Optimal Production Channel for Private Labels: Too Much or Too Little Innovation?

• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jems.12098
• Author: Guy Meunier,Clémence Christin,Claire Chambolle
• Date: 01 June 2015

Optimal Production Channel for Private Labels:

Too Much or Too Little Innovation?

CLAIRE CHAMBOLLE

INRA–UR1303 ALISS 65 boulevard de Brandebourg 94205 Ivry-sur-Seine, France and Department of

Economics

Ecole Polytechnique route de Saclay 91128 Palaiseau

France

claire.chambolle@ivry.inra.fr

CL´

EMENCE CHRISTIN

Normandie Universit´

eUCBN

CREM-UMR CNRS 6211

19 Rue Claude Bloch, 14032 Caen, France

clemence.christin@unicaen.fr

GUY MEUNIER

INRA–UR1303 ALISS 65 boulevard de Brandebourg 94205 Ivry-sur-Seine, France and Department of

Economics

Ecole Polytechnique route de Saclay 91128 Palaiseau

France

guy.meunier@ivry.inra.fr

We analyze the impact of the private label production channel on innovation. A retailer may

either choose to integrate backward with a small firm (insourcing) or rely on a national brand

manufacturer (outsourcing) to produce its private label. The trade-off between insourcing and

outsourcing strategies is a choice between too much or too little innovation (i.e., quality in-

vestment) on the private label. When insourcing, an outside-option effect leads the retailer to

overinvest to increase its buyer power. When outsourcing, a hold-up effect leads to underinvest-

ment. In addition, selecting the national brand manufacturer may create economies of scale that

spur innovation.

1. Introduction

The sale of private label goods has reached approximately 25% of global supermarket

sales, compared with 15% in 2003. In some European countries, these products exceed

half of all sales (53% in Switzerland and 51% in Spain).1In the United States, private

labels accounted for approximately 19% of market shares in 2012.2

Although private labels were initially positioned as low-quality “me-too”

products, their quality has significantly improved and private labels are increasingly

We thank Marie-LaureAllain, Eric Avenel, Eric Giraud-H´

eraud, Julien Troiville,Yaron Yehezkel, participants

at EARIE 2012 as well as seminar participants at the University of Rennes and the University of Grenoble,

the editor and two anonymous referees for their useful comments and references. We gratefully acknowledge

support from the Agence Nationale de la Recherche (ANR) and the Deutsche Forschungsgemeinschaft (DFG)

for the French-German cooperation project “Competition and Bargaining in Vertical Chains” (ANR-12-FRAL-

0012) and the French project OCAD (ANR-11-ALID-0002).

1. http://www.plmainternational.com/industry-news/private-label-today.

2. http://plma.com/storeBrands/sbt13.html.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 2, Summer 2015, 348–368

Optimal Production Channel for Private Labels 349

innovative.3“Economy private labels” and “premium private labels” often coexist on

retailers’ shelves.

The two main channels for the production of private labels are small firms and,

increasingly, national brand producers themselves. In the United States, more than 50%

of national brand producers make private label goods in addition to their national brand

(Quelch and Harding, 1996; ter Braak et al., 2013). Some national brand manufacturers

are leaders in private label goods production, such as Heinz for baby food.

This paper analyzes the main drivers of a retailer’s choice of its premium private

label production channel and the consequences of this choice on product innovation and

welfare.

In the model developed here, a monopolist retailer can sell a national brand and

a premium private label. Some consumers have an intrinsic preference for the national

brand. Todevelop a premium private label, the retailer can choose either an outsourcing

strategy or an insourcing strategy. We define outsourcing as contracting with a national

brand producer that enters into dual branding. In that case, the retailer relies entirely

on the producer’s capacity to innovate. In contrast, we define insourcing as buying the

private label from a (small) dedicated manufacturer that sells at cost to the retailer.

In this case, the innovation process for the private label relies entirely on the retailer.

Insourcing boils down to backward integration. In both cases, innovation is undertaken

before firms bargain over sales revenue.

The trade-off between the two channels is primarily a choice between too much

and too little innovation on the private label. Outsourcing may create economies of scale

that spur innovation. Despite this straightforward argument in favor of outsourcing, this

strategy may lead to too little innovation. Indeed, when outsourcing, a standard hold-up

effect implies that the brand manufacturer underinvests in the private label quality. In

contrast, when insourcing, the retailer overinvests to increase its outside option, and

therefore its buyer power toward the national brand manufacturer.

In equilibrium, insourcing paradoxically emerges when the retailer’s bargaining

power is sufficiently high. This is because the inefficiency due to the outside-option effect

is all the stronger when the retailer’s bargaining power is initially weak. This choice may

be detrimental to welfare because consumers may be hurt by too little innovation on the

private label.

Few papers have analyzed the retailer’s choice of production channel for private la-

bels.4Toour knowledge, only Berg `

es-Sennou (2006), Tarzij´

an (2007), and Berg`

es-Sennou

and Bouamra-Mechemache (2011) have directly analyzed this issue. Berg`

es-Sennou

(2006) focuses on store and brand loyalty, explicitly considering retail competition.

Tar zi j ´

an (2007) analyzes the incentive for a brand producer to enter into dual-branding by

balancing cost synergies with cannibalization effects. In contrast with these two papers

that rule out the issue of quality investments, the present paper focuses on innovation

issues.

Berg`

es-Sennou and Bouamra-Mechemache (2011) consider quality investment on

the private label and assume that quality is contractible. We depart from their analysis

in two main directions: First, we consider noncontractible investments and inherent

3. For instance, although brands held a 55% share of total new product development in 2010 in the United

Kingdom, the balance switched in 2011 in favor of private labels, which accounted for 54% of new prod-

uct development. http://www.storebrandsdecisions.com/news/2012/05/29/ mintel-private-label-product

-development-outpaces-cpg-in-the-uk.

4. The industrial organization and marketing literature has mostly analyzed the retailer’s rationale for

launching private labels (see Berg`

es-Sennou et al., 2004, for a survey).