Working Papers

R & D

* Assistant Professor of Marketing, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France.

** The Eli Lilly Chaired Professor of Innovation, Business and Society, INSEAD, Boulevard de

Constance, 77305 Fontainebleau Cedex, France. A working paper in the INSEAD Working Paper Series is intended as a means whereby a facultyresearcher's thoughts and findings may be communicated to interested readers. The paper should beconsidered preliminary in nature and may require revision. Printed at INSEAD, Fontainebleau, France. Kindly do not reproduce or circulate without permission.

WHY PRIVATE LABELS MAY INCREASE

MARKET PRICES

by

D. SOBERMAN* and

P. PARKER**

2002/105/MKT (Revised Version of 99/39/MKT)

Why Private Labels may Increase Market Prices

David A. Soberman*

and

Philip M. Parker*

September 2002

_______________________________________________________________________ * INSEAD, Boul. De Constance, 77305 Fontainebleau, France (tel: 33-1-6072-4000; fax: 33-1-60-724242); david.soberman@insead.edu; phil.parker@insead.edu This paper has benefited from the gratefully acknowledged comments of participants at research seminars at Stanford University, MIT and UCLA. Research funding was granted by INSEAD's R&D Committee.

1

Why Private Labels may Increase Market Prices

Abstract

Empirical research has found that retail prices do not necessarily fall with the

introduction of private label brands which today represent some 18% of all retail

products sold. In this paper, we show that an equilibrium exists whereby national

brands engage in heavy advertising and retailers introduce private label brands to

better serve their customers. We focus our analysis on a specific type of private label

brand, a quality-equivalent private label supplied by the national brand

manufacturer. Our analysis suggests that in these conditions, quality-equivalent

private label will often lead to higher average prices for consumers and higher profits

for retailers and manufacturers.

Key Words: quality equivalent private label, store brand, retailer brand, national

brand, price discrimination

JEL Classification Codes: D21, L22

2

Why Private Labels may Increase Market Prices

1. Introduction

Representing over $2.55 trillion, the retail sector is at its highest level of

concentration in history (U.S. Department of Commerce News, Census Bureau

Reports, June 29, 2000). While concentration stands to increase retailers' power

within local geographic areas, the latter half of the twentieth century has also

witnessed what appears to be intense retail competition. To the average consumer, a

visible form of this inter-retailer competition has been the emergence of "private

labels", "store brands", "house brands", or "own brands." These brands, a form of

upstream integration by the retailer, often appear to be of equal quality to nationally

advertised brands at relatively lower prices. While one might be tempted to conclude

that these two trends (higher concentration and intensified retailer competition) might

be offsetting, recent empirical research has shown that where “quality-equivalent”

private labels have been launched, advertising on the part of the national brands and

average market prices are high (e.g. Connor and Peterson 1992).

This paper considers a number of popular myths surrounding retail

competition. First, there seems to be a belief that private labels reflect high levels of

competition across retailers while increasing choice for consumers. Rather, we show

that private labels are a mechanism used by retailers to better price discriminate, even

when retail competition is limited. Second, there is a belief that the launching of

private labels somehow reflects the "relative strength" of retailers vis-à-vis

manufacturers, the latter seeing their power decline. We show that the opposite may

be the case and that private labels are most likely to exist when retailers are weak (i.e.

when the level of competition in the retail sector is intense). Finally, there is a

popular understanding that a sole national manufacturer will frequently resist

supplying private labels to distributors or retailers. In what follows, we will show that

a dominant manufacturer always gains from supplying private labels; however, the

benefits are highest (1) when the level of competition between retailers is high and (2)

when advertising is expensive. Private labels are effectively a "gift" provided by the

retailer to the manufacturer who gains from price discrimination. Private labels, in

this world, are a boon to manufacturers.

3

In the next section, we discuss a number of institutional factors concerning

retailing and private labels. We then develop a model closely linked to empirical

observations. In our model, stores endogenously choose whether to offer these

private labels, and then price these and national brands to consumers. Contingent on

the level of retail competition in the market, the model shows that the introduction of

private labels can to an increase in average category prices. Combined, the model

explains why an increasing number of national manufacturers supply private labels to

their distributors, while average market prices increase.

2. Retailing and Private Labels: Empirical Realities

The goal of the paper is make a theoretical contribution to our understanding of

private labels, national brand advertising and pricing in retail markets. These markets

consist of manufacturers and retailers, the latter of which may choose to sell their own

branded products, while the former must decide whether to supply such products to

retailers. In particular, we are interested in understanding how certain trends in

pricing and advertising have come to evolve across these players. In doing so, our

model will heavily rely on certain empirical facts, or realities. Three unequivocal

facts, in particular, have come to light in modern retail markets:

1. Concentration in the retail sector is increasing.

2. Retailers are increasing the number of categories in which they market own-

label products.

3. In markets where retailers integrate upstream, retail prices have not fallen, but

increased; in markets where retailers integrate upstream and increase prices,

manufacturers’ advertising is high.

Combined, the facts above have changed the landscape inside many retail stores.

Previously, retail shelves were filled with several national brands, many of which

were advertised, and one or two generic products amongst which consumer’s could

trade off price, image, and perceived quality. As retailers have merged and become

larger, they have dropped many generic products and launched their own brands

(store-, house-, or private- or own-label brands). In fact, the future action rated as

most likely for retailers in the annual reports of Progressive Grocer (1999, 2000) was

to “Stress Private Labels”. Following the launch of these brands, which offer in many

4

cases identical tangible qualities, the retailers have further “delisted” weaker national

brands, or those not supported by national advertising. Consumers, in many retail

situations, are then left with a choice of fewer options: one or two national brands,

and a store brand. A recent quote (Frozen Food Age, “President’s Choice Continues

Brisk Pace”, March 1998) highlights this trend:

According to the president of Loblaw Brands… own-label President’s Choice sits right next to a national brand with a shelf talker pointing out the price difference and this shelf setting has effectively eliminated or at least, de-emphasized the No. 2 and No. 3 brand competitors.

Recently, empirical evidence shows that average category prices have risen, especially in

categories where there is substantial national brand advertising spend.

First, we review the literature that summarizes these empirical facts. We then

propose a model that recognizes the empirical facts (for example, higher

concentration in the retail sector and the growth of quality-equivalent private labels)

in a game theoretic framework.

Empirical Fact #1: Concentration

The $2.55 trillion retailing sector has recently seen the emergence of firms benefiting

from scale and scope economies through the creation of chain outlets. Chain outlets,

and their cross-ownership within a given retail sector, have led to higher

concentration within both local and national geographic markets (Tangaay et al. 1995,

and Marion 1989). According to the latest estimates by the U.S. Department of

Commerce (1998), supermarket chains supply some 75 percent of all food consumed

with the remaining balance going to grocery stores, convenience stores, and specialty

stores. In addition, there has been significant consolidation in the retail sector over the

last 5 years in North America and Europe. Examples of consolidation in the food

sector include the acquisition of Monoprix by Promodes in France (August 1999), the

November 1988 takeover of Provigo by Loblaws in Canada (2 of Canada’s four

largest grocery retailers); and the acquisition by Ahold (a Dutch food retailer) of

Giant Food (May 1998) and U.S. Foodservice (March 2000) in the U.S1. In

merchandise retailing, 75 percent of all consumer sales are made through national

1References for more than 20 major mergers in the U.S., Canada and Europe are available from the authors.

5

chains, conventional department stores, and discount stores. Discount chains have

recently grown to 20 percent of all sales using a "supercenter" formula which consists

of "large stores loaded with general merchandise and food and committed to servicing

consumers increasingly pressed for time."2

Empirical Fact #2: Upstream Integration

In parallel to higher concentration, modern retailers have integrated upstream by

launching "private", "store", or "house" brands/labels. These products are generally

priced lower than nationally advertised brands while offering equivalent quality

(Hinloopen and Martin 1997, Connor and Peterson 1997). This form of retailing

generates a unique market structure whereby product competition is internalized by a

common agent (the retailer) that simultaneously sells its own brand. Traditionally,

retailers acted to distribute and independently price the products of competing

manufacturers who engaged in advertising and quality competition.

From negligible levels in the 1950s, private label brand sales represented a

significant proportion of total economic activity by the mid-1990s i.e. some 18

percent of the entire U.S. retail market (Liesse 1993a, 1993b). This includes 25

percent of total apparel sales, over 18 percent of packaged goods sales and some 15

percent of grocery sales. Private labels are generally sold in large retail chains, with

many offering, in a single store location over 1000 private label items.3 Private label

sales are more heavily developed for grocery products in Europe and Canada than in

the United States due to the pioneering efforts of retailers such as Loblaws (Canada),

Sainsbury and Tesco (United Kingdom), and Carrefour (France) to offer high quality

private label products. As noted in a recent publication by the European Commission,

“The role of the retailer brand has changed, particularly in the food sector. The

original market position of these food brands was a low price/lower quality alternative

to manufacturer brands; but… they have been repositioned, their quality improved

and are increasingly associated with new product launches”4. As noted by Cortsjens

and Lal (2000), many retailers have moved to higher quality store brands due to their

ability to improve retailer profitability. Quality-equivalent private labels are 2 U.S. Department of Commerce, U.S. Industry & Trade Outlook '98, 1998, pages 42-2. 3 Sources for the information in this paragraph and the next include various issues of Advertising Age, Food Technology, Bobbin, and industry interviews.

6

physically equivalent to nationally advertised products and are often produced by the

same manufacturers. Table 1 shows the development of private label in various

European countries.

(Table 1)

Even in the U.S., a recent study for the PLMA found that 60% of consumers surveyed

believe that private label products are the same as manufacturers’ brands when it

comes to the overall quality of the products, taste, availability, freshness, guarantee of

satisfaction, clarity of labeling, and the quality of packaging among other attributes5.

American retailers with private label offerings span various industries including both

mass and up-scale clothing stores, general discounters, regional drug store chains,

regional and national grocery chains, and specialty retailers: e.g., The Gap, The

Limited, Macy’s, Sak’s Fifth Avenue, Neiman Marcus, Wal-Mart, K-Mart, Arbor

Drugs, May Drug Stores, Schnuck Markets, Dominiks, Wegman’s Food Markets,

Safeway, and Kinney Shoes. Beginning in the 1990s, many of these launched

“quality-equivalent” private label merchandise (similar to the trend that started earlier

in Canada and Europe)6.

Quality-equivalent private label products span the vast majority of consumer

categories. Table 2 lists product classes where quality equivalent private labels are

present. We also provide examples of national brand manufacturers (in each category)

that publicly acknowledge their role in supplying private label.

(Table 2)

More than 50% of U.S. manufacturers of branded consumer packaged goods make

private label goods (Harding and Quelch 1996). The attractiveness of supplying private

label is further underlined by the strategy of R.J. Reynolds, one of the largest consumer

packaged goods manufacturers, that supplies private label products to more than 200

U.S. grocers.

4 From Green Paper on Vertical Restraints in EU Competition Policy, Directorate General for Competition, European Commission, Brussels, 1997. 5 1998 study by MORI for PLMA. 6 Quality equivalence is confirmed by studies such as that by the Wall Street Journal’s Atlanta Bureau that found little difference between Coke and Pepsi and their private branded competitors (McCarthy, M., “The Great Atlanta Taste Test”, Wall Street Journal, March 6, 1992). Consumer Reports (October 1993) found, for example, that Loblaws Decadent Chocolate Chip Cookies ranked first, ahead of national brands such as Chips Ahoy and Pepperidge Farms.

7

Empirical Fact #3: Price-Advertising Correlations

The third empirical is that in many product categories, there appears to be a strong

correlation between pricing and advertising spending by the national brands. Despite

speculation that private labels should place downward pressure on retail prices of the

national brands, the empirical evidence does not point in this direction.

With the advent of upstream integration, retailers play the de facto role of

common agent for both the house brand and the national brand. As a result, retailers

are able to “manage” competition between the national brand and the private label by

virtue of their role as the “setter” of retail prices. The extent to which this position

allows retailers to better price discriminate end consumers depends on the degree of

retail competition. Marketers frequently regard the introduction of private labels as a

boon to consumers and a threat to national brands which advertise purely

psychological benefits. It is not clear, however, that market power, or net economic

prices will fall with the introduction of private labels coupled with higher levels of

retail concentration (Huang et al. 1991, Hurwitz and Caves 1988, Grossman and

Shapiro 1986, Pabba 1986; Putsis 1997).

The empirical literature underlines a number of unambiguous realities in this

context. Connor and Peterson (1992), for example, study hundreds of grocery items

and find that prices are higher in categories with higher levels of advertising spend by

the national brands. In addition, Connor and Peterson find that the “gap” between

national brand and private labels is higher, the higher are category advertising levels7.

Advertising can either serve as a source of information (Nelson 1974, Darby and Karni

1973) which would tend to narrow prices across brands, but can also serve as a source of

differentiation and market power; see Tirole (1990, p. 278), Comanor and Wilson

(1979), and Schmalensee (1978). The latter case appears most plausible for categories

with private labels given both empirical observation and the content of manufacturer

advertising which generally makes no reference to pricing8.

In a second study, reported in Kim and Parker (1999), the authors detail the

explicit dynamics of the trends observed in Conner and Peterson (1992) by

considering the world’s “most consumed” product. In that study, as the national

7 The Connor and Peterson analysis uses the percentage gap between national brand prices and private label prices as an index. 8 Pricing is notably absent from most television, radio, magazine and outdoor advertising and these are the primary media used by manufacturers to advertise to consumers.

8

manufacturers increased advertising expenditures, the retailers increased the prices of

both the national brands and the private labels (at a period of marginal cost declines).

Using a model of market conduct, they show that advertising allows the retailer to

better price discriminate across two segments (brand seekers versus private label

seekers), while gradually increasing the prices for both, thus increasing economic

profits. While the authors empirically confirm the trend seen in Conner and Peterson,

they fail to provide a sound theoretical model of why we might observe such an

outcome. They also fail to consider the role that “macro” effects, such as the product-

line choices made by up-stream players or the degree of retail competition, might

play. A number of authors have also considered the context of private labels on cross-

product conduct but they do not consider industry structure and the dynamics of

market prices resulting from competition (see for example, Mills 1995 and Dhar and

Hoch 1997).

In what follows, we propose a model that takes a step towards explaining this

combination of empirical facts from packaged goods markets. We then provide an

empirical illustration to support the theoretical findings suggested by the model.

3. The Model

Model Intuition

Intuitively, the primary attractiveness of private labels to retailers is that they provide

an opportunity for the retailer to discriminate between those customers who prefer

national brands and those who are happy with a quality-equivalent private label. As a

local monopolist, the retailer has the incentive to price discriminate in order to extract

as much rent as possible across all consumer segments. This use of private labels

was first mentioned by Wolinsky (1987). Retailers can thus drop low-priced generics

and replace these with low-priced private labels. If we assume that advertising by the

remaining national brands appeals to a given segment, the retailer will simply charge

higher prices for the national brands purchased by "advertising attracted" consumers,

while simultaneously optimizing profits from "lower price" oriented consumers.

We propose a model designed to capture two specific aspects of private labels.

First, private labels are attractive to retailers because they enable retailers to charge

different prices to consumers who are heavily influenced by national brand advertising

9

and those who are simply concerned with the physical characteristics of the product.

Second, the model captures differentiation between retailers as an exogenous parameter.

This allows us to study the impact that the intensity of retail competition has on both the

attractiveness of private labels and overall category pricing.

Model Assumptions

The model assumes quality equivalence of the national brand and the private

labels (except that there are a group of consumers who are willing to pay more for a

brand if it is advertised). Private labels are supplied by the national brand

manufacturer (there are no alternate sources of supply) which allows us to abstract

away from a retailer’s desire to either increase margin or reduce the power of the

manufacturer (Wilcox and Narasimhan 1998)9. From the perspective of the retailer,

the model allows us to focus on two potentially conflicting effects for private labels:

that of facilitating price discrimination (which is positive) and the response of

manufacturers in terms of increasing wholesale prices which may be negative. In

addition, retailers need to account for the added costs of stocking and managing a

second brand. In essence, we generalize to situations where price discrimination and

retailer differentiation are the most important forces in the market. The idea is not to

suggest that other explanations (increasing margins, building store loyalty, or

countering the oppressive power of manufacturers) are not important in certain

situations.

Setup. The game considers three types of players: one manufacturer, two

competitive retailers and consumers. Retailers are spatially differentiated to capture

the degree of competition in the retail market. Conceptually, the game being

examined has four stages. The first stage consists of the decision by retailers to

request the supply of private label from the national brand manufacturer.

The national brand manufacturer is assumed to be the only manufacturer

capable of producing a private label (there are no alternate contract manufacturers). A

first reason for this assumption is that we wish to abstract away from the typical “cost

based” rationale for private labels and focus on how private labels both facilitate price

discrimination and affect retail pricing and profits. A second reason is that we wish to

9 Note that under the assumption of a monopolistic manufacturer and two retailers, there is nothing retailers can do (outside of collusion) to reduce the power of the manufacturer

10

focus on a specific class of private labels, those that are quality-equivalent. We

assume that the only the national brand manufacturer is capable of producing such a

product.

The second stage involves the manufacturer making a decision of whether or

not to supply the retailers as requested with quality-equivalent private label. The third

stage of the game occurs after decisions about the availability of private label are

complete. The stage consists of the national brand manufacturer first choosing an

optimal level of national brand advertising and second, setting wholesale prices

simultaneously for both the national brand and the private label (assuming retailers

have decided to carry it). The final stage of the game consists of retailers setting retail

prices optimally given the advertising level and wholesale prices quoted by the

manufacturer. Based on the prices set by retailers, consumers then make decisions

whether or not to buy any of the products the retailers make available.

Consumers. The retail market consists of two identical retailers located at

either end of a linear market of unit length. Consumers are uniformly distributed

along a line of unit length with density δ (i.e. the total number of consumers in the

category is δ). There are 2 types of consumers. The first are referred to as brand

seekers (denoted by superscript b) and the others are referred to as product seekers

(denoted by superscript p). We assume that a fraction λ of consumers are brand

seekers and 1-λ are product seekers (the distribution of both types of consumers are

assumed to be uniform along the linear market as shown in Figure 1).

(Figure 1)

Any consumer is identified by her location in the linear market. In addition to the

money a consumer pays to purchase a product from a retailer, she incurs a

transportation cost that is proportional to her distance from the retailer in question. In

other words, a consumer at x incurs a transportation cost of tx when she buys from the

retailer located at the left end of the line and a transportation cost of t(1-x) when

buying from the other retailer. t is the ‘transportation’ cost per unit distance. The

purpose of the parameter t is to reflect both the time and out-of-pocket costs of

making a trip to a retailer. The utility functions for the two types of consumers buying

a product priced at pd at a retailer located a distance d from the consumer are as

follows.

11

For brand seekers:

National Brand U A v td pdb

dn= + − − (1)

Private Label U v td pdb

dg= − − (2)

For product seekers:

Both Brands U v td pdp

d= − − (3)

Both the national brand and private labels are assumed to provide a benefit v to both

types of consumers. To ensure that markets exist in both segments, we assume,

without loss of generality, that the marginal cost of producing the product c is less

than the reservation price v.

In contrast to product seekers, brand seekers are willing to pay a premium for the

national brand that is equal to A, a measure of advertising effort implemented by the

national brand manufacturer (product seekers are not affected by advertising). We do not

examine the basis for the premium that brand seekers are willing to pay for an advertised

brand. However, as previously mentioned, there is strong evidence that a segment of the

population is willing to pay more for an advertised brand (even when the non-advertised

brand is perceived to be quality-equivalent). One potential explanation for this premium

is the objective familiarity effect identified in the behavioural literature (Wilson 1979,

Obermiller 1985, and Anand, Holbrook and Stephens, 1988). Consumers are observed to

exhibit more positive attitudes towards objects with which they are familiar and

advertising plays the role of familiarising consumers with national brands.

Overall utility is determined by the difference between these benefits and the

price paid plus cost of travelling to the retailer. Each consumer is assumed to buy at

most one unit and she will buy the product that provides the highest utility. However, if

no product/price combination in the market provides a given consumer with positive

utility, that consumer will not purchase. Our interpretation of a consumer not buying is

that she has dropped out of the category because prices are too high. Thus, when retail

prices are high enough a significant proportion of consumers in the market will not buy.

Retailers. The retailer first decides whether or not to request a private label in

addition to the national brand. If the retailer carries a private label, it must set prices

for both the national brand and the private label brand given the brand advertising

level and wholesale prices as quoted by the manufacturer. Because of the symmetric

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model structure, we do not observe asymmetric outcomes where one retailer offers a

private label and the other does not. A retailer that does not launch a private label

when its competitor has will lose most of its ‘product seeker’ customers as well as

incurring a higher wholesale price for the national brand10. As a result, we focus on

symmetric strategy equilibria (where both retailers carry just the national brand or

both offer the national brand and private label). Retailers have the following

objective functions:

With National Brand only

])1([)( 1111

1pb

nn

pffwpMax

nλλδπ −+−= (4)

])1([)( 2222

2pb

nn

pffwpMax

nλλδπ −+−= (5)

With National Brand and Private Label rp

ggb

nn

ppkf)w-(pf)w-(p = Max

gn−−+ ))1( 1

11

11, 11

λδλδπ (6)

rpgg

bnn

ppkf)w-(pf)w-(p = Max

gn−−+ ))1( 2

22

22, 22

λδλδπ (7)

The retailers maximize these objective functions simultaneously taking the

advertising and wholesale prices chosen by the manufacturer as given. The variables

prt is the price for product t where t can equal n (national) or g (private label) at

retailer r, where r can equal 1 or 2; frn is the fraction of buyer type ‘s’ which buys

store r where s can equal b for the brand seeker or p for the product seeker and as

before, r is the retailer in question. Consistent with the requirements of anti-trust law,

the manufacturer charges both retailers the same price wt to for the national brand.

Similarly, we assume that the manufacturer charges the same price to both retailers

for supplying private label. The calculation of frn , the fraction of buyer type buying n

from store r depends on both the prices chosen by retailers and A, the level of

advertising effort chosen by the manufacturer to support the national brand. The

variable kr is the fixed cost incurred by retailer r (where r = 1 or 2) to develop and

carry a private label brand (managerial costs, packaging development, inventory costs

and additional stocking/ control costs). This fixed cost is assumed to be symmetric

across the two retailers. 10 Except when advertising is extremely low, a retailer without a private label brand will be unable to serve product seekers at all. As soon as at least one private label is available, the wholesale price on the national brand is set high to extract the surplus created by advertising.

13

High degrees of differentiation are captured through high transportation costs.

When t is high, a consumer has strong preferences for products located at a retailer

nearby and gives up utility to purchase a product which is further away. Thus, high

transportation costs (relative to other parameters in the model) imply that significant

differences in price will be needed to convince a consumer to make a trip to a retailer

who is far from home. Transportation costs can be described in relation to consumers’

reservation prices and the cost of producing the product i.e. the degree of

differentiation is captured by comparing transportation costs to the societal benefit of

consuming the product (v-c). As we proceed through the analysis, we find that the

ratio of v-c to t has a significant impact on the equilibrium that is observed. In some

sense, this ratio is a comparison of how important it is for a consumer to be in a

category versus how expensive it is to travel to the retailer to buy the product.

The Manufacturer. In reality, a manufacturer who has the potential to supply

private label makes several decisions. First, the manufacturer decides whether or not

to supply private labels (assuming that retailers want private labels). Second the

manufacturer decides how much advertising support to place behind the national

brand. Advertising (in terms of creative production and media purchasing) for

national brands requires significant advance planning and investment so advertising is

set prior to wholesale prices. Finally, the manufacturer sets the wholesale price for the

national brand and the private label (assuming an agreement to supply it was reached

in the first two stages). We simplify by restricting our analysis to two situations: (1) a

market where the retailers carry private labels and (2) a market where they do not. In

general, when both the manufacturer and the retailers have aligned incentives (the

profits of both increase) private labels will be observed. If either the manufacturer or

the retailer suffers reduced profits as a result of the private labels, they will not be

observed11. When private labels are supplied, the manufacturer optimizes the

wholesale prices for the two products simultaneously.

These assumptions imply that the objective function for the manufacturer is

the following:

When Retailers do not carry Private Labels 11 For a narrow range of fixed costs (kr) retailers will find themselves in a Prisoners’ Dilemma i.e. both retailers launch private label even though retailer profits are reduced from equilibrium profits in the absence of private label (all that is needed for an equilibrium of launching private label is that the profit from unilaterally launching private label be sufficiently high). This is a technicality for a very narrow range of kr so we ignore it and focus on a comparison of symmetric profits.

14

( ) [ ]Max w c f f f f Aw A

mn b b p p

n ,( ) ( )( ) $π δ λ λ γ= − + + − + −1 2 1 2

21 (8)

When Retailers carry Private Labels ( ) ( )Max w c f f w c f f A

w w Am

n b b g p pn p, ,

( ) ( )( ) $π δλ δ λ γ= − + + − − + −1 2 1 221 (9)

subject to: $A ≥ 0 (10) w w 0n g, ≥ (11) where the hat on advertising effort (A) implies that it is chosen prior to the setting of

wholesale prices. The marginal cost of the products (which are physically equivalent)

is c and γ is the advertising cost parameter. Consistent with empirical observation, the

cost of advertising is assumed to be a convex function of advertising effort.

Extensive Form of the Game. The extensive form of the game, which

includes the decisions of all players and their sequence, is as follows:

1. The retailers decide whether to request quality-equivalent private labels in

addition to the national brand;

2. The manufacturer decides whether to supply private labels;

3. The manufacturer chooses advertising effort;

4. The manufacturer sets the wholesale prices for the products that it is supplying

to retailers (national brand and potentially private labels);

5. The retailers set retail prices for the products that they are selling (national

brand and potentially private labels);

6. Each consumer observes the prices chosen by retailers and will purchase the

product that provides maximum utility (assuming her participation constraint is

satisfied).

4. Model Solution

To determine Nash equilibria, we start by examining how the retail market unfolds

after advertising and prices have been chosen. The sales made by a retailer are a

function of the fraction of consumers who buy the national brand and private labels at

that retailer, the density of consumers, the price charged and the wholesale costs

incurred to make the sale. We assume (without loss of generality) that when the

retailer launches private labels, only brand seekers purchase the national brand

because product seekers are unwilling to pay more for a product simply because it is

advertised. Under each of the two scenarios (retailers do not launch private labels and

15

retailers do launch private labels), several market outcomes are observed as a function

of exogenous parameters. When private labels are available, three outcomes are

possible:

Scenario 1. All consumers buy;

Scenario 2. All brand seekers buy but some product seekers do not;

Scenario 3. A percentage of both brand and product seekers do not buy.

When private labels are available, a situation in which product seekers are locked out

of the market will not be encountered because the retailer will always direct private

label product to product seekers. Due to the assumption that v>c, a wholesale price

between v and c can always be found that will yield positive sales to product seekers

and make retailers and manufacturers better off.

When retailers do not have private labels available for sale, the following

outcomes are possible assuming that the national brand is advertised:12

Scenario 1. All brand seekers buy and no product seekers buy;

Scenario 2. All brand seekers buy and some (but not all) product seekers buy;

Scenario 3. Some (but not all) brand seekers buy and no product seekers buy;

Scenario 4. Some (but not all) brand seekers buy and some (but not all) product

seekers buy.

When only the national brand is available and it is advertised, there is never an

outcome where all consumers are served. In order to benefit from advertising, a

manufacturer must charge higher wholesale prices and this translates to higher prices

in the retail market. While brand seekers will be willing to pay these higher prices,

poorly located product seekers (i.e. in the middle of the market) will find the prices

too high to yield positive surplus.

Equilibrium with Private Labels Available

We first consider the situation faced by a retailer offering private labels. In

Scenario 1, the decision faced by a product seeker located in attribute space a distance

x from Retailer 1 (Retailer 1 is located at the left end of the market i.e. x=0, and

12 For a range of sufficiently low λ, a manufacturer will choose not to advertise i.e. when

tcvtcv3)(2

2)(−−−−

<λ (see the technical appendix for a derivation of this limit). In this situation, the

manufacturer treats the market as homogeneous (brand seekers and product seekers have the same surplus functions in the absence of advertising).

16

Manufacturer 2 is at the right end i.e. x=1). The surplus obtained from Retailer 1 is v-

tx-p1 and from Retailer 2 is v-t(1-x)-p2 (regardless of whether the consumer considers

the national brand or private label). If the product seeker, who is indifferent between

the two retailers is located at (x*), then:

* 1x = p - p + t

2t2 (12)

All product seekers to the left of x* will purchase from Retailer 1 and those to the

right will purchase from Retailer 2. Because the line segment is of unit length the

expression for x* is equivalent to f p1 and 1- x* is equivalent to f p

2 . Similar reasoning

yields equivalent expressions for brand seekers.

However, the vertical nature of our market means that the national brand

manufacturer will set wholesale prices such that the marginal consumer is indifferent

between buying and not buying (otherwise, he could either raise price or have chosen

a lower level of advertising to increase profit).

Thus, once we are in a situation where all brand seekers and product seekers

are served, the manufacturer will set wholesale prices high enough such that each

retailer is a de facto local monopolist on her half of the market (for each segment); i.e.

the consumer in each segment who is indifferent between the two retailers will

receive zero surplus (or less).

Scenario 2 (all brand seekers buy but some product seekers do not) occurs

when p p v t1 2 2+ > − . In this case, there is a gap in the market of product seekers

because the consumer who is located equidistant from the two retailers would obtain

negative surplus by buying. The fraction of product seekers f rp who would be

willing to buy from each retailer is given by the expression, f v ptr

p r=− . In this

situation, the brand seekers will be fully served; however, the brand seeker who is

indifferent between the two retailers receives zero surplus.

In Scenario 3, there is a gap in the market for brand seekers as well as for

product seekers (the gaps occur in the center of the market). The surplus a brand

seeker obtains from Retailer 1 is A+v-tx-p1 and from Retailer 2 is A+v-t(1-x)-p2.

Similar to the explanation in Scenario 2, this leads to the following expression for the

fractions of brand seekers patronizing each retailer t

pvAf rb

r

−+= .

17

The approach to solving this problem entails identifying boundaries for the

scenarios listed above. These boundaries are a function of both the relationship of

transportation cost (t) to available surplus (v-c) and γ the advertising cost parameter. It

proves useful to adopt the following normalizations:

1. The density of consumers (δ) along the line is assumed to be one. δ is

effectively a scaling factor and it does not affect any of the first order

conditions.

2. The reservation price (v) for all consumers is set to 1.

Based on the above discussions, we derive the equilibrium manufacturer profits,

retailer profits, wholesale prices, and advertising level for each of the above scenarios.

The results are provided in the technical appendix.

We now explain how the boundaries between the three scenarios are

determined. First, we calculate the fraction of each segment served by the retailers

(the fractions for each scenario are shown in Table 3).

(Table 3)

To determine the boundary between Scenarios 3 and 2, we identify the condition in

terms of (t,γ) that must be satisfied for the brand seeker share of market to equal ½.

Similarly to determine the boundary between Scenarios 2 and 1, we identify the

condition that must be satisfied for the product seeker share of market to equal ½. The

conditions are shown in Table 4.

(Table 4)

The appearance of the zones for each scenario (with private label available) is shown

in Figure 2 (we fix λ= ½ and the marginal cost at 0.1).

(Figure 2)

Along the y-axis, both brand and product seekers are fully served because

transportation costs are low compared to the surplus associated with an unadvertised

product. However, as we move to the right (and transportation costs increase), we

enter a zone where only brand seekers are fully served. As transportation costs rise,

the product seekers who are far away do not buy because product seekers in general

enjoy lower benefits from buying (they perceive no benefit other than v, the value

from the physical product). Finally, in the upper right area, not only are transportation

costs high, so are advertising costs. As a result, in this area, there is not enough

advertising to keep distant brand seekers in the market either.

18

Equilibrium with only the National Brand available

When only a national brand is marketed, the procedure to determine the

boundaries of the four scenarios (outlined at the beginning of section 4) is analogous

to the approach used when private labels are available with two key exceptions:

1. In contrast to Figure 2 (when both private labels and national brands are

available), the region where both brand and product seekers are partially served

(Scenario 4), has a border with two different scenarios. The first occurs when a

reduction of travel costs leads to brand seekers being fully served (this is

analogous to the boundary between Scenarios 2 and 3 in Figure 2). The second

occurs when reductions in the cost of advertising create an incentive to choose

high advertising levels and serve only brand seekers (this scenario does not exist

when both national and private label brands are available).

2. In contrast to the case of national and private label being marketed (where there is

a unique optimal price for each product sold), the national brand manufacturer

always has a choice between trying to serve both types of consumers or ignoring

product seekers and serving only brand seekers. Thus, when only the national

brand is available there are two local maxima. The profits of each maximum need

to be compared directly. As advertising costs get small (γ gets smaller), the

manufacturer prefers the scenario of serving only brand seekers.

Similar to the equilibrium when both the national brand and private label are

available, we derive the equilibrium manufacturer profits, retailer profits, wholesale

prices, and advertising level for each of the four scenarios. These results are provided

in the technical appendix. To determine the boundaries (with the exception of the

boundary related to the discussion in point 2), we analyze the fractions of each

segment served by the retailer. The reduced form equations for these factors are

shown in Table 5.

(Table 5)

Using similar reasoning to that used when the national brand and private labels are

available, we construct the regions that define the equilibrium market structure given

the exogenous parameters t, λ and γ. The boundaries between each of the key

scenarios when only national brands are available are shown in Table 6.

(Table 6)

19

To illustrate how these regions appear, Figure 5 shows the various boundaries and

scenarios when only the national brand is available (as before, we fix λ= ½ and the

marginal cost at 0.1).

(Figure 3)

The areas labelled 1a and 1b are where the equilibrium is Scenario 1, the area labelled 2

is where the equilibrium is Scenario 2 and so on. Note that we have divided Region 1

into Regions 1a and 1b because in Region 1a there are two local maxima: one in which

all consumers are served (and there is no advertising) and the other in which only brand

seekers are fully served. Our interest lies in categories where national brands are

advertised, both in the absence and presence of private labels. As a result, we restrict our

attention to the part of the parameter space where the “no advertising” outcome is

dominated. Following footnote 12, with a large enough λ, the “no advertising”

maximum is strictly dominated.

The primary observation to be made is that when advertising is inexpensive (i.e.

one is near the x-axis in Figure 3), the tendency is for a manufacturer to price such that

product seekers are not served. In contrast when advertising is expensive (and we find

ourselves in Scenarios 2 or 4), a manufacturer wants to serve some product seekers

although the share of product seekers served is always less than the share of brand

seekers served.

We now identify the equilibrium product strategies (national brand only or

national and private label) for the market using the profit functions for manufacturers

and retailers as determined earlier.

Equilibrium Market Outcome

The outcomes in this model involve the comparison of two subgames, one

where there are 3 equilibrium scenarios and the other where there are 4 equilibrium

scenarios. In addition, even with the normalizations already implemented, we have

three exogenous parameters: the distribution of customers (λ), the marginal cost for

the manufacturer (c), and the fixed cost of private label stocking incurred by the

retailer. To illustrate several key findings, we use the outcomes calculated in the

previous section to conduct a simulation. For the simulation, we make the following

normalizations:

20

1. The marginal cost is set to 0.1. Higher marginal costs have the effect of moving

the boundaries towards the origin in both cases (partial coverage becomes more

likely) but do not change the shape of the equilibrium zones.

2. The fixed cost of introducing a private label is set at .01. This means that when the

benefits of private labels become arbitrarily small, private labels will not be

introduced (higher values of k simply reduce the attractiveness of private label for

the retailer).

3. The distribution of the market is normalized to 50% brand seekers and 50%

product seekers (i.e. λ=0.5). The impact of increasing λ is to move the boundaries

in the National Brand only case (Figure 3) upwards (there is no effect on the

boundaries in the National and Private Label case).

As noted earlier, Figure 3 indicates that there are two distinct situations when only

National Brands are available: the first occurs when advertising is expensive and

some product seekers are always served. The second occurs when advertising is

inexpensive and product seekers are not served.

In order to understand these two distinct outcomes, we have conducted

simulations for γ=0.3 (advertising is expensive) and γ=0.05 (advertising is

inexpensive). The results of the simulation are shown in Figures 4 and 5.

(Figures 4 and 5)

General Findings

There are three general conclusions that the simulation helps to illustrate. First, the

manufacturer always benefits from the retailer’s decision to carry private labels (thus,

she will always provide a “feasible” quote to a retailer interested in carrying a quality-

equivalent private label). Private labels are effectively a gift from the retailers to the

manufacturer because they allow the manufacturer to offer products that are better

tailored to the two segments of consumers in the market. When only the national

brand is sold, the manufacturer is always forced to compromise by either not serving

product seekers or by advertising less and charging prices that are a compromise

between the two segments. This provides a basis for understanding why the dominant

manufacturer in many categories has been willing to supply private label products that

are of equal quality to its own brand even when it is the only manufacturer in the

category capable of delivering such quality.

21

Second, in terms of retail profit, Figure 4 highlights that retailers have the

most to gain from private labels when transportation costs are low (under either case).

This advantage occurs because private labels allow all product seekers to be served

and product seekers are relatively more attractive when transportation costs are low

(in both the expensive and inexpensive advertising cases). This suggests that retailers

are more likely to launch private labels when transportation costs are low (or retail

competition is high). In contrast, when transportation costs are high, the benefit of

stocking private label is less significant.

Interestingly, the manufacturer’s profit function (under either scenario) is

relatively smooth and is not affected as the transportation costs increase and the

equilibrium moves through different zones. In contrast, the retailer’s profit function is

continuous but neither smooth nor monotonic as transportation costs increase. The

affect of increasing transportation costs on profitability is highly dependent on the

equilibrium zone in question.

Contrast between Expensive and Inexpensive Advertising Environments

First, we consider the manufacturer’s profits in Figure 4 and we notice a more

consistent relationship between the advantage of private label distribution and

transportation costs when advertising is expensive than when it is inexpensive. This

occurs because the main effect of private labels under inexpensive advertising is to

allow the manufacturer to serve product seekers who find the national brand too

expensive. Without private labels, inexpensive advertising causes the manufacturer to

focus entirely on brand seekers.

In terms of retailer profit in Figure 4, we observe a significant difference

between the two cases of expensive advertising and inexpensive advertising. This is

captured in Proposition 1 (proofs are provided in the appendix).

22

Proposition 1

When advertising is inexpensive and some product seekers are not served, the benefit

to retailers of private label distribution is strictly decreasing in transportation cost. In

contrast, when advertising is expensive, retailer profits are increasing in

transportation costs when

t<

−++++−−−+−−

−−

−γ

γλγλγγλλγγλγγλγγλ ccccccMIN

323242882842281,

21

4

22242222

.

When advertising is inexpensive, the main effect of private label is to add a block of

customers to the retailer’s revenue that are otherwise unserved. However, the net

benefit of offering private label declines as transportation costs increase primarily

because product seekers become less important as a source of revenue (a significant

number are left unserved).

When advertising is expensive, at low levels of differentiation, we see that

increases in t can actually lead to increases in the profit that private labels create for

retailers. This provides insight as to why the recent spate of mergers in the retail

sector may also have led to an increase in the number of categories where retailers

have launched quality equivalent private labels. In the context of the model, increased

concentration can be viewed as leading to higher transportation costs. With higher

concentration, there is less direct competition for each store and conditions of local

monopoly are created in many smaller communities (for example, in Smith Falls,

Ontario, the merger of Provigo and Loblaws meant that the two operating

supermarkets were owned by the same chain). The reason that retailer profits increase

in this zone is that retailer profits are a direct function of the number of customers

served. The launch of private labels allows the retailer to increase the total number of

customer served in the market (prior to the private label, many product seekers do not

buy because the national brand is simply too expensive).

We report retail price as the average price for all units sold in the market.

Because there are equal quantities of brand and product seekers, the average is simply

the price each segment pays weighted by the fraction of each segment that buys.

When advertising is inexpensive, the impact of private labels on average category

pricing is to reduce prices as highlighted in Proposition 2.

23

Proposition 2

When advertising is inexpensive, private labels will tend to reduce the level of

category pricing.

The intuition for Proposition 2 is straightforward. When advertising is inexpensive

and only the national brand is available, product seekers are not served. When private

label is introduced, brand seekers continue to pay high prices for highly advertised

national brands. But the private labels allow retailers to serve product seekers at lower

prices. In these conditions, the availability of private labels drives prices down. This

story follows from a situation in which the main effect of private labels is to expand

the market.

When advertising is expensive, we obtain the reverse result as highlighted in

Proposition 3. We demonstrate the result for λ=½ and c=0.

Proposition 3

When advertising is expensive, the introduction of private labels leads to an increase

in average category pricing.

When advertising is expensive, the introduction of private labels leads to higher

average prices in the category. This occurs because manufacturers are able to offer a

more highly advertised and highly priced product to brand seekers when private labels

are available (this effect outweighs any reduction in the price paid by product

seekers). This provides an explanation of why the distribution of quality-equivalent

private labels can often lead to higher category prices. Of note, a key requirement for

this effect is that a significant number of product seekers buy the national brand in the

absence of private label alternatives.

5. Empirical Illustration

As noted in the introduction, our contention is that the primary source of growth in

private label has been the introduction of numerous quality-equivalent store brands.

Moreover our analysis suggests that increases in private label share will lead to an

increase in average category prices when the major effect is to shift volume from the

national brand to the store brand. Conversely, when the major effect of private label

24

share introductions is to increase category volume, the model predicts that category

prices will drop. To test these ideas, we have collected a set of data on 18 major retail

categories from the Private Label Manufacturers Association (PLMA), IRI and AC

Nielsen. The dataset contains annual data from 1993-1998 inclusive on category

volume, average category pricing, and private label market share. Thus, we have 108

potential data points. However, due to missing observations, we only have seven

complete categories (Breakfast Cereals, Cheese, Fresh Vegetables, Frozen Poultry,

Frozen Ready Meals and Pizza, Still Fruit Juices and Diapers) and 73 data points.

Summary statistics from the complete categories are provided in Table 6.

(Table 6)

We propose to estimate the following model.

iPLsharecat %VolPL%Vol%P ε∆β∆β∆ββ∆ ++++= 3210 (13)

Because we only have six data points per category, we use percentage change in the key

variables. This allows testing of the model’s predictions with a significant number of

data points (percentage changes allows aggregation across all categories for the

estimation). The analytical model makes no predictions about the intercept or the impact

of %Volcat∆ (nevertheless, in an aggregate model such as this, we might expect β0 to be

a proxy for the inflation rate). However, the model predicts that β2 will be positive

reflecting the fact that increases in Private Label share should lead to price increases

ceteris paribus. The model also predicts that β3 will be negative. Here %VolPL∆ is a

proxy for the degree to which Private Label introductions contribute to increases in

category volume. This follows from the analytical model’s prediction that private label

introductions will lead to price decreases when their major impact is to increase volume.

Here, we estimate the model on two samples. The first uses data from the categories that

are complete (hence 35 data points). The second uses data from 15 of the 18 categories

allowing an increased number of data points (52 data points). However, the 52

observation sample contains more uncontrolled noise due to its composition (a number

of categories contribute 2 or less observations).

(Table 7)

As expected, the intercept is significant and varies between 1.3% and 1.6% which very

closely parallels the inflation rate during the 93-98 period. In neither sample does

%Volcat∆ have a significant effect on the percentage change in price. However, both β2

and β3 are directionally consistent with the predictions of the analytical model. In the 35

25

observation model, both are significant at the 10% level. With the 52 observation model,

only β3 is significant; however β2 is marginally outside significance at the 10% level.

In sum, the empirical analysis is largely consistent with the predictions of the

analytical model. Private Label is playing an important role in allowing retailers to price

discriminate amongst heterogeneous consumers. As a result, increases in Private Label

share seem to lead to higher category prices ceteris paribus. Only when the share

increases of Private Label are primarily generated by increases in category volume is the

impact of Private Label introductions negative on average category pricing.

Returning to Figure 5, we observe that private label introductions lead to

significant increases in advertising for the national brand when advertising is expensive.

Coupled with Proposition 3, this echoes the findings of Connor and Peterson (1992) who

find that prices are higher in categories with higher levels of advertising spending by the

national brands. In contrast, the level of advertising is unaffected when advertising is

inexpensive. When advertising is inexpensive and only the national brand is available,

the objective of the manufacturer is to serve brand seekers as efficiently as possible (she

simply ignores product seekers). As a result, the objectives in managing the national

brand are unchanged by the availability of private labels. An interesting empirical

extension to this work would be to examine the advertising levels of major national

brands across a number of categories where private labels have recently taken on

increased importance.

6. Discussion

The goal of the model is to highlight several aspects of private label marketing and

explain certain empirical findings on aggregate market prices. As mentioned earlier,

Connor and Peterson (1992) analysed over 225 grocery categories and found that

advertising is positively related to average prices in markets where private labels are

significant. The growth of private labels comes at a time of reduced competition at

retail (due to mergers) and increasingly expensive advertising costs. This has two

implications in our modelling framework.

1. A higher level of t which reflects a lower level of competition between

retailers and,

2. Advertising costs which are increasing (i.e. a higher γ).

26

In addition, we would also mention that the relative fixed cost of introducing a private

label has gone down because

1. There is more volume over which to spread the fixed costs (increases in

concentration suggest that the new firms should be larger); and

2. The costs of inventory management and avoiding stockouts have gone down

due to computerisation.

This clarifies the empirical facts. In the past (when retail competition was more

intense and advertising was less expensive), the reason for launching private labels

was that they offered large profit gains from a segment of product-oriented consumers

who wanted to buy merchandise at lower prices. This frequently resulted in lower

pricing in the category (this relates to the simulation for γ=0.05 in Figure 4).

Recently however, a less competitive retail environment and increasingly

expensive costs of advertising means that there is less of an explicit reason for private

labels. Nonetheless, the profit potential of launching private labels has increased

because the fixed cost of doing so has gone down (the zone where private label is

profitable increases with reductions in the fixed cost of launching them). In addition,

the model also shows that increases in t (or a less competitive retail environment) can

lead to increases in the profitability of stocking private labels when advertising is

expensive. However, the model also shows that the advantages of private label

stocking start to decline, once transportation costs reach a certain threshold (in an

expensive advertising environment). This suggests that while the growth of private

labels recently has been phenomenal, further mergers in the retail sector (and less

competition) may lead to stagnation in their growth.

Finally, the model provides an explanation for the higher prices at retail that

are observed across a number of categories where private labels have become more

important. In fact, work by Sudhir and Meza (2002), confirms that retailers increase

the prices of national brands after private labels are introduced. Prices rise in the

aggregate, despite the appearance of lower priced private labels. Additionally, the

launching of private labels stimulates higher advertising on the part of the

manufacturer. As noted earlier, there is evidence of higher levels of advertising in

categories where the growth of private label is associated with higher market prices.

Moreover, the vast majority of advertising in categories where brands have tangibly

equivalent qualities consists of non-price “persuasive” messages.

27

Our analysis suggests that the popular belief that competition between private

labels and national brands is intense may be exaggerated. In a recent Harvard

Business Review article, Quelch and Harding (1996, p. 100) conclude that private label

competition remains a serious threat to national brands. In his popular marketing text,

Kotler (1994, p. 449) calls this competition the battle of the private-label brands. Here,

we find that advertising can significantly increase the profitability of a national brand

manufacturer even when the actual volume of the national brand declines. The battle

between private labels and national brands may not lead to reductions in manufacturer

profits or in average market prices. The model demonstrates that manufacturer and

retailer profits can increase as a result of advertising, which serves to create

differentiation, and private labels which facilitate price discrimination. The “losers” in

this arrangement may be smaller national brands (of lower quality) that are gradually

dropped by the retailers. When a dominant manufacturer supplies quality-equivalent

private labels to retailers, we find that the manufacturer’s clout in the marketplace

increases. This also provides a basis for explaining why certain manufacturers have

announced that they will discontinue brands unless they are the largest or second largest

in their categories (Quelch and Harding, 1996).

28

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Liesse, J. “Private-Label nightmare: Big name marketers are being stalked by high-quality store brands.” Advertising Age, Vol. 64-15 (1993a), pp. 1-4. Liesse, J. “Private Label Losing its Enemy Status” Advertising Age, Vol. 64-43 (1993b), pp. 27. Marion, B. W. “The Concentration-Price relationship in Food Retailing.” Concentration and Price, Leonard W. Weiss ed., Cambridge, Mass and London, MIT Press, 1989, pp. 185-93. Meza, Sergio and K. Sudhir (2002), “In favor or Out of favor? Effects of Store Brand Introduction on Retailer Pricing of National Brands”, Working Paper, Stern School of Business, New York University. Mills, David E. (1995), “Why Do Retailers Sell Private Label”, Journal of Economics and Management Strategy, Vol. 4, No. 3, pp. 509-528. Nelson, P. “Advertising as information.” Journal of Political Economy, Vol. 81 (1974), pp. 729-754. Pabba S. “’Brand-naming’ as an Entry Strategy in the White Goods Industry,” Cambridge Journal of Economics, Vol. 10 (1986), pp. 305-18. Obermiller, Carl (1985), “Varieties of Mere Exposure; The Effects of Processing Style and Repetition on Affective Responses,” Journal of Consumer Research, 12 (June), pp. 17-30. Putsis, W. “An Empirical Study of the Effect of Brand Proliferation on Private Label – National Brand Pricing Behavior.” Review of Industrial Organization, Vol. 12-3 (1997), pp. 355-71. Quelch, J. A. and Harding D. “Brand versus private labels: Fighting to win.” Harvard Business Review, January-February (1996), pp. 99-109. Schmalensee, R. “A model of advertising and product quality.” Journal of Political Economy, Vol. 86 (1978), pp. 485-500. Tangaay, G. Vallee, L. and Lanoie, P. “Shopping Hours and Price Levels in the Retailing Industry: A Theoretical and Empirical Analysis.” Economic Inquiry, Vol. 33-3 (1995), pp. 516-24. Tirole, J. The Theory of Industrial Organization, Cambridge, MA: MIT Press, 1990. U.S. Department of Commerce. U.S. Industry & Trade Outlook '98. (1998), pages 42-2 Wilcox, R. and C. Narasimhan (1998), “Private Labels and the Channel Relationship: A Cross Category Analysis”, Journal of Business, Vol. 71, No. 4, 573-600.

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31

Table 1 Store Brands: Percent Market Share of European Supermarket’s Own Brand

Products (1998)

Country Volume % Value % Belgium 34.8 25.9 France 22.2 19.1 Germany 33.7 24.9 Netherlands 21.1 18.9 United Kingdom 44.7 43.2 Average 31.3 26.4

Source: A.C. Nielsen (1999)

Table 2

Key Quality Equivalent Private Label Categories and National Brand Manufacturers who Supply Private Label

Product Category Products National Brand Manufacturers

Automotive Products oil, oil filters, accessories Valvoline Oil Company, Bosch Gmbh

Cleaning Products detergents, plastic bags, powder and liquid soaps

Colgate Palmolive

Disposable Products facial tissues, mouth washes, disposable cameras, film

Eastman Kodak Company

Do it Yourself Products power and hand tools General Electric Corporation

Financial Services credit lines, credit cards Barclays Bank Food Products table salt, spices/seasonings,

cookies, snacks, frozen food, seafood, breakfast cereals, beverages, dairy products

Keebler Company, RJ Reynolds, Parmalat, Starkist

Health and Beauty Aids toothbrushes, feminine hygiene products, rubbing alcohol, cold capsules, vitamins, tonics, first aid dressings

Baxter Healthcare Corp

Miscellaneous dog food, kitty litter, clothing, footwear

Nabisco Brands

32

Table 3 Demand Realized by Each Retailer in Equilibrium

(National and Private Label available)

SCENARIO Brand Seekers (share of market)

Product Seekers (share of market)

1. Full/Full 21

21

2. Full/Partial 21

tc

41−

3. Partial/Partial λγ

γ−−

t)c(

41

tc

41−

Table 4 Boundaries between Scenarios

(National and Private Label available)

Boundary Equation for the Boundary Scenario1/Scenario 2

⇒−<22

1 ct Scenario 1

Scenario2/Scenario 3 ⇒

+−<

ct 224λγ Scenario 2

Table 5 Demand Realized by Each Retailer in Equilibrium

(National Brand alone)

SCENARIO Brand Seekers (share of market)

Product Seekers (share of market)

1. Full/None 21 0

2. Full/Partial 21

t(tcctt

γλλλλλ

++−−++−−

− 22642222234

21

3. Partial/None λγ

γ−−

t)c(

41 0

4. Partial/Partial )t(t

)t)(c(2

2

41

λγγλλ

−+−−

)t(t)t)(c(

2

2

41

λγλγ

−−−

33

Table 6 Boundaries between Scenarios

(National Brand only)

Boundary Equation for the Boundary 1a. Scenario1/Scenario 2 (feasibility)

⇒−−++−

< 2

2222223t

tcct λλλλγ Scenario 1

1b. Scenario 1/Scenario 2 (profitability) Discussed in the technical appendix 2. Scenario 1/Scenario 3

⇒+−

<ct 224

λγ Scenario 1

3. Scenario 2/Scenario 4 ⇒

+−−+++−

<)ct(t

)tcc(122

2222 λλλλγ Scenario 2

4. Scenario 3/Scenario 4 ⇒<

t

2λγ Scenario 3

Table 7

Summary Statistics from Six Retail Categories 1993-1998

Category Average Annual % Change in

Category Average Price

Average Annual % Change in

Category Volume

Average Annual Change in

Private Label Share

Average Annual % Change in Private Label

Volume Breakfast Cereals -0.57% +3.64% +0.54% +12.90%

Cheese +0.22% +0.88% +5.06% +22.73% Fresh Vegetables +3.09% +1.33% +4.95% +20.3% Frozen Poultry +2.01% +16.16% 3.10% +46.92% Frozen Ready Meals & Pizza

+0.22% -2.64% +3.89% +38.19%

Still Fruit Juices +.32% +1.67% -1.21% -1.00% Diapers +2.93% -5.29% +2.20% +11.54%

Table 8 Results from Estimation

Model Intercept

β0

T-stat

(p-value) %Volcat∆

β1

T-stat

(p-value) sharePL∆

β2

T-stat

(p-value) %Vol PL∆

β3

T-stat

(p-value)

R2

7 cat @ 5

obs./cat

0.012384 3.56625

(0.001)

0.051621 1.237215

(.225)

0.190602 1.778842

(.085)

-0.03165 -1.9715

(.058)

.12053

52 obs.

15 cat.

0.01641 5.176743

(1.0E-5)

0.063199 1.478989

(.146)

0.165336 1.603361

(.115)

-0.03511 -2.2160

(.031)

.10265

34

Figure 2 Equilibrium Zones for a Market with Equal Proportions

of Brand and Product Seekers (National and Private Labels available) (λ=0.5, c=0.1)

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2

transportation costs

adve

rtis

ing

cost

par

amet

er

full coverage forbrand seekers

and partial coverage for product seekers

full coveragefor

brand seekersand

product seekers

partial coverage for both brand and product seekers

23

1

35

Figure 3

Equilibrium Zones for a Market with Equal Proportions of Brand and Product Seekers and no Private Labels

(λ=0.5, c=0.1)

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5

transportation costs

adve

rtis

ing

cost

par

amet

er

full coverage forbrand seekers

and partial coverage for product seekers

partial coverage for brand seekers andproduct seekers not served"full coverage for brand seekers"

dominates " full coverage forbrand seekers and partial

coverage for productseekers" (both regimes

are local maxima)

partial coverage for both brand and product seekers

full coverage for brand seekers andproduct seekers not served

4

3

1a

2

1b

36

Figure 4 Equilibrium Outcomes for Expensive/Inexpensive Advertising Environments

Expensive Advertising

001105030 .k,.c,.,. ==== λγ

Manufacturer Profit for Expensive Advertising

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.6 0.9 1.1 1.4 1.6 1.9 2.1 2.4 2.6 2.8

Transportation Cost

Man

ufac

ture

r Pro

fit

manuf profit (national brand only) manuf profit (national and private label)

Retailer Profit for Expensive Advertising

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.6 0.9 1.1 1.4 1.6 1.9 2.1 2.4 2.6 2.8

Transportation Cost

Ret

aile

r Pro

fit

retailer profit (national brand only) retailer profit (national and private label)

Inexpensive Advertising

0011050050 .k,.c,.,. ==== λγ

Manufacturer Profit for Inexpensive Advertising

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

0.9 1.4 1.9 2.4 2.9 3.4 3.8 4.3 4.8 5.3

Transportation Cost

Man

ufac

ture

r Pro

fit

manuf profit (national brand only) manuf profit (national and private label)

Retailer Profit for Inexpensive Advertising

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.9 1.4 1.9 2.4 2.9 3.4 3.8 4.3 4.8 5.3

Transportation Cost

Ret

aile

r Pro

fit

retailer profit (national brand only) retailer profit (national and private label)

37

Figure 5 Equilibrium Outcomes for Expensive/Inexpensive Advertising Environments

Expensive Advertising

001105030 .k,.c,.,. ==== λγ

Category Average Retail Price (Expensive Advertising)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

0.6 0.9 1.1 1.4 1.6 1.9 2.1 2.4 2.6 2.8

Transportation Cost

Cat

egor

y A

vera

ge P

rice

cat. average price (national brand only) cat. average price (national and private label)

Advertising Levels under conditions of Expensive Advertising

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0.6 0.9 1.1 1.4 1.6 1.9 2.1 2.4 2.6 2.8

Transportation Cost

Adv

ertis

ing

advertising (national brand only) advertising (national and private label)

Inexpensive Advertising

0011050050 .k,.c,.,. ==== λγ

Category Average Retail Price (Inexpensive Advertising)

0

1

2

3

4

5

6

7

0.9 1.4 1.9 2.4 2.9 3.4 3.8 4.3 4.8 5.3

Transportation CostC

ateg

ory

Ave

rage

Pric

ecat. average price (national brand only) cat. average price (national and private label)

Advertising Levels under conditions of Inexpensive Advertising

0

1

2

3

4

5

6

0.9 1.4 1.9 2.4 2.9 3.4 3.8 4.3 4.8 5.3

Transportation Cost

Adv

ertis

ing

advertising (national brand only) advertising (national and private label)

i

Technical Appendix “Why Private Labels may Increase Market Prices”

Table TA-1

Equilibrium Outcomes for three Scenarios National and Private Label Brands

Scenario 1 Full/Full

Scenario 2 Full/Partial

Scenario 3 Partial/Partial

Manufacturer Profit

γγγγλ

442 ct 4 − 4 − +

tc

tc

ttc

tc

tct

4244

241

422

2

λλλ

λλλγ

λ

−+−+

−+−−+

( ) ( )

( )λγλλγ

−++−+−

4441 22 tc

Retailer Profit

rkt−

4

rkt

cccct−

−+−+−+16

2214 222 λλλλ

( ) ( )

( ) rktt

tttc−

−++−−−

2

222322

41616881

λγγλλγλγλ

Wholesale Price National Brand

t−+12γλ

t−+12γλ

1422

−−+

tctct

γλγγ

Wholesale Price Private Label

Average Price

21

2

2 t−+

γλ

γγλγλλγγγ

γγγλγλλ

tcccc

tttt

8232

83484

22

22

−−++

−+−−−

−

Too long for presentation

purposes.

Advertising

t−1 21 c+

21 c+

γλ2γ

λ2 γλ

λλt

c4−+−

ii

Table TA-2

Equilibrium Outcomes for Four Scenarios under the National Brand Only Case

Scenario 1 Full/None

Scenario 2 Full/Partial

Manufacturer Profit

++−+−

+−+−

+ 12

4444

23

141

2

2223

cctct

ttctt

ttγγγ

γ

Retailer Profit

Wholesale Price

( )tctttcct

γλλλγλγλλλλ

++−+−−++−+−+

2

2222

2642222264642

Retail Pricing

Advertising

ct λλλγ

λ−−+

4

2

4tλ

t−γλ2

21

2t

−+γλ

γλ2

( )( )22

2 422231

161 tct

ttγ

γ−+−−

+

tttct

γγγ

2322 2

+−+++

tct

γ23225

21

++−

iii

Table TA-3

Equilibrium Outcomes for Four Scenarios

under the National Brand Only Case

Scenario 3

Partial/None Scenario 4

Partial/Partial

Manufacturer Profit

( )

2

2

412

λγγ

−+−

tcc

Retailer Profit

( )( )2

22

414

1

−

−

t

ct

γ

γ

Wholesale Price

Retail Price

Advertising

The Boundary between Scenario 1 and Scenario 2 (National Brand only) The expression which describes a value of γ below which serving only Brand Seekers is more profitable than serving both segments is too long for presentation. However, evaluated at λ=0.5, the expression reduces to the following:

)tc(t)cctcccttcttctcttcctt(cctctt

14106412109126441420912223

2

2142223232432322

−++++−+++−+−−++−−+++−−+

=γ

This is the value of γ which has been used to determine the equilibrium manufacturer and retailer profits in the simulation conducted for λ=0.5, c=0.1 and f=0.01.

2

2

422

λγγγλ

−++−

ttctc

116412

−++−

ttctc

γγγ

( )116

12−

−t

cγ

( )2

2

412

λγγ

−+−

tcc

( )( )2

22

414

1

−

−

t

ct

γ

γ

2

2

422

λγγγλ

−++−

ttctc

116412

−++−

ttctc

γγγ

( )116

12−

−t

cγ

iv

Derivation of the Limit for t such that National Brands are advertised (in the absence of Private Labels) In Scenario 2, the reduced form of the manufacturer’s profit function:

22212 At

)AtA)(cAtA(M γ

λλπ −

++−−−−+=

At

))(cAtA(t

)AtA)((A

M γλλλλπ 22212222−

−−−−++

++−−=

∂∂

at

A=0 this reduces to: t))(ct()(

A A

M 22120

−−−+−=

∂∂

=

λλπ

. This expression is

negative when tcvtcv3)(2

2)(−−

−−<λ .

Proof of Proposition 1 The benefit from introducing private label when some product seekers are not served and advertising is inexpensive obtains by looking at the gain of Scenario 2 profits (NL and PL) versus Scenario 1 profits (NL only).

4162214 222 tk

tcccct

riλλλλλπ∆ −−

−+−+−+=

tc

i 16)1)(1( 2−−

=⇒λπ∆ and

2

2 116

)1)(1(t

ct

i −−−=

∂∂ λπ∆ <0.

In contrast, when advertising is expensive, the benefit from introducing private label obtains by looking at the gain of Scenario 4 profits (NL and PL) versus Scenario 3 profits (NL only) when

21

4ct −

−<γλ and

t<γ

γλγλγγλλγγλγγλγ ccccc 323242882842281 22242222 −++++−−−+−−

− .

When 2

14

ct −−>

γλ and

t>γ

γλγλγγλλγγλγγλγ ccccc 323242882842281 22242222 −++++−−−+−−

− , the gain from

introducing private label is given by comparing Scenario 3 profits (NL and PL) to Scenario 4 profits (NL only) Note the expressions for t obtain by rearranging the boundaries given in Tables 3 and 5 (we select the positive root for t because the expression from Table 5 generates a quadratic expression in t). When

21

4ct −

−<γλ and

t<γ

γλγλγγλλγγλγγλγ ccccc 323242882842281 22242222 −++++−−−+−−

−

v

( )( )22

2

222

422231

161

162214 tct

ttk

tcccct

ri γγ

λλλλπ∆ −+−−+

−−−+−+−+

=

It is not possible to show analytically that this expression is increasing but we have simulated the derivative for a range of t and γ that satisfy the conditions for expensive advertising and it is always positive.

λ=0.5 and c=0

0 0.02 0.04 0.06 0.08 0.1

0.12 0.14

0.6

0.8

t 0.2

0.3 g

Value of Derivative of the Benefit of Launching Private Label (Retailer)

λ=0.333 and c=0

00.020.040.060.080.10.120.14

0.6 0.8 t

0.2

0.3g

Value of Derivative of the Benefit of Launching Private Label (Retailer)

λ=0.666 and c=0

0

0.05

0.1

0.15

0.2

0.25

0.6 0.8

t 0.26 0.28 0.3 0.32 0.34

g

Value of the Derivative of the Benefit of Launching Private Label (Retailer)

When

21

4ct −

−>γλ and

t>γ

γλγλγγλλγγλγγλγ ccccc 323242882842281 22242222 −++++−−−+−−

− ,

( ) ( )( ) 2

41

22

2

222322

)4()1(

41616881

−−

−−−

++−−−=

tctk

tttttc

ri γγ

λγγλλγλγλπ∆ . It cannot be shown that that

derivative of this expression with respect to t is negative for all c and λ, however for

c=0 and λ=½: 22

22

)116()18(138448

−−++−

=∂

∂ttttt

ti

γγγγπ∆ . For this to be negative, t<

γγ 483

161

+ . Which

combined with the initial contraint implies that γ<.0528 which lies outside the allowable zone for expensive advertising.

vi

Proof of Proposition 2 Using the expression from Tables TA-1 and TA-2. Prices with National Brand only

(Scenario 1) are 2

12

t−+

γλ and with both Private Label and National Brand (Scenario

1) are 2

12

2 t−+

γλ . Since λ<1, Average prices drop with the introduction of Private

Label. When t is higher, we compare average prices with National Brand only (Scenario 1) to average prices with Private Label and National Brand (Scenario 2). The difference is given by: 2 1 t

2 18

42t8t4t232cc232cc2

t

184t8t4t242t8t4t232cc232cc2

t It is not possible analytically to show that this is positive however, if we look at the case where the market is evenly divided between Brand Seekers and Product Seekers

and c=0, this simplifies to: γ

γγγt

ttt16

3482 2 ++−−− . The expression γγγ 3482 2 ++−− ttt

is negative for sufficiently small γ implying that γ

γγγt

ttt16

3482 2 ++−−− >0 when

advertising is inexpensive. Proof of Proposition 3 Using the expression from Tables TA-1 and TA-2. Prices with National Brand only

(Scenario 1) are 2

12

t−+

γλ and in the case of National Brand and Private Label

tttct

γγγ

2322 2

+−+++ (Scenario 2). If prices with the Private Label rise then

21

2t

−+γλ -

tttct

γγγ

2322 2

+−+++ >0. At λ=½ and c=0, this is greatest at the upper limit of t i.e.

21

=t

and simplifies to )3(

381

γγγ

+− . This expression is positive for all γ that satisfy the

condition in footnote 9. If transporation costs are greater than we compare the average prices with National Brand only (Scenario 2)

γγλγλλγγγγγλγλλ

tccccttt

82323484 2222 −−+++−+−−

to the case of National Brand

vii

and Private Label (Scenario 2)t

ttctγ

γγ2322 2

+−+++ . The difference simplifies to

116

6t24t28t162t282t3962tt32t .

We cannot analytically show that this expression is positive but a simulation over the allowable range for t and γ shows that it is positive.

0

1

0.5

0.6

0.7

0.8

t

0.260.280.30.320.34 g

Difference between Average Pricing with Private Label and National Brand versus

National Brand only