Managing Channel Profits with Positive Demand Externalities

Long Gao (), Dawei Jian (), Mehmet Gumus () and Birendra K. Mishra ()
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Long Gao: School of Business, University of California, Riverside, California 92521
Dawei Jian: Sheldon B. Lubar College of Business, University of Wisconsin-Milwaukee, Milwaukee, Wisconsin 53202
Mehmet Gumus: Desautels Faculty of Management, McGill University, Montreal, Quebec H3A 1G5, Canada
Birendra K. Mishra: School of Business, University of California, Riverside, California 92521

Management Science, 2025, vol. 71, issue 10, 8491-8509

Abstract: 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 the problem as a dynamic game, wherein the retailer can privately observe and control evolving market conditions, and consumers can act either myopically or strategically. Our contribution is threefold. (i) We characterize the optimal contract: It resolves a dynamic tradeoff between exploiting demand externalities, screening new information, and optimizing channel efficiency; moreover, it has a simple implementation of quantity discount. (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. Our results also shed light on when and why manufacturers should moderate demand externalities and prefer long-term contracts. By highlighting the dual role of demand externalities in long-run channel performance, this study sharpens our understanding of channel theory and practice.

Keywords: distribution channel; diffusion; word-of-mouth; social learning; information asymmetry; advance selling (search for similar items in EconPapers)
Date: 2025
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