A Theory of Forward Buying, Merchandising, and Trade Deals

Abstract

Manufacturer-supported trade deals remain one of the major competitive tools in today's marketplace. This is true despite the fact that such trade deals are often claimed to be unprofitable for manufacturers. The unprofitability is attributed to the fact that retailers forward buy and do not pass the price discounts on to the consumers. The audience for this paper includes practitioners and academics who have been concerned with the ubiquitous practice of trade dealing in spite of its purported unprofitability. The paper attempts to understand the motivations for trade dealing by comparing the profitability of trade dealing in the presence of forward buying to a situation in which retailers carry no inventory. Moreover, we shed light on why manufacturers sometimes offer trade deals even though the retailers do not pass through these deals to the consumers. We study the problem of trade dealing through an economic model that includes the manufacturers, the retailer, and the consumers. In this way we include all three levels of the distribution system, and model the dynamic effects of forward buying by the retailer. The main features of the model can be summarized as follows. At the manufacturer level, each of two manufacturers is allowed to offer a regular price and a deal price, which, if accepted by the retailer, requires the retailer to display and merchandise the product. Moreover, the manufacturer is assumed to incur a selling cost with respect to offering a trade deal. The retailer, on the other hand, decides whether to accept the deal, determines how much to order, and sets the retail prices of the two brands. The retailer needs to set a price below the regular price to achieve maximum effectiveness from its display and merchandising activities. If the retailer accepts a trade deal, it incurs a fixed cost of display and merchandising the product reflecting the opportunity cost of display. If the retailer does not accept the trade deal, it can order at the non-deal price. Furthermore, the retailer can order more than what can be sold to the consumers in that period, i.e, forward buy. The retailer can carry inventory from either manufacturer at a cost but has an upper limit to the total amount of inventory carried in any period. The consumer population is assumed to consist of brand loyals and switchers. The brand loyals buy as long as the price is below the reservation price, while the switchers choose the brand on display if the retail price is lower than the regular price and the price of the competing brand. With these as the basic elements of the model, we characterize the equilibrium manufacturer and retailer pricing strategies with and without inventories in an infinite-horizon model with discounting. The central result of the paper is derived by comparing the profits to the manufacturers for the case when retailers are allowed to forward buy to the case when they are not allowed to forward buy. This comparison shows that although forward buying is profitable to the retailer through the availability of goods at lower prices, an important consequence of forward buying is the decreased intensity of competition between manufacturers. The decrease in the intensity of competition yields higher profits to the manufacturers as compared to the case where the retailer is not allowed to carry any inventory. The intuition behind our result is seen by taking a closer look at intensity of trade dealing in the presence and absence of forward buying. Consider the worst and the best trade deals offered by manufacturers, in equilibrium, when the retailer is not allowed to carry any inventory and explore their viability when the retailer is allowed to inventory. If the retailer is allowed to carry inventory and holds some inventory, the worst trade deals become unacceptable to the retailer. This is because the inventory allows the retailer to not buy all the units demanded in the subsequent period, and the retailer can therefore reject such trade deals. Similarly, the best trade deals offered by manufacturers when the retailer is not allowed to inventory do not remain as profitable because the retailer forward buys and the manufacturers lose future sales and profits. Thus trade deals at both extremes (the best and the worst) that were profitable to the manufacturers when the retailer is not allowed to forward buy are no longer viable when the retailer is allowed to forward buy. This increases the overall probability of not offering trade deals and leads to decreased intensity of competition.