When thinking about channels of distribution arrangements one must always remember that the goals of the various firms in the channels may diverge from one another. This is natural since various members are separate firms with distinct business models.
Take, for example, a manufacturer who sells products through a retailer. While a manufacturer is devoted to its own products, a retailer (and other distribution partners like "distributors") typically sells the products of many manufacturers. A manufacturer may want to educate customers about its own product, while the retailer may not want to bear the costs (or have the expertise) to provide product education. In fact, a retailer may simply be interested in pushing the products of any manufacturer that provides the highest margin. This is not surprising because, again, the manufacturer and retailer are separate firms.
As a result of divergent interests between channel partners, various problems can arise that require a manufacturer to think in terms of channel incentives. Lets think about two of the classic problems: bait and switch and free-riding.
BAIT AND SWITCH
To understand bait and switching, consider the following figure.
Bait and switching occurs because Manufacturer 1 spends resources educating customers about a product category while Manufacturer 2 does not. This education effort is costly and can result in lower margins for the retailer. After all, its Manufacturer 1 who is pulling in the customers via the education effort, so why give the retailer a big margin. But sine Manufacturer 2 isnt involved in educating the market (but gets some benefit, especially due to greater awareness about the product category) can provide a higher margin to the retailer than Manufacturer 1. So what happens? The retailer has an incentive to use Manufacturer 1s product as the bait (i.e., to attract customers), but then push Manufacturer 2s product once the customer comes in the store (the switch).
Free-riding involves earning profits on the efforts of others. For example, consider a customer segment the cares about the benefit "before-sales service" and a channel arrangement where retailers provide that service.
Free-riding occurs when one retailer decides to lower the service they provide to the segment. In many situations the retailer may have an incentive to do this if it perceives it can make more money, even at the expense of others. More money can come from drawing in another "price-sensitive" segment and even providing a way for customers who value service to obtain that service and the product at a lower price (they simply get the service from a retailer who provides it, and purchases the product from the free-rider)