The paper analyzes a differential game model of a two-member marketing channel. A manufacturer invests in national advertising with the purpose of improving (or sustaining) the image of one of her brands, and her retailer makes local promotions for the brand. The manufacturer has the option of affecting the retailer's efforts by offering to support local promotional efforts. The manufacturer advertises in national media, for instance, TV, radio, and newspapers while the retailer uses local media (newspapers, flyers, in-store displays).

It is well known, from the literature and from practice, that uncoordinated decision making in a channel can create "inefficiencies", in the sense that channel members' noncooperative payoffs are less than what they could obtain in a coordinated setup. The paper assumes that the manufacturer takes the role of a channel leader, and that the retailer accepts being a follower. The leader announces her strategy in advance and commits to playing that strategy. By doing so the manufacturer wishes to induce the retailer to implement a certain outcome and, given the leader's announcement, the retailer as a follower can do no better than to react rationally to the leader's strategy. An incentive strategy of the manufacturer can be conditioned upon the retailer's past or present actions. Here we suppose that the manufacturer offers the retailer promotional support such that the former pays the latter an amount per unit of actual retail promotion effort.

The paper deals with two specific instances of channel coordination: How can the manufacturer, through her choice of marketing strategy, induce the retailer to implement an outcome that (i) is favored by the channel members as a group, or (ii) is favored by the manufacturer only? In Case (i) the manufacturer wishes to induce the retailer to act in accordance with a cooperative outcome, viz., the joint maximization outcome. Here the manufacturer acts in the best interest of the channel and the resulting outcome is Pareto optimal (group rational). In Case (ii) the manufacturer wishes to induce the retailer to act in such a way that the manufacturer's individual payoff is maximized. The manufacturer acts in her own best interest.

The two incentive problems are asymmetric (one-sided). One channel member (the manufacturer) assumes the role of a channel leader who designs an incentive for the retailer. The latter acts as a follower. Assignment of roles is exogenous, that is, the manufacturer is a channel leader by assumption.

Studies of marketing channels have identified a number of mechanisms that can lead to coordination, under alternative hypotheses about the manufacturer's objective. Coordinating mechanisms are, for instance, quantity discounts, advertising allowances, and retailer promotion cost subsidies. Most of these works have assumed a static environment. There are still not many attempts to examine the channel coordination issue in an intertemporal setting. The literature here uses differential games to demonstrate that channel coordination can be achieved, primarily through advertising allowances. However, these studies did not address the question whether coordinated outcomes can be sustained (enforced) over time. This issue is addressed explicitly in the paper where the problem is resolved by designing an incentive such that coordinated outcomes are (Nash) equilibria.

Our findings indicate that the manufacturer can design an incentive strategy, being dependent on the retailer's promotional effort rate, such that the retailer will act in accordance with the manufacturer's wishes, stated as Cases (i) and (ii) above. It is also shown that it is not always in the manufacturer's best individual interest to implement the joint maximization outcome, cf. Case (i).