Impact of the arm’s length regulation on a supply chain with asymmetric retailers

Abstract

In many supply chains, suppliers that provide a key component to retailers in the wholesale market also have their own retail divisions in the retail market and form vertically integrated producers (VIPs) with these divisions. A VIP’s profit comes from two sources: (i) the wholesale profit from supplying the key component to retailers and (ii) the retail profit from its own retail division. In this situation, the VIP’s intra-company discount is often restricted by the arm’s length regulation (ALR) to induce fair competition in the retail market and improve the consumer benefit. However, the ALR may not always result in the desired outcome, especially when the retailers are asymmetric. Thus motivated, we investigate the impact of the ALR on the supply chain profit and the consumer benefit. Our analysis incorporates two types of asymmetry commonly observed among retailers: (i) retailer-specific selling costs and (ii) private information regarding the intra-company discount. Our results have several important implications. First, the ALR improves the supply chain profit only when the rival retailer is more competitive than the VIP’s retailer. Also, the ALR benefits consumers when the rival retailer is more competitive and the competition intensity is low. Second, under information asymmetry, while the rival retailer would not benefit from the VIP’s private information, the VIP’s gain does not always outweigh the rival retailer’s loss. Hence, the total supply chain profit may increase with the ALR. In addition, the consumer surplus can increase under information asymmetry unless the VIP’s intra-company discount is extremely limited.