Product Diversion to a Direct Competitor

A manufacturer will often limit competition among downstream partners by authorizing only a select group of retailers to carry its product. However, it is not uncommon for authorized retailers to create an additional competitor by diverting units to an unauthorized seller. This paper presents an analytical model that demonstrates how diversion from authorized retailers to an unauthorized direct competitor can occur under circumstances not considered by the prior literature. In fact, diversion can represent a prisoner's dilemma whereby retailers diminish their own profit by selling to the unauthorized direct seller. The authorized retailer's profit loss actually increases as the per-unit diversion costs incurred by the authorized retailer decrease. The model also shows that the unauthorized direct seller earns greater profit by strategically procuring a unilaterally constraining quantity, even though this procurement strategy results in an equivalent increase in the quantity sold by the retailers. Combined, the results identify a new reason for diversion and its consequences for retailers and the unauthorized direct seller.