The name is absent



Vertical competition between manufacturers and retailers and upstream
incentives to innovate and differentiate

Luciano Venturini

Universita' Cattolica del Sacro Cuore, Largo A. Gemelli, 1 20123 Milano, Italy.
Department of International Economics, Via Necchi 5 20123, Milano, tel. +39-
02.7234.2692; fax. +39- 02.7234.2475. Institute of Food Economics, Via Emilia
Parmense, 84 29100 Piacenza, tel. +39- 0523.599.225.

E-mail: [email protected]

Abstract

Vertical competition, namely competition between retailers’ store brands (or private labels) and
manufacturers’ brands has become a crucial factor of change of the competitive environment in several
industries, particularly in the grocery and food industries. Despite the growing literature on the
determinants of the phenomenon, one topic area regarding the impact of vertical competition on the
upstream incentives to adopt non- price strategies such as product innovation as well as horizontal and
vertical product differentiation has so far received little attention. An idea often put forward is that the
increasing bargaining power of retailers and higher vertical competitive pressures can have negative
effects on such incentives by lowering manufacturers’ profits. On the other hand, there is a significant
empirical evidence supporting the view that non- price strategies of product innovation and
differentiation continue to play a key role and remain a crucial source of competitive advantages for
several manufacturers.

In this paper, we present a simple conceptual framework which allows us to focus on two hypotheses
which interacting explain why the disincentive effects are not so obvious. The first hypothesis regards
the existence of an inverse relationship between the strength of a given brand and the retail margin as
suggested by Robert Steiner. Through a two- stage model in which manufacturers do not sell directly to
final consumers and the retail industry is not perfectly competitive, Steiner argued persuasively that in
such models leading brands in a product category yield lower retail margins than less strong brands.
Retailers are forced to stock strong brands and therefore have relatively less bargaining power in
negotiating wholesale prices. In addition, price competition among retailers is more intense on strong
brands since consumers select these brands to form their perceptions of stores’ price competitiveness
and are ready to shift to lower price stores if retail price of these brands is not perceived as competitive.
Thus, intensive intrabrand competitive pressures discipline retailers pricing policy on stronger
manufacturer brands much more than on weaker brands. A key prediction of Steiner’ s two- stage model
is that, since manufacturers’ non- price strategies have a margin depressing impact which is additional
to their direct demand- creating effect, manufacturers face greater incentives to invest in advertising
and R&D.

The second central hypothesis in our framework is that in a world of asymmetric brands and intense
vertical competition there is a further mechanism at work due to retailers’ delisting decisions. Given
that retailers have to make room for their store brands at the point of sale, they have to readjust their
assortments delisting some manufacturer brands. Retailers would like delisting strong brands given
that the retailer’ s margin on these brands is lower. The problem is that strong brands can contrast
vertical pressures better than weaker brands and cannot be delisted. In making shelf- space decisions,
rational retailers will recognise that they can delist only the brands whose brand loyalty is lower than
their store loyalty. On the contrary, retailers cannot delist brands for which brand loyalty is greater than
store loyalty. This implies that manufacturer brands operate in a two- region environment. We call these
two regions, respectively, the ‘delisting’ and ‘no- delisting’ region and show that the demarcation point
between them is given by the level of retailer’ s store loyalty.

By combining the Steiner’ s hypothesis with the mechanism of delisting, we argue that in a competitive
environment characterized by vertical competition is at work a threshold effect which increases optimal



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