Expanding to direct channel: Market coverages as entry barrier

Abstract

A direct marketer can be either a manufacturer selling directly to the final consumers or a retailer that sells an assortment of products from multiple manufacturers. From a manufacturer's point of view, expanding to an online direct channel seems very attractive because intermediaries can be bypassed in reaching final consumers, while the Internet has substantially lowered the entry barrier. With the rapid diffusion of electronic commerce, numerous manufacturers have been considering a direct online channel as an alternative or a supplement to existing retailer channels. However, we observe in the real market that not many manufacturers are fully engaged in online retailing. One major factor frequently mentioned is the conflict with existing dealers who will not be pleased with a manufacturer's attempt to cannibalize their sales. This paper attempts to provide another explanation by comparing theoretical market coverage of manufacturers in a direct channel and a channel with intermediaries. We show that the direct channel can support fewer firms than the traditional retailer channel does, which becomes an effective entry barrier to latecomers. In equilibrium, the products are positively but finitely differentiated in their qualities, and the top two quality tiers would capture more than 75% of the direct channel's market potential (i.e., the “finiteness property”). Thus latecomers would find it difficult to gain a substantial market share against the existing pioneers in the competitive direct market unless they can find other meaningful ways to differentiate horizontally. The sales data of the online retail industry supports our finding.