Value of membership-based free shipping in online retailing: Impact of upstream pricing model

A consumer-side innovation in online retailing is membership-based free shipping (MFS) in which a retailer bears the shipping cost for purchases made by members that have paid an upfront membership fee. On the supplier side, the agency model of selling, where a retailer allows a third-party manufacturer to sell his product on the site for a commission, has been gradually replacing the wholesale model, where the retailer buys from the manufacturer at a wholesale price and resells to consumers at a retail price. We show that the shift to the agency model enhances the value of the MFS program to the retailer in the sense the retailer gains more from the MFS program and MFS is profitable to the retailer in a larger region of the parameter space under the agency model than the wholesale model. The retailer's gain from MFS comes at the expense of consumers and the society under the wholesale model, but the consumers and the society can also benefit from MFS under the agency model. The key driver of these results is that, under the wholesale model, the MFS program increases the severity of the double-marginalization problem because the MFS program increases the retailer's marginal cost; however, under the agency model, the MFS program reduces the impact of marginalization at the manufacturer end because the manufacturer faces consumers with lower purchasing cost on average. Thus, the MFS program hurts channel coordination in the wholesale model but helps it under the agency model.