Bricks-and-Mortar Entry by Online Retailers in the Presence of Consumer Sales Taxes

Abstract

This paper presents a parsimonious model of the bricks-and-mortar entry choice of online retailers in light of consumer sales taxes. On the one hand, a retailer benefits by entry since the second distribution channel enables it to reach new customers, giving it a leg up on rivals. On the other hand, physical entry typically compels the retailer to start collecting sales taxes even for online transactions, making its consumers particularly price sensitive. This paper examines this trade-off to characterize a retailer’s entry decision, as well as the market-level equilibrium of bricks-and-mortar penetration. The paper then layers in supply market considerations—namely, the retailer’s procurement of products from upstream suppliers. The analysis demonstrates that sales taxes not only reduce the consumers’ willingness to pay for products in the retail market, but also dampen the retailer’s willingness to pay for the products in the wholesale arena. This reluctance influences the clearing price in the supply market and, thus, the firm’s decision to establish the physical retail store. This paper was accepted by Shivaram Rajgopal, accounting.