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The Impact of Internet Referral Services on a Supply Chain

Stern School of Business, New York University, 40 West Fourth Street, New York, New York 10012
Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, Pennsylvania 15213
Ross School of Business, University of Michigan, 701 Tappan Street, Ann Arbor, Michigan 48109
aghose{at}stern.nyu.edu
tridas{at}andrew.cmu.edu
urajan{at}umich.edu

In many industries, Internet referral services, hosted either by independent third-party infomediaries or by manufacturers, serve as digitally enabled lead generators in electronic markets, directing consumer traffic to downstream retailers in a distribution network. This reshapes the extended enterprise from the traditional network of upstream manufacturers and downstream retailers to include midstream third-party and manufacturer-owned referral services in the supply chain. We model competition between retailers in a supply chain with such digitally enabled institutions and consider their impact on the optimal contracts among the manufacturer, referral intermediary, and the retailers. Offline, retailers face a higher customer discovery cost. In return, they can engage in price discrimination based on consumer valuations. Online, they save on the discovery costs but lose the ability to identify consumer valuations. This critical trade-off drives firms' equilibrium strategies. We derive the optimal contracts for different entities in the supply chain and highlight how these contracts change with the entry of independent and manufacturer-owned referral services. The establishment of a referral service is a strategic decision by the manufacturer. It leads to diversion of supply chain profit from a third-party infomediary to the manufacturer. Further, it enables the manufacturer to respond to an infomediary, by giving itself greater flexibility in setting the unit wholesale fee to the profit-maximizing level. Both third-party and manufacturer-sponsored referral services play a critical role in enabling retailers to discriminate across consumers' different valuations. Retailers use online referral services to screen out low-valuation consumers and sell only to high-valuation consumers in the online channel. Our model thus endogenously derives a correlation between consumer valuation and online purchase behavior. Finally, we show that under some circumstances, it is too costly for the manufacturer to eliminate the referral infomediary.

Key Words: internet referral services; electronic markets; price dispersion; franchise fees; discovery costs; electronic intermediary; digital supply chain
History: This paper was received on August 13, 2005.