Andrei Hagiu and Julian Wright (MS, 2015). Marketplace or Reseller?

I write about the basic formulation in Hagiu and Wright (2015)’s paper modelling the choice an intermediary makes between being a marketplace and a reseller to revise for my Industrial Organization II final.

Professor Julian Wright taught the model in this paper to us this semester, and I’m going to try my best to do it justice here (hope I haven’t misunderstood anything!) Sidenote: Prof Wright is very clear and very, very, patient, and if you’re an NUS Economics student reading this, I highly recommend EC4324 Economics of Competition Policy and EC4322 Industrial Organization II! I learned a lot, and these modules got me really interested in micro theory.

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Introduction

Hagiu and Wright (2015) model the conditions under which an intermediary chooses to be a marketplace, and those under which it chooses to be a reseller. Basically, if it is better for the supplier to retain “control rights over a non-contractible decision variable,” then the intermediary will choose to be a marketplace, and if it is better for the intermediary to hold these rights, then it will choose to be a reseller. The authors give the example of marketing, and they use Best Buy, so I’ll give you a different example for further illustration.

Let’s look at, for instance, knick knack stores in Singapore. We have Naiise, a multi-brand reseller which stocks toys, novelty gifts, and more.

We also have a marketplace like Boutique Fairs Singapore, a flea market for crafts, with product offerings in domains similar to the range of items stocked by Naiise.

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How do these intermediaries decide whether to set up in reseller or marketplace mode?

An intermediary in this market may have more updated information about the general trends in the market, so they can drive up buyer demand through advertising that products are handcrafted, for example. But the individual artisans (suppliers) have more information about their specific target clientele or loyal customers, who they may interact with, and think that it is more important to advertise that the product was made from recycled fabric. Assume that it is extremely difficult or costly for the intermediary and supplier to convey their private information to each other, perhaps because this information is constantly being updated as trends change in the market. Whether the intermediary or the supplier has relatively more important information will determine whether the intermediary chooses to be a reseller or a marketplace.

Model Setup

  • There are N > 1 independent suppliers, each incurring a marginal cost of c = 0 in producing their products.
  • Each buyer is willing to pay v for each product she is interested in. The buyer must make the purchase from/through the intermediary.
  • The number of buyers for product i is m - (a_{i} - a_{i}^*)^{2}. What this says is basically that the marketing activity chosen for the product affects buyer demand.
    • a_{i} is the choice of marketing activities made by the intermediary (when it is in reseller mode) or the supplier (when the intermediary is in marketplace mode and the supplier is marketing its own product on the marketplace.
    • a_{i}^{*} is the optimal marketing activity for the product i.
    • There are two things we should realize from the use of the squared term (a_{i} - a_{i}^{*})^{2} to denote how the buyer demand is affected by the choice of marketing activity here.
      • The first thing we immediately observe is that (a_{i} - a_{i}^{*})^{2} is always positive (and so obviously (a_{i} - a_{i}^{*})^{2} is always negative), so any difference between a_{i} and a_{i}^{*}, whether that difference is in the positive direction a_{i} - a_{i}^{*} > 0 or the negative direction a_{i} - a_{i}^{*} < 0 will reduce buyer demand (i.e. consumers want what they want, no more, no less).
      • The second thing we observe is that (a_{i} - a_{i}^{*})^{2} punishes larger deviations from the optimal marketing activity. Say the total number of buyers in the market is 20, and the optimal marketing activity a_{i}^{x} is 3. If I choose a_{i} = 4, the number of buyers for product i is 20 - (4 - 3)^{2} = 19, i.e. I lose one buyer. If I choose a_{i} = 5, the number of buyers for product i is 20 - (5 - 3)^{2} = 16, i.e. I lose three more buyers from the same magnitude of increase in my choice of marketing activity. If I choose a_{i} = 6, the number of buyers for product i is 20 - (6 - 3)^{2} = 11… You get my drift.
  • a_{i}^{*} = \theta + \gamma_{i} + \delta_{i}
    • The optimal marketing choice can be additively separated into what both the supplier and the intermediary know (\theta), what the supplier knows (\gamma_{i}), and what the intermediary knows (\delta_{i}). Further exposition is in the bullet points below.
    • \theta is known to both the supplier and the intermediary.
    • \gamma_{i} represents the private information about the marketing of product i known only to the intermediary, and is a random variable that is independently and identically distributed. E[\gamma_{i}] = 0 and Var[\gamma_{i}] = V_{\gamma}.
    • \delta_{i} represents the private information about the marketing of product i known only to the supplier, and is a random variable that is independently and identically distributed. E[\delta_{i}] = 0 and Var[\delta_{i}] = V_{\delta}.
  • The entity holding control over marketing activity (reseller or supplier) will incur a fixed cost for each product, F, and a variable cost for each sale, f. Later we discuss different cost structures.

Marketplace or reseller?

Under the assumption that each entity learns their private information before deciding on the marketing activity a_{i} (the full set of timing assumptions may be found in the paper), and that the intermediary will make positive profits whether in marketplace or reseller mode, we have

Reseller

The reseller offers to buy each supplier’s product for zero to maximise its own profit. We assume that suppliers who are indifferent between selling to the reseller and not selling to the reseller will sell to the reseller. Since suppliers’ outside option (alternative) gives zero profit, and their marginal costs are normalized to zero, they are indifferent when presented with an offer of zero, and therefore choose to sell to the reseller. The cost the reseller incurs on buying each unit to resell is therefore zero.

The reseller’s expected profit is therefore given by the following expression

\pi_{R}(n) = (v - f)\sum_{i=1}^{n}E_{R}[m-(a_{i} - (\theta + \gamma_{i} + \delta_{i}))^{2}] - nF

from

\pi_{R}(n) = (v - f)\sum_{i=1}^{n}E_{R}[m-(a_{i} - a_{i}^{*})^{2}] - nF

Expanding a little, we get

\pi_{R}(n) = (v - f)\sum_{i=1}^{n}E_{R}[m - a_{i}^{2} + 2a_{i}(\theta + \gamma_{i} + \delta_{i}) - (\theta + \gamma_{i} + \delta_{i}))^{2}] - nF

The price is fixed, and the costs are fixed. But the reseller can still choose its marketing activity, a_{i}, to maximise the number of buyers. How does the reseller choose a_{i}? We first “take out” all the terms in a_{i}.

E_{R}[- a_{i}^{2} + 2a_{i}(\theta + \gamma_{i} + \delta_{i})]

The reseller has to guess at \delta_{i}, which is the private information about optimal marketing activity only known by suppliers, as mentioned above. Recall that E_{R}[\delta_{i}] = 0 (so we set all terms in \delta_{i} to be zero). We then get

E_{R}[- a_{i}^{2} + 2a_{i}(\theta + \gamma_{i})]

With all the information the reseller has, they now choose a_{i} to maximise the number of buyers, so then we have the first order condition

\frac{\partial m - a_{i}^{2} + 2a_{i}(\theta + \gamma_{i})}{\partial a_{i}} = 2a_{i} - 2\theta - 2\gamma = 0

From this, we get

a_{i} = \theta + \gamma_{i}

So with a_{i} = \theta + \gamma_{i}, what do we have for the expected number of buyers?

\pi_{R}(n) = (v - f)\sum_{i=1}^{n}E_{R}[m - ((\theta + \gamma_{i})  - (\theta + \gamma_{i} + \delta_{i}))^{2}] - nF

Simplifying, we observe that this reduces to

\pi_{R}(n) = (v - f)\sum_{i=1}^{n}E_{R}[m - \delta_{i}^{2}] - nF

Since E_{R}[m] = m and E_{R}[\delta_{i}^{2}] = E_{R}[\delta_{i} - 0]^{2} = E_{R}[\delta_{i} - E_{R}[\delta_{i}]]^{2} = Var[\delta_{i}] = V_{\delta}, we have that the expected profit of selling all N products is

\pi_{R} = N(v - f)(m - V_{\delta}) - NF

Marketplace

The marketplace charges each supplier P to be on the platform. We first see that each supplier i‘s profit-maximizing a_{i} will be a_{i} = \theta + \delta_{i}, by the same solving process as above. So each supplier makes

\pi_{i} = (v-f)(m - V_{\gamma}) - F - P

The marketplace may set P = (v-f)(m - V_{\gamma}) - F in order to extract all surplus from suppliers. At this point suppliers are indifferent between joining and not joining, and we assume, as above, that all suppliers who are indifferent will join the marketplace.

The monopolist therefore makes

\pi_{M} = N(v-f)(m - V_{\gamma}) - NF

Which makes larger profit: the marketplace or the reseller? For your convenience, I’m going to put both profit functions here for the comparison.

\pi_{R} = N(v - f)(m - V_{\delta}) - NF, \pi_{M} = N(v-f)(m - V_{\gamma}) - NF

It is easy to see that which mode allows the intermediary to make larger profit depends on whether V_{\delta} or V_{\gamma} is higher. As mentioned in the summary, whether the intermediary or the supplier has relatively more important information will determine whether the intermediary chooses to be a reseller or a marketplace.

Now we add different cost structures and heterogeneous product demand.

Heterogeneous products and costs

We now have that the reseller and the supplier (in marketplace-mode) incur variable costs f_{R} and f_{M} respectively, and fixed costs F_{R} and F_{M} respectively.

We now substitute these new parameters into the profit expressions we solved for previously.

For each product i, the reseller gets

(v-f_{R})(m - V_{\delta}) - F_{R}

For each product $latex i, the marketplace gets

(v-f_{M})(m - V_{\gamma}) - F_{M}

Which mode will the intermediary choose? Now, we see that this also depends on what f_{R}, f_{M}, F_{R}, F_{M}, and m are.

For the intermediary to be indifferent between operating in the two modes,

(v-f_{R})(m - V_{\delta}) - F_{R} = (v-f_{M})(m - V_{\gamma}) - F_{M}

vm - f{M}m - vV_{\gamma} +f_{M}V_{\gamma} - F_{M} = vm - f_{R}m - vV_{\delta} +f_{R}V_{\delta} - F_{R}

We remove the common terms, such that we have

(f{R} - f_{M})m = V_{\gamma}(v-f_{M}) - V_{\delta}(v-f_{R}) + F_{M} - F_{R}R

If f_{M} > f_{R}, m \geq m^{*},

m \geq m^{*} = \frac{V_{\gamma}(v-f_{M}) - V_{\delta}(v-f_{R}) + F_{M} - F_{R}}{f_{R} - f_{M}}

m(f_{R} - f_{M}) \geq V_{\gamma}(v-f_{M}) - V_{\delta}(v-f_{R}) + F_{M} - F_{R}

m(f_{R} - f_{M}) \geq V_{\gamma}(v-f_{M}) - V_{\delta}(v-f_{R}) + F_{M} - F_{R}

(v-f_{R})m - V_{\delta}(v-f_{R}) - F_{R} \geq (v-f_{M})m - V_{\gamma}(v-f_{M})-F_{M}

So we know that when f_{M} > f_{R}, for large enough m, product i should be offered in reseller-mode, because the profits made by a reseller are higher than those for a marketplace. For small m, product i should be offered in marketplace-mode. The converse applies for f_{M} < f_{R}.

This is an intuitive result: if the intermediary incurs a higher f_{M} than f_{R}, they should sell more popular products (with large m) in reseller mode (in order to pay a lower variable cost on each product sold), and if they incur a higher f_{R} than f_{M}, they should sell more products (with small m) in marketplace mode for the same reason.

Network externalities

If the number of buyers m is increasing in n (more buyers want to join the intermediary when there are more products being sold on it/by it, because it’s more convenient to browse, etc.). Then we have the number of buyers joining the intermediary = m(n), which is increasing in n, and m(N) = m. What this means is that if more suppliers join, more buyers join, which attracts more suppliers, which attracts more buyers, and so on. We examine what happens in marketplace mode.

Favorable beliefs

Favorable beliefs refer to the situation where suppliers believe that all other suppliers will join the intermediary whenever it is an equilibrium (they make non-negative profits). Their optimism means that their expected profit from joining an intermediary is \pi_{i}^{e} = (v-f)(m - V_{\gamma}) - F - P in equilibrium. In this case, the previous results hold.

Unfavorable beliefs

This refers to the situation where suppliers believe that no other suppliers will join the marketplace in equilibrium, like in the case in which a new marketplace has just been set up. Their expected profit from joining an intermediary is \pi_{i}^{e} = (v-f)(m(1) - V_{\gamma}) - F - P in equilibrium.

What this means is that the monopolist can only charge the supplier (v-f)(m(1) - V_{\gamma}) - F.

In this case, the monopolist makes profit

\pi_{M} = n((v-f)(m(1) - V_{\gamma}) - F)

What does the reseller make? Since the reseller is purchasing the products and selling them, it gets

\pi_{R} = n((v-f)(m(N) - V_{\delta}) - F)

So in this case, reseller-mode is always preferred to marketplace-mode if

V_{\delta} > V_{\gamma} + m(N) - m(1)

This should be easy to observe from the comparison of the two profits above.

More extensions and the proofs are available in the paper! I sincerely hope I didn’t get anything wrong, and if I did, you can let me know in the comments. I’m going to write up an extension on this that I attempt in preparation for my final in a later post.

The full paper is available here.

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