The impact of production diseconomies on manufacturer encroachment

We consider a supply chain with a manufacturer and a retailer, where the manufacturer is diseconomy of scale regarding production and may encroach into the downstream market. We prove that the production diseconomy changes the traditional wisdom regarding the impact of manufacturer encroachment on supply chain performance. First, we show that the production diseconomy disincentivizes the manufacturer's encroachment. Second, different from the literature that believes retailer can be better off as long as it has a selling cost advantage compared with the manufacturer, we establish the condition where encroachment always hurts the retailer regardless of the selling cost advantage. Third, we find that when the price does not respond sensitively to the quantity, an encroaching manufacturer would increase the wholesale price. Surprisingly, the supply chain's profit still could increase. Finally, we check how the retail competition, imperfect substitution, and price competition affect the corresponding results shown above. We show that the retail competition disincentivizes the manufacturer's encroachment and weakens the whole industry's profit benefit from the encroachment. In contrast, imperfect substitution increases the manufacturer's encroachment incentives and strengthens the industry's profit benefit from the encroachment. In the case of imperfect substitution with quantity competition, the consumers might be worse off after the manufacturer encroaches; otherwise, they benefit from the manufacturer's encroachment.