The emergence of a new marketing channel affects the economy by expanding the consumer's choice of products, altering the competitiveness of retail markets and having an influence on manufacturers' profitability. The electronic commerce channel through the Internet constitutes a typical marketing channel with these features. In this paper, we construct a vertical product differentiation model comprising an upstream manufacturer and two downstream retailers. Our model is closely related to that in Chiang, Chhajed and Hess (2003). We incorporate cost asymmetry across the retailers into the model, a new feature which is not in their model. In this model, the manufacturer not only produces a physical product it sells to the downstream retailers, but also has an option of "versioning" to open a new direct channel for an alternate digital product. We find that, when the marginal cost of the physical product is in some range given other cost parameters, the direct digital channel reduces the quantity of the physical product sold by the inefficient retailer even if it increases total quantity of the physical product. We also find that, when it is higher than the above-mentioned range, the direct digital channel increases the quantity of the physical product sold by the efficient retailer even if it reduces its total quantity. Cost asymmetry across the retailers plays a role in these results. Taking the above results into account, we discuss managerial implications for a manufacturer supplying the physical and digital products.

• Yuji Nakayama(Osaka Prefecture University, Japan)