Product Diversion to a Direct Competitor

April 2012 Abstract A manufacturer will often limit competition among downstream partners by authorizing only a select group of retailers to carry its product. However, it is not uncommon for authorized retailers to create an additional competitor by diverting units to an unauthorized seller. Prior research proposes that this diversion will not be optimal unless the diverted units are sold in new markets, expand demand, or take advantage of price differentials created by channel incentives. However, anecdotal evidence suggests that retailers sell to unauthorized sellers who then steal customers from the diverting retailer. This paper demonstrates in an analytical model that diversion from authorized retailers to an unauthorized direct competitor can occur even without previously viewed necessary conditions. In fact, diversion can represent a prisoner’s dilemma whereby retailers diminish their own profit by selling to the unauthorized direct seller. The unauthorized direct seller earns greater profit by procuring fewer units from retailers than it could profitably sell to consumers even though such an order results in an equivalent increase in the quantity sold by the retailers. When authorized retailers are vertically differentiated, the inferior retailer diverts more units and has greater total sales than the higher quality retailer, though it has fewer sales to consumers.