Context-dependent preferences and retailing: Vertical restraints on internet sales

•We investigate the incentives of a brand manufacturer to restrict retailers’ online sales activities.•Depending on the choice set, a consumer overvalues a good’s quality or price.•Banning online sales aligns a retailer’s incentives with the manufacturer’s interest to highlight the high quality of his product.•A ban on distribution systems that prohibit internet sales increases consumer and total welfare. We provide an explanation for a frequently observed vertical restraint in e-commerce, namely that brand manufacturers partially or completely prohibit that retailers distribute their high-quality products over the internet. We assume that a consumer has context-dependent preferences in the sense that he overvalues a product attribute – quality or price – that stands out in the choice set. Our analysis reveals the following: If online competition determines the margin a retailer can charge at his brick-and-mortar store, he has no incentive to draw consumers’ attention to a product’s high quality. If however, the high-quality branded good is not available online, a retailer can charge a significant markup on it and this markup is higher if consumers focus on quality rather than price. Thus, a ban on online sales aligns a retailer’s incentive with the brand manufacturer’s interest to highlight its relative advantage, quality, and allows the manufacturer to charge a higher wholesale price. Consumer welfare and total welfare, however, are higher if distribution systems that prohibit internet sales are forbidden.