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.
The Internet search engine market has seen a proliferation of entrants over the past few years. Whereas Yahoo was the early market leader, there has been entry by both lower-quality engines and higher-quality ones (such as Google). Prior work on quality differentiation requires that low-quality products have low prices in order to survive in a market with high-quality products. However, the price charged to users of search engines is typically zero. Therefore, consumers do not face a tradeoff between quality and price. Why do lower-quality products survive in such a market? We develop a vertical differentiation model that explains this phenomenon. The quality of the results provided by a search engine is inherently stochastic, and there is no charge for using an engine. Therefore, users who try out one engine may consult a lower-quality engine in the same session. This "residual demand" allows lower-quality products to survive in equilibrium. We then extend our model to incorporate horizontal differentiation as well and show that residual demand leads to higher quality and less differentiation in this market. Engines want to attract competitors' customers and therefore have a strong incentive to be "similar" to each other.