Strategic effects of private labels

This paper presents a model of retailer-manufacturer interaction that focuses on retail competition between national brands and private labels positioned by retailers to compete with them. The final demand side involves vertical differentiation between the private label (low quality) and the national brand (high quality). It is assumed that production costs for the national brand and the private label differ not only by sunk costs (advertising) but also by marginal costs, and that the marginal cost function is increasing and convex in quality. We study equilibrium price strategies for both agents when the quality of the private label varies and we compute the optimal private label quality from the retailer's point of view. We also determine the effect of the private label on the agents' profits. Our results suggest that the wholesale price of the branded good may increase as the private label good becomes a closer substitute for it. Moreover, introducing a private label reduces the double marginalisation problem in the vertical structure.