A bane or a boon? Profit‐margin‐guarantee contract in a channel with downstream competition

Abstract In recent decades, manufacturers have relied on giant retailers or e‐tailers to distribute their products. Given this evolution, some retailers have started demanding a profit‐margin‐guarantee contract (PMG contract), under which the manufacturer must ensure that the retailer's profit margin does not fall below a certain level (PMG rate). Conventional wisdom suggests that a PMG contract creates a life‐or‐death struggle for the manufacturer and that a retailer with a PMG contract can gain a competitive edge over his competitors. This study investigates the strategic impact of the PMG contract in a competitive environment. We consider a distribution channel consisting of one manufacturer and two competing retailers. In this channel, the manufacturer has signed a PMG contract with one retailer (signed retailer) but not with the other (unsigned retailer). Our analyses show that in response to the PMG contract, the manufacturer can adopt a “ cost‐independent ” pricing strategy (i.e., setting the wholesale price independent of the production cost) to strategically trigger or void the PMG contract. For this reason, interestingly, the manufacturer is not always hurt by, nor does the signed retailer always benefit from, the PMG contract. Depending on the production cost and the downstream competition intensity, the PMG contract may yield a win–win , win–lose , lose–win , or lose–lose outcome for the manufacturer and the signed retailer. Moreover, the unsigned retailer may be able to free ride on the PMG contract, making her even better off under this unfavorable competitive situation. Nevertheless, the PMG contract cannot yield a win–win–win outcome for all firms, whereas a lose–lose–lose outcome may arise under certain conditions. Our results have useful managerial and regulatory implications.