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Friction in Related-Party Trade When a Rival Is Also a Customer

There are many circumstances in which manufacturers provide inputs to wholesale customers only to subsequently compete with these wholesale customers in the retail realm. Such dual distribution arrangements commonly suffer from excessive encroachment in that the manufacturer's ex post retail aggression is harmful ex ante because it undercuts potential wholesale profits. This paper demonstrates that with dual distribution, a manufacturer can benefit from decentralized control and the use of transfer prices above marginal cost. Although these arrangements often create coordination concerns, a moderate presence of such concerns permits the manufacturer to credibly convey to its wholesale customer that it will not excessively encroach on its retail territory. This, in turn, permits the manufacturer to reap greater wholesale profits. We also note that this force can point to a silver lining in arm's-length (parity) requirements on transfer pricing in that they can solidify commitments to a particular retail posture.