Abstract
This paper examines the relationship between one manufacturer and two retailers who sell a product on their downstream markets. If a retailer invests in activities that enhance demand and, for example, improve the perceived image of the product, he or she might attract more customers, as well as increase the sales volumes of other retailers. In such a situation, free rider problems arise between the retailers, which finally lead to reduced sales efforts. We show that for linear wholesale prices, the manufacturer's pricing strategy depends on the retailers' investment costs and derive conditions for the optimality of wholesale price discrimination. We find that for low and high costs the manufacturer charges the retailers identical wholesale prices and thus does not have to bear any agency costs due to free riding. In all other cases, the manufacturer mitigates this problem by engaging in wholesale price discrimination. Our results indicate why it might make sense for a manufacturer to charge different wholesale prices even when the retailers have equal cost structures, market conditions, and investment options.
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