Managing Channel Profits with Positive Demand Externalities

Authors: Long Gao, Dawei Jian, Mehmet Gumus and Barry Mishra

Publication: Management Science, Forthcoming 2024.

Demand externalities arise when past sales stimulate future demand. They pervade many consumer markets. To penetrate such markets, how should manufacturers contract with retailers? We formulate this new class of channel problems as a dynamic game: in our model, the retailer can privately observe and control evolving market conditions, consumers can act either myopically or strategically, and demand externalities can come from either network effects or social learning. Our contribution is three-fold. (i) We characterize the optimal contract. It resembles the classic second-best in the short run but converges to the dynamic first-best in the long run. This structure is driven by the dynamic interplay of information friction and demand externalities. (ii) We characterize the dual role of demand externalities. Although demand externalities can improve channel surplus by expanding market size, they can also exacerbate information friction by enhancing the retailer's ability to manipulate the market. Ignoring the dark side of the agency cost, previous studies may have overestimated the benefit of demand externalities. (iii) We provide new practical guidance. We show private information per se need not hurt channel efficiency: the manufacturer can use recursive advance selling to extract new information for free. Ignoring information endogeneity and dynamic learning, however, previous studies may have overstated the harm of information asymmetry. Our results also shed light on when and why manufacturers should moderate demand externalities, overproduce supply, prefer long-term contracts, favor incumbent retailers, and improve retailer information capability, despite information asymmetry.