Abstract
This paper provides a positive theory of private labels in new product development when a non-integrated distribution channel is faced with demand uncertainty. We consider a regular marketing environment in which a manufacturer endowed with a branded product seeks to design a new product to resolve its retailer’s mis-targeting problem and to optimally screen consumers. Assuming that only linear pricing schemes are available and that the retailer learns the state of demand earlier than the manufacturer does, we show that the presence of a private label always improves channel efficiency. Moreover, a private label is more likely to prevail when the existing branded product is a premium item.
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Notes
Currently private labels account for 20%, 34%, and 45% of sales in the United States, Germany, and the United Kingdom, respectively (Kumar 2007). In both Europe and the United States, the success of private labels has induced retailers to actively engage in R&D activities (Dunne and Narasimhan 1999).
We make this assumption for several reasons. First, previous research has pointed out that only manufacturers in a more powerful position than their retailers may use a two-part tariff (Jeuland and Shugan 1983), and a manufacturer's using quantity discounts may violate Robinson–Paman Act’s prohibition of price discrimination against retailers. Second, in reality, most wholesale pricing contracts are extremely simple, renewed on quarterly basis, and specify only unit prices (Blattberg and Neslin 1990). Third, in both economics and marketing literature, it is standard to assume that manufacturer offers linear pricing schemes to its retailer (Gerstner and Hess 1991, 1995; Villas-Boas 1998).
If the manufacturer wants the retailer to serve only the highs, all it needs to do is to prevent the retailer from pricing low, which can be accomplished by choosing a high wholesale price. In this case, the manufacturer does not need to provide trade promotions.
Plenty of evidence suggests that retailers may possess demand information that manufacturers do not have. There is a huge body of literature analyzing retailers' motivations for sharing their superior demand information with the upstream suppliers in a supply chain; see for example Lee et al. (2000). In studying what might determine the magnitude of slotting allowances that retailers charge manufacturers for new products, Rao and Mahi (2003) find in their survey data that most retailers and manufacturers pointed to the information advantage that a retailer may possess over the manufacturer about the likely success of a new product.
Manufacturers of premium brands have supplied a significant portion of private labels (Boyle 2003, Fortune). Since our purpose is to provide a new perspective regarding why private labels may arise efficiently in equilibrium, we choose to build our theory in an environment where a retailer can only seek a branded manufacturer's cooperation in the production of the private label. We show that even in this worst possible situation from the retailer's perspective, it may still be the private label rather than a branded new product that prevails in equilibrium.
In our model, a private label prevails in equilibrium if and only if the manufacturer accepts the retailer’s offer. In the absence of such an offer, the manufacturer would induce the retailer to serve only the highs, and would offer no trade promotion.
In our model, private labels arise because the manufacturer’s marketing strategies may fail to attain channel efficiency, which is partly due to the manufacturer’s lack of demand information. We thank an anonymous reviewer for an inspiring comment that allows us to discover this implication.
In our model, the private label appears in equilibrium only if it is a low-end item and only if the demand is in the success state. In that situation, the existing and the new products will typically be used to screen consumers, with the private label and the national brand being respectively sold to the lows and the highs. The lows have a lower hedonic value than the highs for the category.
Condition (i) ensures that every targeting strategy generates a positive total surplus. Condition (ii) says that the total surplus from serving the highs is maximized by selling the highs the high-end item rather than the low-end item. Condition (iii) ensures that in the absence of the low-end item, the retailer always prefers to sell the high-end item to the highs only, that unit production costs for the two products do not differ by too much, and that whether the distribution channel is vertically integrated or not, the manufacturer endowed with two products that both fall in consumers’ latitude of acceptance always wishes to screen consumers with different products. Condition (iv) ensures that new product development is costly enough to become a relevant issue. We discuss these conditions in Section 4.
Like M, R is restricted to choose only a linear pricing scheme (W HR , W LR ). No matter which one between M and R gets to choose (W HR , W LR ), R is the one who will then specify the ordered quantities (Q HR , Q LR ).
The assumed interactions between R and M try to capture the widely documented phenomena in distribution channels: concentration of retailers implies that they may be able to make a firm offer when negotiating with manufacturers, and innovation of information systems may explain why they may receive demand information before manufacturers do.
In state B, the retailer would rather sell the low-end item to all consumers than to only the highs if and only if \( \theta_1 - W_{LB} \ge \beta \left( {\theta_1^{\prime} - W_{LB} } \right) \), and hence the manufacturer is better off serving all consumers if and only if \( {{\left( {\theta_1 - \beta \theta_1^{\prime} } \right)} \mathord{\left/ {\vphantom {{\left( {\theta_1 - \beta \theta_1^{\prime} } \right)} {\left( {1 - \beta } \right) - c_1 \ge \beta \left( {\theta_1^{\prime} - c_1 } \right)}}} \right. } {\left( {1 - \beta } \right) - c_1 \ge \beta \left( {\theta_1^{\prime} - c_1 } \right)}} \), which is true under Assumption 1. In state G, the manufacturer may or may not want to serve the lows, but if it does, it never pays to serve the lows with the high-end item, and moreover, Assumption 1 (βθ 2 > θ 1) implies that serving all consumers with the low-end item is dominated by screening consumers with different product items. Hence, the manufacturer is left with two un-dominated state-G strategies: to serve only the highs with the high-end item, or to screen consumers with two items. Because \(\theta _{1} > \beta {\left( {2 - \beta } \right)}\theta ^{\prime }_{1} + {\left( {1 - \beta } \right)}^{2} c_{1} \), Assumption 1 implies that screening is the optimal strategy in state G.
This is indeed the retailer’s state-B equilibrium profit. In state G, note that selling only the low-end item to all consumers is always an option to the retailer, and to deal with this mis-targeting problem, the manufacturer’s optimal wholesale prices \( W_{LG}^{*} \) and \( W_{HG}^{*} \) must equate the retailer’s equilibrium profit to what it would get by selling only the low-end item to all consumers.
To see the idea, suppose instead that R does make an offer in equilibrium, which is accepted by M. This implies that by carrying out the transactions stated in the offer, R’s expected profit is strictly higher and M’s expected profit is not lower than without this offer. This contradicts the fact that without this offer the (expected) total channel profit has already been maximized.
Note that Lemma 3 remains true even if we relax most conditions imposed in Assumption 1. What matters is that the retailer’s mis-targeting problem does not cost the manufacturer in state B, which is generally true when the existing branded product is a high-end item.
Note that the presence of the first offer avoids the un-desired outcome where both firms spend on new product development ex-ante, and the chance to make a new offer allows the channel’s retail pricing and production decisions to adapt to new demand information.
The above offer is merely one optimal choice. Several other alternatives can each attain full channel efficiency as well. For example, R’s first offer only asks for (i) M’s permission to develop the new product; (ii) M’s promise of producing the new product for R; and (iii) a right to offer some (Q HR , Q LR , W HR , W LR ) after R learns the demand state. In this case R will offer (Q HR , Q LR , W HR , W LR ) = (β, 1 − β, θ 2 − t, c 1 + βt / (1 − β)) in and only in state G. For another example, R’s first offer specifies (Q HR , Q LR , W HR , W LR ) = (β, 1 − β, θ 2 − t, c 1 + βt / (1 − β)) and, instead of allowing R to make a new offer subsequently, it specifies a fine βt on R if R chooses to cancel its order for the low-end item subsequently. In this case, R will cancel the order and pay the fine in and only in state B.
For example, the manufacturer with a low-end existing product will always serve only the highs with its most valuable item (i.e., the new product in state G and the existing product in state B) if a set of conditions on the parameters hold.
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Acknowledgments
The authors would like to thank the anonymous reviewers and the editor for their helpful suggestions. Shan-Yu Chou also gratefully acknowledges the financial support (NSC 93-2416-H-002-010-) from the National Science Council of Taiwan, Republic of China.
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Chen, CM., Chou, SY., Hsiao, L. et al. Private labels and new product development. Mark Lett 20, 227–243 (2009). https://doi.org/10.1007/s11002-009-9075-4
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DOI: https://doi.org/10.1007/s11002-009-9075-4