Consider a dominant manufacturer wholesaling a product to a retailer, who in turn retails it to the consumers at $p/unit. The retail-market demand volume varies with p according to a given demand curve. This basic system is commonly modeled as a manufacturer-Stackelberg ([mS]) game under a ‘deterministic and symmetric-information’ (‘det-sym-i’) framework. We first explain the logical flaws of this framework, which are (i) the dominant manufacturer-leader will have a lower profit than the retailer under an iso-elastic demand curve; (ii) in some situations the system's ‘correct solution’ can be hypersensitive to minute changes in the demand curve; (iii) applying volume discounting while keeping the original [mS] profit-maximizing objective leads to an implausible degenerate solution in which the manufacturer has dictatorial power over the channel. We then present an extension of the ‘stochastic and asymmetric-information’ (‘sto-asy-i’) framework proposed in Lau and Lau, coupled with the notion that a profit-maximizing dominant manufacturer may implement not only [mS] but also ‘[pm]’ – i.e., using a manufacturer-imposed maximum retail price. We show that this new framework resolves all the logical flaws stated above. Along the way, we also present a procedure for the dominant manufacturer to design a profit-maximizing volume-discount scheme using stochastic and asymmetric demand information. Using our sto-asy-i framework to resolve the logical flaws of the det-sym-i framework also reveals two noteworthy points: (i) the attractiveness of the perfectly legal but overlooked channel-coordination mechanism [pm]; and (ii) volume discounting as a means for the dominant manufacturer to benefit from information known only to the retailer.
