Efficient Channel Contracting for Vertically Differentiated Products

We describe research on a supply chain contracting problem that was sponsored by a major semi-conductor manufacturer. The manufacturer sells products (semiconductor parts) with varying quality levels through a network of distributors to end consumers (independent computer shops, system configurators, hobbyists, etc.) who have heterogeneous valuations for quality. Since production costs for semi-conductors are essentially independent of quality levels (within a part family), the manufacturer earns much more selling higher quality parts. However, the firm’s distributors traditionally care more about total unit volume since their margins are similar on all products. As a result, the economics of the two parties have historically not been well aligned. The manufacturer wanted to better understand this incentive problem and develop new strategies to improve its own and distributors profits. The analysis presented here supported this effort. To analyze this problem, we consider the simple case in which the product family consists of two parts with high and low quality. We first identify the distortions inherent in the firm’s status quo wholesale pricing contracts. We then investigate alternative mechanisms that may better coordinate their channel. We start our analysis with the single-distributor case and show that revenue sharing coordinates the channel and can be designed to arbitrarily allocate profits. We study potential asymmetric contracts which create different incentives for different parts within a given product line and show which ones can potentially improve channel performance. Taking into account the fact that in many regions the manufacturer has a network of distributors, we then extend our results to the case of Cournot competition. We first characterize the distributor’s strategic interaction and then analyze a similar set of coordinating mechanisms. We show that the efficiency of the wholesale pricing contract improves as the number of competitors increases. Lastly, we discuss some of the challenges and roadblocks encountered as we tried to implement a revenue sharing program at our sponsor and why other contracts were not good candidates for implementation. The experience sheds some light on the challenges transforming supply chain contracting concepts into workable real-world programs.