cost increases. In other words, it is more
likely for a manufacturer to use dual channels when consumers are
very sensitive to product differentiation.
Proposition 4 addresses the issue of whether adding the direct
channel harms the retailer.
Proposition 4. (i) In Case I, adding the direct channel is detrimental
to the retailer; (ii) in Case II, adding the direct channel is not
detrimental to the retailer if and only if (a) g
^1 < g 6 g
^ 22 and r d < ^rd1
or (b) g > maxfg ^1 ; g
^ 22 g and cd P ^cd2 , where ^r d1 ¼ r  cr 
     
A21 A21  8ft =ð16t 2 gÞ and ^cd2 ¼ A21 A21  8ft = 16A33 þ ft=A3 ; (iii)
In Case II, the Pareto range over which the two players are better off
using dual channels is non-empty.
Proposition 4 states that adding the direct channel may reduce
the equilibrium profit of the retailer due to reduced demand for the
standard product or a lower profit margin. However, under some
conditions, adding the direct channel is beneficial to the retailer be-
cause the retailer can secure a higher profit margin or obtain a
higher demand. Thus, the retailer may encourage the manufacturer
to add the direct channel because this action raises the retailer’s
profit. This argument is consistent with Tsay and Agrawal (2004),
who found that given the retail price, the addition of a direct chan-
nel alongside an indirect (reseller) channel is not necessarily detri-
mental to the reseller. Proposition 4(iii) means that the dual
channel structure for the two players may Pareto dominate the sin-
gle indirect channel in Case II. Thus, they may have an incentive to
collaborate with each other to add the direct channel.
4. Robustness of the channel structure strategy
In this section, based on the basic model, we develop two alter-
native models to examine the robustness of the channel structure
strategy to channel leadership and exogenization of product vari-
ety by comparing them with the basic model. Alternative model
1 assumes that the manufacturer acts as the Stackelberg pricing
leader and the retailer is the follower, and alternative model 2
assumes that the product variety level is exogenously set.
4.1. Channel leadership
We have considered the RS model where the retailer is the pricing
leader and the manufacturer is the follower. How does the channel
leadership structure (i.e., sequence of decisions) affect the manufac-
turer’s equilibrium channel structure strategy? To address this issue,
we consider an MS model in which the manufacturer is the Stackel-
berg leader. Specifically, in the first stage, the manufacturer first de-
cides whether to engage in direct sales, and then determines the
product variety n, unit wholesale price w of the standard product,
and price pd of the custom product (if the manufacturer opens the di-
rect channel). In the second stage, the retailer determines the retail
price p of the standard product.
For the sake of convenience, in this subsection we use the first
number suffix 3 to represent the case of using the single indirect
channel and 4 to represent the case of using dual channels. We first
consider the case where the manufacturer only uses the indirect
channel. The market demand is given by Eq. (1). The retailer’s
profit is pR3 = x1  (p  w  cr) and the manufacturer’s profit is
pM3 = (w  c)x1  gn2/2  nf. Table 2 summarizes the equilibrium
outcomes and profits, where n32 is the unique positive root of
 
t  gn3  fn2 = 0, and g^ 3 ¼ A1 A21  4ft =ð8t 2 Þ.
121
When the market is partially covered, the effects of the
parameters on the equilibrium outcomes and profits are similar
to those under the RS model. When the market is fully covered
and n32 > 2t/A1, we find that product variety decreases with the
variety cost factors (g, f) and is independent of the total surplus
of the indirect channel (r  c  cr), which differs from the RS mod-
el. If n32 6 2t/A1, the product varieties under the two models are
identical when the market is fully covered. Furthermore, from
Proposition A.1 and Table 2, we see that the manufacturer charges
a higher unit wholesale price and achieves a higher profit under
the MS model than under the RS model. When the market is fully
covered, the retailer makes a smaller profit under the MS model
than under the RS model. That is, there exists a first-mover advan-
tage for the retailer (Choi and Fredj, 2013). However, when the
market is partially covered, the first-mover advantage no longer
exists for the retailer. It is now the case where the retailer can
counter-intuitively gain a higher profit due to a higher demand un-
der the MS model than under the RS model. We summarize the
core insights in Theorem 2.
Theorem 2. (a) In the single indirect channel setting, channel
leadership plays an important role in determining product variety if
the variety cost is sufficiently low; otherwise, the effect of channel
leadership on product variety is small. (b) Whether the retailer has an
incentive to act as a leader depends on whether the market is fully
covered in the single indirect channel setting.
When the manufacturer uses dual channels, the marginal con-
sumer is indifferent between the standard and custom products,
i.e., r  p  tx/(2n) = rd  pd P 0. Thus, in using dual channels, the
demand for the standard product is x4 = 2n(pd  p + r  rd)/t. Fur-
thermore, the retailer’s profit is
pR4 ¼ 2nðpd  p þ r  rd Þðp  w  cr Þ=t
and the manufacturer’s profit is
pM4 ¼ 2nðpd  p þ r  rd Þðw  cÞ=t þ ½1  2nðpd  p þ r  rd Þ=t
 ðpd  c  cd Þ  gn2 =2  nf :
Solving the first-order condition @ pR4/@p = 0 for p, we have
p4 = (cr + pd + r  rd + w)/2. Substituting p4 into x4, we have
x4(w) = n(r  cr + pd  rd  w)/t. When the constraint x4(w) 6 1 is
satisfied, inserting p4 into pM4, we obtain the manufacturer’s profit
pM4(n, pd, w). Differentiating pM4(n, pd, w) with respect to w yields
the first-order condition
Solving it for w, we have w(pd) = pd + (r  cd  cr  rd)/2. If
r < cd + cr + rd, we have w(pd) < pd, so the unit wholesale price reac-
tion is w4(pd) = w(pd). If r P cd + cr + rd, the constraint w(pd) 6 pd is
binding such that the unit wholesale price reaction is w4(pd) = pd.
Considering the unit wholesale price of the standard product in
using the indirect channel, the manufacturer determines (n, pd) to
maximize pM4(n, pd, w4 (pd)). We can show that pM4(n, pd, w4(pd))
Table 2
Equilibrium outcomes and profits when only using the indirect channel.
g > g^ 3 (Partially covered, g 6 g^ 3 (Fully covered, j = 2)
j = 1)
n3j ðA21  4ftÞ=ð4t gÞ n32 ¼ maxfn32 ; 2t=A1 g
w3j (c + r  cr)/2 r  cr  t=n32
 
p3j (c + cr + 3r)/4 r  t= 2n32
 
x3j A1 A21  4ft =ð8t 2 gÞ 1
pM3j  2  2
A21  4ft =ð32t2 gÞ A1  t=n32  g n32 =2  n32 f
pR3j
    
A21 A21  4ft =ð32t2 gÞ t= 2n32
Feasible f < A21 =ð4tÞ
range
122 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124

is an increasing function of pd and a concave function of n. Similar
to the RS model, the manufacturer has no incentive to use dual
channels if pd > rd. Thus, the manufacturer will offer the direct
channel price pd4 ¼ r d in using dual channels. Table 3 summarizes
 
the equilibrium outcomes and profits, where g ^ 41 ¼ A2 A22  4ft =
ð8t 2 Þ < g ^ 42 ¼ A3 ðcd A3  ftÞ=t 2 ¼ g
^ 3 and g ^ 22 .
From Proposition A.2 and Table 3, we observe that in using dual
channels, the effects of the parameters on the equilibrium outcomes
and profits are similar to those under the RS model. However, the
range over which the unit wholesale price is lower than the direct
channel price is smaller than that under the RS model. If the reserva-
tion price r of the standard product is sufficiently large, the equilib-
rium outcomes are identical under both the RS and MS models. If the
reservation price of the standard product is sufficiently low (r < cd + -
cr + rd), the unit wholesale price and retail price in using dual chan-
nels are higher than using the single indirect channel. This result is
different from Chiang et al. (2003). However, it is consistent with
that under the RS model. Hence, we argue that the channel leadership
is not one of the major factors that account for this difference (in the ef-
fect of channel structure on prices) but customization in using the direct
channel is the major factor.
Similar to Propositions 1 and 2, we derive the following.
Proposition 5. Under the MS model, we have: (i) when r < cd + cr + rd,
the manufacturer chooses dual channels if and only if g > g ^3,
 2
or g^ 41 < g 6 g
^ 3 and A22  4ft =ð32t2 gÞ  A2 þ t=n32 þ n32 f þ
  2
g n32 =2 > 0; and (ii) when r P cd + cr + rd, the manufacturer
chooses dual channels if g 6 minfg ^3 ; g
^ 42 g; A1 < 2A3 , and n32 < t/A3.
Comparing Propositions 1, 2, and 5, we find that the qualitative
results on the channel structure strategy are robust to the relative
channel leadership of the players. Similar to Proposition 3, we can
show that a higher marginal selling cost cd decreases the manufac-
turer’s motivation to use dual channels.
From Propositions 2 and 5, we see that if g > g ^ 3 ð> g
^ 1 Þ and
r < cd + cr + rd, the manufacturer uses dual channels under both
the RS and MS models; and if g > maxfg ^3 ; g
^ 42 gðP maxfg ^1; g^ 22 gÞ
2 2
and r P 3cd + cr + rd, we can show ½ðcd A3  ftÞ  ðA21  8ftÞ =64
2 2
=ð2t 2 gÞ > ½ðcd A3  ftÞ  ðA21  4ftÞ =16=ð2t2 gÞ, which implies Cor-
ollary 4.
Corollary 4. The manufacturer has a stronger incentive to use dual
channels under the RS model than the MS model if the variety cost is
sufficiently large.
We can explain Corollary 4 as follows: when the retailer is the
leader, the retailer extracts most of the profit in the indirect chan-
nel, which decreases the manufacturer’s profitability. Thus, one of
Table 3
Equilibrium outcomes and profits when using dual channels.
the main incentives for the manufacturer to use dual channels is to
strengthen its bargaining power in the indirect channel. When the
manufacturer is the leader, the incentive of the manufacturer to
strengthen its bargaining power via adding the direct channel is
weaker. That is, the channel leadership advantage of the retailer gives
the manufacturer a stronger incentive to use dual channels.
4.2. Exogenization of product variety
We have considered the endogenous variety setting and we
now investigate how the exogenization of product variety affects
the optimal channel structure strategy. From Proposition A.1 and
A.2, we derive Proposition A.4 (Appendix A). We find that if the res-
ervation price r is sufficiently low, the manufacturer prefers dual
channels to the single indirect channel because adding the direct
channel can attract more consumers or reduce the retailer’s profit
margin, regardless of product variety. However, in the endogenous
variety setting, if the variety cost (g) is sufficiently low, this result
is no longer valid. Now, the manufacturer has no incentive to use
dual channels. Here, the insight is summarized in Theorem 3:
Theorem 3. (i) The endogenization of product variety inverts the
manufacturer’s channel structure strategy if the reservation price of
the standard product and the variety cost are sufficiently low. (ii) If the
reservation price r is sufficiently low, the retailer may object to the
addition of the direct channel because adding the direct channel harms
the retailer through reducing the retailer’s profit margin or demand.
In the exogenous variety setting, if the reservation price r is suffi-
ciently high, the manufacturer’s motivation to use dual channels de-
pends on product variety, i.e., product variety plays an important
role in making the channel structure decision. Specifically, if product
variety is sufficiently high (n P max{t/A3, 2t/A1}), a higher product
variety will increase the manufacturer’s motivation to use dual
channels due to a lower unit wholesale price in using the
single indirect channel. However, if product variety satisfies
t/A3 6 n < 2t/A1, a greater product variety weakens the manufac-
turer’s motivation to use dual channels due to a higher gross profit
excluding the variety cost in using the single indirect channel. If
product variety is sufficiently small (n < t/A3), the manufacturer
chooses dual channels only if the marginal selling cost in using
the direct channel cd is sufficiently low due to a high profitability
for the direct channel. Here, we have Theorem 4.
Theorem 4. The monotonicity of the manufacturer’s motivation to
using dual channels in product variety depends on product variety,
and the reservation price or costs in the direct channel.
5. Conclusions
With the emergence of e-commerce, the dual channel distribu-
tion structure is becoming an important channel structure strategy

r < cd + cr + rd (j = 1) r P cd + cr + rd (j = 2)

g > g^ 41 g 6 g^ 41 g > g^ 42 g 6 g^ 42
 
n4j A22  4ft =ð4tgÞ n41 ¼ maxfn32 ; 2t=A2 g (cdA3  ft)/(tg) n42 ¼ maxfn32 ; t=A3 g

w4j (r  cr + rd  cd)/2 r cr  t=n41 rd r  cr  t=n42

 
p4j r  A2/4 r t=ð2n41 Þ (cr + r + rd)/2 r  t= 2n42
 
x4j A2 A22  4ft =ð8t 2 gÞ 1 A3(cdA3  ft)/(t2g) 1

p  2  2 2  
M4j ðA22  4ftÞ t g n41 ðcd A3  ftÞ t g n42 2
 c  cd þ r d A1    n41 f  c  cd þ r d A1    n42 f
32t2 g n41 2 2t 2 g n 2
      42
pR4j 2 2
A2 A2  4ft =ð32t2 gÞ t= 2n41 A23 ðcd A3  ftÞ=ð2t 2 gÞ t= 2n42

Feasible range f < A22 =ð4tÞ f < cdA3/t

 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124 123

for manufacturers. Owing to the development of economy and Acknowledgements

technology, consumer’s needs for product variety and customiza-
tion increase such that product variety and customization are We would like to thank the two anonymous referees for their
becoming important competing dimensions. We develop an RS helpful suggestions and insightful comments, which have signifi-
model of a one-manufacturer and one-retailer two-echelon supply cantly improved the presentation of this paper. Tiaojun Xiao’s re-
chain to investigate the interactions between product variety and search was supported in part by the National Natural Science
channel structure strategy for a manufacturer in the case where Foundation of China under Grants 71371093, 70971060 and
the manufacturer sells a custom product via the direct channel. 71071073. Tsan-Ming Choi’s research was supported partially by
We also develop two alternative models to examine the robustness the Research Grants Council of Hong Kong, under Grant No. PolyU
of the channel structure strategy to channel leadership and exoge- 5424/11H.
nization of product variety.
In the basic model, namely the RS model, the retailer is the Appendix A. Technical notes
pricing leader and the manufacturer is the pricing follower. We
give the equilibrium outcomes and profits in the single indirect
and dual channel settings, and find that when the variety cost Proposition A.1. Assume f < A21 =ð8tÞ. When the manufacturer only
is sufficiently large, the integrated firm provides a smaller prod- uses the indirect channel, the unique SPNE and the respective decisions
uct variety in dual channels than in the single indirect channel; are given as follows: (i) the SPNE market demand is
otherwise, the integrated firm provides a greater product variety ( 
A1 A21  8ft ; Þ=ð16t 2 gÞ; if g > g^1
in dual channels. The decentralization of the supply chain may in- x1 ¼ (ii) the SPNE variety is
vert the effect of channel structure on product variety. Unlike 1; if g 6 g
^1
( 
Chiang et al. (2003), adding the direct channel enhances the dou- A21  8ft =ð8t gÞ; if g > g ^1
n1 ¼ ; the SPNE margin is
ble marginalization effect due to customization in using the direct 2t=A1 ; if g 6 g
^1
channel if the reservation price r is sufficiently low. When the  
m1 ¼ cr þ A1 =2, and the SPNE unit wholesale price is w1 ¼ c þ A1 =4;
variety cost is sufficiently high and the reservation price of the and (iii) the SPNE profits of the two players are
standard product is sufficiently low, the manufacturer would like 8 2
to use dual channels. In addition, we find that the manufacturer’s >
< A21  8ft =ð128t 2 gÞ; if g > g
^1
motivation to use dual channels decreases with the unit produc- pM1 ¼ and
tion cost, the reservation price of the standard product, and the >
: A1  2ft  2t22g ; if g 6 g
^1
4 A1 A1
marginal selling cost in using the direct channel, while increases ( 2 2 
with the marginal selling cost of the retailer and the fit cost. The A1 A1  8ft =ð32t 2 gÞ; if g > g
^1
pR1 ¼ ;
decentralization of the indirect channel may invert the channel A1 =2; if g 6 g
^1
structure strategy for the manufacturer if the variety cost is suf-
ficiently low. We give the conditions under which the dual chan-  
nels structure for the retailer dominates the single indirect where g^ 1 ¼ A1 A21  8ft =ð16t 2 Þ. P.S.: The assumption f < A21 =ð8tÞ en-
channel structure. sures that the equilibrium outcome is feasible.
Comparing the MS model with the RS model, we find that in the
n o
single indirect channel setting, channel leadership (and hence se-
Proposition A.2. Assume f < min A22 =ð8tÞ; cd A3 =t . In using dual
quence of decisions in the supply chain) plays an important role channels, we have pd2 ¼ r d and:
in determining product variety if and only if the variety cost is suf-
ficiently low; and whether the retailer has an incentive to act as a (i) For Case I, the SPNE decisions are: m2 ¼ cr þ A2 =2;
pricing leader depends on whether the market is fully covered. The
w2 ¼ ½r  cr þ 3ðr d  cd Þ=4, and
manufacturer has a stronger incentive to use dual channels under ( 
the RS model than the MS model if the variety cost is sufficiently A22  8ft =ð8tgÞ; if g > g ^ 21
n2 ¼ ; the SPNE demand for
large because adding the direct channel serves as a means for the 2t=A2 ; if g 6 g
^ 21
manufacturer to strengthen its power over the retailer. In the exog- the standard product is
(  
enous variety model, we give the variety range over which the 2
A2 A2  8ft =ð16t2 gÞ; if g > g^ 21 ; and the SPNE profits are
x2 ¼
manufacturer would like to use dual channels and find that 1; if g 6 g
^ 21
whether a greater product variety weakens the manufacturer’s 8 2
< A2  8ft =ð128gt 2 Þ  c  cd þ r d ; if g > g^ 21
motivation to use dual channels depends on the product variety pM2 ¼
2
and
: A2  2ft  2t2 g  c  cd þ r d ; if g 6 g^ 21
and reservation price of the standard product. Product variety 4 A2 A22
influences the channel structure strategy and the retailer prefers (  
A22 A22  8ft =ð32t 2 gÞ; if g > g^ 21 ;
collaborating with the manufacturer in adding the direct channel pR2 ¼ where g^ 21 ¼
A2 =2; if g 6 g^ 21
only when the reservation price of the standard product is suffi-  
ciently high. We find that endogenizing product variety inverts A2 A22  8ft =ð16t2 Þ;
the channel structure strategy of the manufacturer if the reserva- (ii) For Case II, the SPNE decisions are: m2 ¼ ðcr þ r  r d Þ=2;

tion price of the standard product and the variety cost are suffi- ðcd A3  ftÞ=ðtgÞ; if g > g ^ 22
w2 ¼ rd , and n2 ¼ ; the SPNE
ciently low. t=A3 ; if g 6 g
^ 22
In this paper we assume that the direct channel can customize demand for the standard product is

the whole circular spatial market. In reality, the manufacturer may  A3 ðcd A3  ftÞ=ðt 2 gÞ; if g > g ^ 22
x2 ¼ ; and the SPNE profits
only customize a part of the market. Thus, considering the custom- 1; if g 6 g ^ 22
(
ization range is an interesting topic for future research (Dewan 2
ðcd A3  ftÞ =ð2t2 gÞ c  cd þ rd ; if g > g ^ 22
et al., 2003). We assume that the variety cost is independent of are pM2 ¼ 2 2 and
r d  c  tf =A3  t g= 2A3 ; if g 6 g ^ 22
the demand for the standard product. Future research may relax  2
2
this assumption to examine the robustness of the channel struc- pR2 ¼ A3 ðcd A3  ftÞ=ð2t gÞ; if g > g^^22 , where g^ 22 ¼
ture strategy to cost structure by making use of information A3 =2; if g 6 g22
technology. A3 ðcd A3  ftÞ=t2 .
124 T. Xiao et al. / European Journal of Operational Research 233 (2014) 114–124
Proposition A.3. Assume f < minfA22 =ð8tÞ; cd A3 =tg. In Case II, adding
the direct channel: (i) decreases the unit wholesale price if and only if
r > cr  3c + 4rd; (ii) when g > maxfg ^1; g
^ 22 g, increases the product
variety of the standard product if cd > A21 =ð8A3 Þ and increases the
market demand for the standard product if cd > ^cd1 ¼
 
A1 ðA21  8ftÞ= 16A23 þ ft=A3 ; (iii) when g 6 minfg ^1; g
^ 22 g or
g^ 1 < g 6 g^ 22 , increases the product variety of the standard product
if cd > A3; and (iv) when g ^ 22 < g 6 g
^ 1 , increases the product variety
of the standard product if cd > ft/A3 + 2t2g/(A1A3).
Proposition A.4. In the exogenous product variety setting, we have:
(i) In Case I, the manufacturer would like to use dual channels and
adding the direct channel reduces the retailer’s benefit, regard-
less of product variety;
(ii) In Case II, (a) the manufacturer uses dual channels if (n P max
{t/A3, 2t/A1} and n > t/[2(rd  c)]), (n < min {t/A3), (2t/A1} and
cd < ^cd3 ), (2t=A1 6 n < t=A3 and cd < ^cd4 ) or (t/A3 6 n < 2t/A1
and r d > c þ nA21 =ð8tÞ); and (b) adding the direct channel does
not reduce the retailer’s benefit if and only if (c > ^c1 and
n < min {t/A3, 2t/A1}) or (t/A3 6 n < 2t/A1 and n < 2tA3 =A21 Þ,
where ^cd3 ¼ ½r d  c  nA21 =ð8tÞ  ffiffiffinA3 =tÞ; ^cd4 ¼ ½rd  c  t=
pffiffiffi =ð1 p
ð2nÞ=ð1 nA3 =tÞ and ^c1 ¼ 2r d  ð 2  1Þ ðr  cr Þ.
Appendix B. Supplementary material
Supplementary data associated with this article can be found, in
the online version, at http://dx.doi.org/10.1016/j.ejor.2013.08.038.
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