Opening a Direct Digital Channel: The Impact of Versioning on the Physical Product Market With Heterogeneous Retailers

Abstract

In this paper, we construct a vertical differentiation model comprising an upstream manufacturer and two downstream retailers with cost asymmetry. In this model, the manufacturer not only produces a physical product it sells to the downstream retailers, but also has an option of "versioning" to open a new direct channel for an alternate digital product. We find that the direct digital channel may reduce the quantity of the physical product sold by the inefficient retailer even if it increases total quantity. It may also increase the quantity of the physical product sold by the efficient retailer even if it reduces total quantity. Cost asymmetry across the retailers plays a role in these results. Moreover, under certain conditions related to the manufacturer's cost and if the quality of the digital product is sufficiently low, then the manufacturer raises the wholesale price of the physical product and ceases to deal with the inefficient retailer, thereby eliminating retail competition, which may raise its retail price. This lowers the welfare of consumers who continue to purchase the physical product after the new digital product comes onto the market.