Reverse Pricing and Revenue Sharing in a Vertical Market

Abstract

Advancing in information technology has empowered firms with unprecedented flexibility when interacting with each other. We compare welfare results in a vertical market (e.g., manufacturers and retailers) across several types of pricing strategies depending upon (1) which side (retailers or manufacturers) chooses retail prices and (2) whether there is revenue sharing or linear pricing between the two sides. Our results are as follows. Under revenue sharing, retail prices (and thus industry profits) are higher if and only if they are chosen by the side featuring less competition. Under linear pricing, however, retail prices are higher if they are chosen by the side featuring more competition (for linear demand functions). Relative to linear pricing, revenue sharing always leads to lower retail prices, higher consumer surplus and social surplus. However, the comparison on industry profits depends on the demand elasticity ratios. Revenue sharing raises industry profits when the elasticity ratios are small, but the results are reversed when the elasticity ratios are large.

Keywords: Reverse pricing, Revenue sharing, Vertical relationship

JEL Classification: D43, L13