Who Creates Demand? Retail Entry and Distribution Networks

Manufacturers rely on retailers both to sell their products and to create demand. Investment in demand creation can reverse the usual profit effects of retail entry on manufacturers and incumbent retailers. As the network grows, the manufacturer invests more and each retailer invests less. Entry can reduce the manufacturer's profit despite a higher wholesale price and greater sales, or increase incumbents' profits through savings on investment costs. When investment is sufficiently effective, the manufacturer prefers a finite network even when adding retailers is costless. Cheaper manufacturer investment expands its preferred network, whereas cheaper retailer investment contracts it and can reduce sales and consumer surplus. With identical investment technologies and finite optimal networks, the manufacturer's network is no larger than the socially optimal network; with different technologies, this ordering can reverse. The welfare consequences of distribution limits therefore depend on which firms create demand and bear its cost.