Production Arrangements and Strategic Brand Level Competition. in a Vertically Linked Market

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1 Production Arrngements nd Strtegic Brnd Level ompetition in Verticlly Linked Mrket Wseem Ahmd, Sven Anders nd Philippe Mrcoul Ph.D. ndidte nd Associte Professors, Deprtment of Resource Economics nd Environmentl Sociology, 55 Generl Services Building, University of Albert, Edmonton, AB, T6G H, nd, orresponding uthor Wseem Ahmd: Selected Pper prepred for presenttion t the Agriculturl & Applied Economics Assocition s 3 AAEA & AES Joint Annul Meeting, Wshington, D, August 4-6, 3. opyright 3 by [Wseem Ahmd, Sven Anders nd Philippe Mrcoul]. All rights reserved. Reders my mke verbtim copies of this document for non-commercil purposes by ny mens, provided tht this copyright notice ppers on ll such copies.

2 Production Arrngements nd Strtegic Brnd Level ompetition in Verticlly Linked Mrket ABSTRAT This pper develops nd tests different theoreticl models of competition in verticlly linked mrket ssuming different production rrngements for retiler privte lbel brnds (). We then empiricl estimte retiler mnufcturer competitive behvior bsed on best-fit gmes nd determine the impct of production rrngements on pricing strtegies for s nd s. Retilers re using different production rrngements to produce products. In fct, retiler my own production fcility, ntionl brnd mnufcturer () produces the product exclusively for the retiler or the retiler outsources production to non- mnufcturer. These possible, different production rrngements cn hve significnt implictions for the competitive interctions nd mrket outcomes between retilers nd mnufcturers. Existing economic literture hs identified significnt degree of vrition in the type of competitive interctions cross grocery product ctegories. However, the mjority empiricl studies in IO hve typiclly imposed ssumptions bout the nture of verticl production rrngement without formlly nd explicitly investigting the nture of - competitive interction under different production rrngements. The nlysis builds on the Non-Nested Model omprison (NNM) pproch nd employs weekly store-level retil scnner dt, for mjor North Americn retil chin. The findings from different theoreticl models nd their empiricl ppliction revel tht no consistent pttern of competitive interctions exists between s nd s cross different food product ctegories. ompetitive ptterns nd outcomes vry depending on the nture of the production rrngement. Our study contributes to the IO literture by being the first to consistently derive nd estimte the impct of production rrngement on brnd-level competition. Keywords: ompetition, Bertrnd Nsh, Stckelberg leder follower, Non-Nested Model omprison, ndin retil level, Privte lbel, Ntionl brnd, Production rrngements

3 INTRODUTION For the lst severl decdes, mnufcturers hve been the min producers of brnded consumer pckged products. This ledership position hs eroded over time s mjor grocery retil chins hve introduced their own brnded product lines - privte lbel () brnds (Wu nd Wng 5; Kumr nd Steenkmp 7). products hve shown significnt increse in mrket cross retil mrket, nd in 998 they were mong the top three brnds in 7 percent of ll retil product ctegories (Wu nd Wng 5). In nd, retil sles were $.4 billion, roughly 5% mrket shre in (Nielsen ). The rpid growth of retil brnds (s) hs creted new nd stiff competition for mny estblished mnufcturers, s retilers hve been found to use s s strtegic brgining wepons in negotitions with producers (Gomez nd Benito 8). Moreover, Berges nd Boumr-Mechemche () mong others show tht the introduction of product ffects both the horizontl nd verticl competitive reltionship between S nd s. Retilers re using three different production rrngements for products (Berges- Sennou 6). Some own the production fcility to gin more control on the production; in this regrd, Doug Ruch, president of Trder Joe s (which crries bout 8 percent products), sid we could put our destiny in our own hnds (Kumr nd Steenkmp 7). In, one mjor retil chin in nd owned bout 4 percent of totl sles production fcilities (Sfewy ). Retilers lso outsource products from locl mrkets. Kumr nd Steenkmp (7) stted tht thousnds of firms focus exclusively to produce products. Also, mnufcturers produce products for retilers. For instnce, hen et l. () reported tht more thn 5 percent of products re being supplied by the mnufcturers. These different production rrngements (retiler owns the production fcility for products, retiler outsources products, mnufcturer produces products) rise concerns for retilers, mnufcturers nd policy mkers regrding competitive behvior. In verticlly linked mrket, the strtegic competition between s nd s is mutully dependent nd the choice of mrketing instruments is ffected by the rivl s competitive behvior under different production rrngements. The production rrngement ssumptions of brnd re criticlly importnt to the retiler s nd mnufcturer s optiml competitive strtegy. Therefore, to understnd the effect of the mrketing mix on the profit of the producer

4 (retiler/ mnufcturer), we need to understnd the competitive interction between retiler nd mnufcturer under different production rrngements. To ssess the effectiveness of different mrketing instruments (price nd promotion), it is importnt to know the underlying production rrngements nd competitive interctions between nd. Previous economic studies empiriclly nlyzed competition between nd. These studies hve typiclly mde ssumptions bout underlying production rrngements nd competitive interction between nd, but in relity the competitive interction my differ for different product ctegories nd under lterntive production rrngements. So the wrong ssumptions regrding nd competitive interction my result in flse conclusions. It is importnt to determine the type of competitive interction between nd under different production rrngements insted of ssuming prticulr type of competitive interction. Bsed on the literture review conducted in this subject re, there is no study tht tested the nture of competitive interctions under different production rrngements. Thus, the min objective of this study is to see the type of competition between nd in verticlly linked mrket when there re different production rrngements. We extend the theoreticl model of competition, ssuming different production rrngements of products. Furthermore, we estimte the model empiriclly by using ndin retil dt nd identifying the competitive interction between nd tht ctully exists in the mrket. The empiricl nlysis helps us to identify how nd prices influence the demnd for these products in the ndin context. In this regrd, we use retil scnner dt for the period 4 to 7. The dtset contins retil sles informtion (price, pplicble discount, sles quntity, retil mrgin) for Universl Product ode (UP) product ctegories vilble t mjor North Americn retil chin with stores in nd. The fst growth of s plys n importnt role in both intr- nd inter-store retil competitions. As products re often less expensive thn their substitutes, they often produce higher retil mrgins, mking products n importnt source of retiler revenue nd profit (Hoch nd Bnerji 993). There is sufficient evidence tht vilbility/introduction of reduces or voids double mrginliztion problem which hs positive impct on the socil welfre (Berges-Sennou et l. 4). Mills (995) rgues tht retiler gins from mrketing t the expense of decrese in sles of nd the retiler s gin exceeds the loss. Retilers 3

5 re using mrketing s n instrument to overcome the problem of double mrginliztion. The net effect of mrketing results in n improvement in the performnce of distribution chnnel. Nrsimhn nd Wilcox (998) found tht products re often used s strtegic wepons by retil chins in their competition ginst food mnufcturers. To dte, evidence from the economic literture suggests tht retilers my be effectively using brnd lines to exert mrket power ginst mny mnufcturers (Nrsimhn nd Wilcox 998; Symn, et l. ; Mez nd Sudhir ). The complex nture of the competitive interctions between s nd s hs become concern (to set the price of nd, to increse profit, shre etc.) not only to mrketing mngers in food industries, but lso economists nd policy mkers responsible for competition policy nd fir prctices long verticl food mrketing chnnels (otterill et l. ). Volpe () nd other reserchers (orstjens nd Ll ; otterill nd Putsis ) note tht incresing levels of product qulity hve significntly contributed to the penetrtion of s in mny retil product ctegories. The qulity of s is lso documented by lrge number of publictions in the retil press (e.g., Progressive Grocer) tht show rise in populrity nd retiler efforts to promote higher qulity s to consumers in order to mximize sles nd increse ctegory mrket shres. The shift to nd focus on qulity over time hs intensified brnd competition (Volpe ). Behind this development stnds the observtion tht consumers in mny mrkets, including nd, incresingly recognize the qulity of products nd hve developed preferences for mny brnd lines (e.g. Loblws President s hoice). New nd incresingly differentited product lines re used to ttrct dditionl consumer demnd nd, therefore, intensify competition between s nd s. Severl lrge retil chins hve developed differentited good for you product lines nd lbeling schemes round their helthy product options. For exmple, ndin Loblws developed President s hoice Blue Menu nd Sfewy developed Eting Right helthy product lines. These helthy product lines focus on reducing or removing unfvourble ingredients (e.g., ft, sodium, sugr, slt, etc.) (Anders nd Moeser ). In the present study, regulr nd verticlly differentited bcon (low slt bcon) products re considered to see how the competitive interction vries between nd. 4

6 The reminder of this pper is divided into five sections. The first reviews the economic literture, the second dels with the model development, the third nd fourth re concerned with the dt issues nd empiricl estimtion respectively, nd the lst discusses the study s conclusions. REVIEW OF LITERATURE Very few studies in economic literture discuss different issues relting to the production of store brnds (Quelch nd Hrding 996; Verhoef et l. ; Berges-Sennou 6; Berges nd Boumr-Mechemche ). Verhoef et l. () nd Wu nd Wng (5) discuss dvntges nd disdvntges to the mnufcturer producing products. Verhoef et l. () identified vrious fctors (e.g., brnd strength, imge, product vriety, bility to crete technologicl product differentition) tht mnufcturers consider before tking on production. The study concludes tht mnufcturers do not directly compete with by reducing the price of the product; rther, they minly focus on incresing the distnce from products. Berges nd Boumr-Mechemche () studied vrious fctors ffecting the production process. The study shows tht if production cost is low, the retiler prefers to buy its product from independent firms, nd if production cost is high then it is beneficil for the retiler to get its products from mnufcturers. The study lso observes tht when the mnufcturer s brgining power goes up, there re fewer chnces for the retiler to buy products from the mnufcturer. The uthors further conclude tht if the qulity of the is low or high then the retiler prefers to sell only, while for intermedite qulity it is beneficil for the retiler to sell both nd. Berges-Sennou (6) studied the impct of different production rrngements of s on the retiler s brgining nd customer loylty. The results of the study indicte tht the retiler entrusts the mnufcturer when either the retiler hs lower brgining power or numerous consumers re loyl to the. The uthor further explins this behvior s if consumers re loyl to the nd the is less ttrctive to the consumers; then, there re more chnces for the retiler to ssign production to the mnufcturers. If the consumers re less loyl to the nd the retiler hs stronger brgining power, there is greter chnce tht the retiler will buy the product from the competitive mrket. 5

7 A number of economic studies ssume prticulr production rrngement (Nrsimhn nd Wilcox 998; Rju et l. 995; Wu nd Wng 5; Krry nd Herrn 9). For exmple, Nrsimhn nd Wilcox (998) nd Rju et l. (995) ssume tht retilers outsource products. Rju et l. (995) further ssume tht retilers buy products t fixed per unit price. They conclude tht introducing s in product ctegory with lrge number of competing s would increse the retiler s profit in the respective product ctegory. Nrsimhn nd Wilcox (998) show tht the penetrtion of products cross ctegories is ssocited with overll higher mrgins for the retilers. Wu nd Wng (5) ssume the mnufcturer produces both nd products. They discuss the economic benefits for the mnufcturer to produce products. For this purpose, they develop theoreticl model tht considers the interction of two s nd one store brnd. The study concludes tht if the mnufcturer supplies products to the retiler, it benefits the mnufcturer s it decreses its promotionl expenditures. Krry nd Herrn (9) ssume tht the retiler owns the production fcility for products. They nlyze the impct of dvertising on product sles over time. The uthors conclude tht the effect of dvertising on brnd sles depends on whether the mnufcturer nd retiler s dvertising re competitive or complementry in nture. In the cse of competitive dvertising from the mnufcturer, the dvertising expenditure hs negtive reltionship with the retil price of both nd brnds. A significnt mount of literture exists on the question of how products re competing with s t the retil level. A number of studies hve ssumed prticulr competitive behvior (Stckelberg leder follower) nd developed theoreticl models (Rju et l. 995; Nrsimhn nd Wilcox 998; Wu nd Wng 5; Krry nd Herrn 9; Mez nd Sudhir ). Most of the studies conclude tht introducing products benefits retilers. Some studies, however, focus explicitly on testing different gme specifictions ssuming prticulr production rrngement on the dtset (Putsis nd Dhr 998; nd otterill nd Putsis ). These studies conclude tht the nture of gmes plyed differs cross product ctegories. Putsis nd Dhr (998) use the conjecturl vrition pproch nd test the presence of leder follower gmes between s nd s. The study shows tht the most common behvior is tht behves s leder, while for some product ctegories (milk, frozen vegetbles nd fresh bred), the behves s the leder. otterill nd Putsis () pply non-nested model comprison 6

8 pproch on US dt. The study ssumes tht retilers outsource their products from the mnufcturer. The results show tht verticl Nsh is most common type of competition between the nd, while only out of product ctegories show the mnufcturer s Stckelberg leder. Previous theoreticl literture either ssumes prticulr competitive interction between nd or tests different competitive interction gmes. However, these rticles do not tke into ccount the vrition in how products re produced. In relity, retilers re using three different production rrngements for products nd these rrngements hve serious implictions for retilers nd mnufcturers. Despite lrge number of studies on the - competition in retiling, the literture hs provided no insight on the nture of the - competitive reltionship with vrying production rrngements in the ndin retil sector. The present study mkes significnt contribution in filling the knowledge gp by developing theoreticl models under vrious production rrngements of brnds nd shows how the different production rrngements of hve n impct on both the retiler s profit nd the mnufcturer s profit. Another contribution is empiricl testing of the nture nd extent of pricing competition cross different food product ctegories nd between s nd s in the ndin retil mrket. This study lso contributes to the literture by testing the nture nd extent of pricing competition under vrious production rrngements of products by using retil scnner dt. Finlly, it helps to drw conclusions regrding pricing strtegies between s nd s in different product ctegories under different production rrngements. MODEL DEVELOPMENT Historiclly, before the introduction of products, mnufcturers were considered to be the min producers of consumer products. Mnufcturers produced nd supplied brnded products to retilers, who supplied these products to consumers in the mrketplce (s shown in figure ). 7

9 Figure : Mnufcturer Produces Only nd Retiler Does not hs Product Wholesle price of Retil price of Mnufcturer of Mx π (Wholesle price)* Retiler Mx π (Retil Price)* onsumer Figure describes the chnges in the mrketing orgniztion fter products re introduced in the mrketplce. In this cse, the mnufcturer produces products for the retiler (hen et l. ). The mnufcturer s mximizes profit not only with the production of s, but lso with s. As in Figure, the mnufcturer produces nd supplies both products to the retiler nd the retiler sells these products to the consumers. Figure : Mnufcturer Produces both nd Products Wholesle price of nd Retil price of nd Mnufcturer of Mx π (Wholesle price of, ) Retiler Mx π (Retil Price, )* onsumer 8

10 Figure 3 shows the cse where the retiler outsources products. In this scenrio, different mnufcturers produce nd seprtely nd supplies the products to the retiler who sells them to the consumers. Figure 3: Retiler Outsources Product nd Mnufcturer Produces Brnd Mnufcturer of Mx π (Wholesle price of )* Mnufcturer of Mx π (Wholesle price of )* Wholesle price of nd Retil price of nd Retiler Mx π (Retil Price, )* onsumer In figure 4, we ssume tht the retiler owns the production fcility. In this cse, the retiler s function is to produce nd sell products to the consumers, wheres the mnufcturer lso supplies its products to the retiler, who then sells both products ( nd ) to the consumers. Figure 4: Retiler Owns the Production Fcility nd Mnufcturer Produces Brnd Mnufcturer of Mx π (Wholesle price of )* Retiler s own product () Wholesle price of Retil price of nd Retiler Mx π (Retil Price, )* onsumer 9

11 Estimtion strtegy The method used in the present study is bsed on the new empiricl industril orgniztion (NEIO) pproch used by otterill nd Putsis (). Kdiyli et l. () stted tht the NEIO pproch is bsed on the development nd estimtion of structurl, strtegic, econometric models nd firms competitive behvior. This pproch hs three bsic chrcteristics: demnd specifiction (liner, logit etc.), cost specifiction (constnt mrginl cost or liner, log liner specifiction of cost) nd the interction of competitive behvior (Kdiyli, et l. ). To identify the competitive behvior, two kinds of pproches re commonly used: the conjecturl vrition (V) pproch nd the menu pproch (or Non-Nested Model omprison (NNM)) (Roy et l. 6). Iwt (974) developed method to mesure the numericl vlue of V. In this pproch, ech firm s strtegic vrible effect nd its rection cn be cptured using one prmeter. There cn, however, be severe bises in this single coefficient. There re lso some problems interpreting this prmeter; for exmple, positive vlue of V shows tht there is coopertion in the mrket. On the other hnd, V lso shows the positive vlue if decrese (increse) in the price of one firm is ccompnied by similr behvior in rivl firm. This price chnge could be the strtegic response to the competitor. In other words, the positive vlue of V does not show coopertive or non-coopertive behvior (Roy et l. 6). The NNM pproch develops lterntive competitive behvior models, such s Bertrnd or Stckelberg leder-follower. These strtegic models re pplied on the dtset nd whichever model best fits the dt is considered the most pproprite description of the mrket (Putsis nd Dhr, 998; Kdiyli et l. ). This pproch lso hs certin disdvntges s it cnnot be implemented if the estimtion is not done simultneously. It therefore requires lrge degrees of freedom nd enough exogenous instruments so it is possible to identify ech eqution in the system (Roy et l. 6). The other disdvntge to this pproch is tht s the number of firms or number of brnds increses to more thn two, it becomes difficult to pply, becuse the number of possible competitive behviors increses very rpidly (Vilcssim et l. 999). Roy et l. (6) compred different estimtion pproches (e.g., V nd NNM) nd concluded tht the NNM pproch performs better thn the V pproch. Since the present study dels with two brnds nd uses retil scnner dt, it is esy to use the NNM pproch to

12 understnd different competitive behviors in verticlly linked mrket nd to see how these behviors impct equilibrium prices t retil nd wholesle levels. The theoreticl model ssumes tht mnufcturer nd retilers re using price s strtegic vrible. Vrious scenrios re explined below:. The mnufcturer supplies the product to the retiler, which does not hve its own product (s shown in figure ).. The mnufcturer supplies both nd products to the retiler, which sells both products to the consumer (see figure ). 3. The mnufcturer supplies the to the retiler nd the retiler outsources product but the retiler sells both nd products to the consumer (see figure 3). 4. The mnufcturer produces only the product nd supplies it to the retiler, while retiler owns the production fcility. Furthermore, the retiler sells both nd products to the consumer (s shown in figure 4). se : Only One Product nd No In this cse, we ssume tht only one product is vilble in the mrket nd the retiler s role is to sell it to the finl consumer. Our interest in describing this cse is to compre the prices nd profits for the retiler nd mnufcturer with other cses where nd brnds exist simultneously. This comprison lso helps us to understnd whether there is chnge in the pricing behvior mong different competitive models when both brnds re vilble in the mrket. In this scenrio, the mnufcturer mximizes profit by setting the wholesle price, nd the retiler mximizes by setting the retil price of the. We derive the first order conditions under vrious equilibrium interctions (Stckelberg leder follower nd Bertrnd) in verticlly linked mrket between the mnufcturer nd the retiler. Bertrnd competitive behvior ssumes tht the competitor does not rect to the chnge in the strtegic vrible (price) (Kdiyli et l. ), while in Stckelberg leder follower, the leder sets the strtegic vrible with knowledge of the competitor s rection in the first stge, nd in the second stge the follower sets the strtegic vrible (Nrsimhn nd Wilcox 998). The demnd for the cn be specified s

13 Q P = () Where Q denote the quntity demnd of the, P is the price of the t the retil level nd defined s Where prmeters. P = W m W is the wholesle price nd m is the retil mrgin on nd, re The bove specifiction pplies liner functionl form of demnd. The reson for using this specifiction insted of other demnd specifictions (double log) hs to do with computtion. The double log specifiction complictes the nlysis nd violtes the conditions required to estimte vrious mrket structures (Kdiyli, 996). For exmple, while estimting the leder follower gme, we need to estimte the first order condition of the follower nd invert it to obtin prices in terms of the leder s price. We then substitute this inverted price condition into the leder s profit mximiztion condition. With double log demnd specifiction, this inversion my led to multiple solutions or noninvertible solution (Kdiyli, 996). Thus, for trctbility, liner demnd specifiction hs been used in this study. Let denote the retiler s profit nd W denote the wholesle price. The profit functions of the retiler cn be written s π = m Q () R Let nd denote the mnufcturer of s profit nd cost of production of respectively. M π R π M ( W ) Q π = (3) Eqution (3) shows the profit function of the mnufcturer. Equilibrium vlues under vrious competitive behviors re given in tble. The retil price s equilibrium vlues show tht the cost of producing hs positive impct on the retil nd wholesle price, which is expected ccording to economic theory. These theoreticl results re consistent with the findings of hoi (99). The theoreticl model shows tht the retil price of remins the sme for different competitive behviors (whether the retiler behves s leder or the mnufcturer behves s leder) but the wholesle price differs in different competitive equilibriums. It lso revels tht the totl chnnel profit remins the sme whether

14 the retiler behves s leder or the mnufcturer behves s leder (hoi 99). As expected, the retiler s equilibrium profit is highest when the retiler behves s leder while the mnufcturer s profit is the highest when the mnufcturer behves s leder. Theoreticl models show tht industry s whole enjoys the highest profit nd consumers enjoy the lowest price when there is Bertrnd competition. Tble : Equilibrium Vlues under Vrious ompetitive Interctions When Only the Product is Avilble t Retil Level Mnufcturer of Retiler behves s Bertrnd ompetition behves s leder & Prticulrs between retiler & leder & retiler mnufcturer s mnufcturer of s follower follower Retil Price (P ) 3 ( 3 ) ( ) Wholesle Price (W ) ( ) Profit (π Retiler ) ( ) ( ) ( ) 6 Profit (π Mnufcturer ) ( ) ( ) ( ) se : Only One Product nd One se.: mnufcturer produces both nd product In this cse, we ssume tht both nd product re vilble in the mrket nd the retiler is selling both the nd products to the consumers. The mnufcturer produces both the products nd mximizes profit by setting the wholesle price. The retiler optimizes by setting the retil price of the nd (see figure ). Following hoi (99), the demnd for nd cn be specified s Qi Pi = P Where i, j = nd, nd i j (4) j 3

15 P j. Let Where Q i is the demnd for brnd i ( or ) t price P i given the price of other brnd m denote the retiler s mrgin for. The retiler s objective is to mximize the ctegory profit. The retiler s profit cn be written s π = m Q m Q (5) R Let denote the cost of production of. The profit function of the mnufcturer cn be specified s M ( W ) Q ( W ) Q π = (6) We estimted different competitive gmes (Bertrnd Nsh, Stckelberg leder follower) nd the equilibrium vlues under vrious equilibrium interctions (Stckelberg leder follower nd Bertrnd) re given in Tble. Equilibrium vlues show tht reducing production costs of the nd decrese the retil nd wholesle prices, s expected from economic theory. Retil prices remin the sme in both competitive interctions (whether the retiler behves s leder or the mnufcturer behves s leder) but these retil prices re different from the Bertrnd competition. The wholesle price, however, vries under ll competitive behviors. These results show tht regrdless of who becomes the leder in the mrket, the leder chieves higher profits (These results re vilble upon request). Tble : Equilibrium Vlues under Vrious ompetitive Interctions When the Mnufcturer Produces Both nd Products Prticulrs Mnufcturer of behves s leder nd retiler s follower Retiler behves s leder nd mnufcturer of s follower Bertrnd ompetition between retiler & mnufcturer of Retil Price 3 3 (P ) 4 4( ) 4 4( ) 3 3( ) Retil Price 3 3 (P ) 4 4( ) 4 4( ) 3 3( ) Wholesle 3 Price (W ) ( ) 4 4( ) 3 3( ) Wholesle Price (W ) ( ) ( ) ( ) 4

16 se.: mnufcturer produces product nd retiler outsources product In this scenrio the mnufcturer produces product nd supplies it to the retiler (who sells products to finl consumers). The retiler outsources the product nd sells it to the consumers. The objective of the mnufcturer nd producer is to mximize profit by optimizing the wholesle price of the nd respectively. The retiler s objective is to mximize retil profit by optimizing with respect to the retil price of both the nd products (s shown in figure 3). The demnd for nd cn be written s Qi Pi = P Where i= nd (7) j The retiler s objective is to mximize the ctegory profit (profit from both nd products). The retiler s profit function cn be specified s π = m Q m Q (8) π π R M M = = The profit function of the nd mnufcturer cn be written respectively s ( W ) Q ( W ) Q (9) () Equilibrium vlues of competitive interctions between mnufcturer nd the retiler where he outsources the product hve been determined under vrious ssumption i.e. mnufcturer of behves s leder nd retiler s follower, retiler behves s leder nd the mnufcturer of s follower nd Bertrnd competition between retiler nd mnufcturer of. These equilibrium vlues re shown in tble 3. Results of the theoreticl model show tht there is no difference between the retil prices in both leder follower competitive interctions (retiler behves s leder or mnufcturer behves s leder) but these prices re different for the Bertrnd interction. Since equilibrium vlues re nonliner in prmeters, it is hrd to sign them. For interprettion of equilibrium vlues, we ssign rbitrry vlues to the prmeters using economic theory intuition (own price cross price). omprtive sttistics show tht if >, then the cost of production of s nd s hs the positive impct on the nd retil nd wholesle prices. 5

17 6 Tble 3: Equilibrium Vlues under Vrious ompetitive Interctions When the Mnufcturer produces nd the Retiler Outsources the Product Prticulrs Mnufcturer of behves s leder nd retiler s follower Retil Price (P ) ( ) ( )( ) Retil Price (P ) ( ) ( )( ) Wholesle Price (W ) ( ) 4 Wholesle Price (W ) ( ) 4 Retiler behves s leder nd mnufcturer of s follower Retil Price (P ) ( ) ( )( ) Retil Price (P ) ( ) ( )( ) Wholesle Price (W ) ( ) ( ) ( ) Wholesle Price (W ) ( ) ( ) ( ) Bertrnd ompetition between the retiler & mnufcturer of Retil Price (P ) ( ) ( )( ) Retil Price (P ) ( ) ( )( ) Wholesle Price (W ) ( ) Wholesle Price (W ) ( ) se.3: mnufcturer produces product nd retiler produces product In this cse, it is ssumed tht the retiler owns the production fcility. The mnufcturer s role is to supply products to the retiler. The retiler then sells these products

18 to the consumers. The mnufcturer mximizes its profit by optimizing the wholesle price of the nd the retiler mximizes its profit by optimizing with respect to the retil price of the nd (see figure 4). The theoreticl model cn be written s Qi Pi R = P Where i= nd () ( P ) Q mq j π = () π M = ( W ) Q (3) omprtive sttistics of the bove model re given in tble 4. Results show tht the retil price of the nd is identicl under both leder follower behviors while the wholesle price vries in ll competitive interctions. The cost of producing s nd s hs positive impct on the retil price of s nd s under ll competitive behviors, which is expected from economic theory. The theoreticl model revels tht the retiler erns the highest profit when the retiler behves s leder, nd the mnufcturer mkes the lowest profit when the mnufcturer behves s follower. The reverse is true when the mnufcturer behves s leder. The totl industry profit remins the sme under both leder follower behviors (retiler behves s leder or mnufcturer behves s leder). These results re similr to the cse, where the results show tht consumer enjoys the lowest price nd industry erns the highest profit under Bertrnd behvior. 7

19 Tble 4: Equilibrium Vlues under Vrious ompetitive Interctions When the Mnufcturer Produces nd the Retiler Owns the Production Fcility Mnufcturer of behves s Retiler behves s leder nd Prticulrs leder nd retiler s follower mnufcturer of s follower Retil Price (P ) ( ) Retil Price (P ) ( 3 ) ( ) 4 ( ) 4 4 Wholesle 3 Price (W ) Bertrnd ompetition between retiler & mnufcturer of Retil Price (P ) ( ) Retil Price (P ) Wholesle Price (W ) ( 4 ) ( ) ( 3 ) ( ) Econometric Model Specifiction mnufcturer produces both nd products Bertrnd Behvior between nd In order to estimte the competitive interction between nd under vrious theoreticl ssumptions, we use the Bertrnd model. In Bertrnd competition both producers (retiler nd mnufcturer) set the price of their own products ssuming tht the competitor does not rect to this price chnge (Kdiyli et l ). Qst Pst Pst 3Sst 4Sst υ st = (4) Qst b b Pst b Pst b3s st b4s st υst = (5) ( b W W S S ) = b P υ (6) st st 4 st 3 st Pst st 3st 8

20 ( b b W W b S b S ) = b υ (7) st st 3 st 4 st Pst Pst 4st b b ( b b W P P S S ) Wst = st st st st st 3 st 4 st υ 5 st ( b W b b P b P b S b S ) Wst = st st st st st 3 st 4 st υ 6 st b Where Q st, Q st denote the quntities of s nd s demnded in store s t time t S (8) (9) respectively. nd S show promotionl dummy vribles for nd products respectively. Where υ, υ, υ, υ υ nd denote contemporneously correlted error st st 3st 4st, 5st υ 6 st terms. In this study we ssume tht these errors re jointly normlly distributed nd the equtions cn be estimted s simultneous eqution system. The detils of other econometric specifictions re vilble from uthors upon request. DATA For the purpose of nlysis, we chose cse study product ctegory nd product pirings in which the regulr nd helthy nd products were so similr tht they could esily be substituted for ech other. The mtching criterion is bsed on the fct tht products re direct, close substitutes within the sme product ctegory, nd tht both products (, ) crry close to identicl chrcteristics s identified from the product description. The nlysis in this study is bsed on set of proprietry scnner pnel dt mde vilble through the SIEPR-Ginnini Dt enter (SIEPR-Ginnini Dt enter ). The dt provide retil sles informtion for UP product ctegories for mjor North Americn retil chin with stores in nd. Aggregte weekly store level sles dt re used from ll retiler opertionl regions. The dt include informtion t the individul UP level for price, pplicble discounts, sles quntity, nd retil gross nd net mrgin for week -4 to week 7-7. The retilers nd mnufcturers re using qulity differentited products to ttrct consumers. For this purpose, severl lrge retil chins hve developed differentited good for you product lines nd lbeling schemes round their helthy product options. The present study uses two cse study exmples to see how qulity differentition ttributes ffect the pricing nd promotionl competitive interctions between s nd s in the retil ctegories. 9

21 products hve trditionlly been successful mong brnds with the lower degree of product differentition such s met, fruits nd vegetbles. In 8, the dollr shre incresed ggressively in comprison to s in met nd sefood (9 percent). The penetrtion rte ws the highest in oil nd fts, followed by met, fish nd poultry (AAF ). Among different met products, bcon showed significnt (. percent) increse in consumption during (Slvge ). onsumers re eting helthier, nd s result re chnging their consumption ptterns of processed met products. In response, mnufcturers nd retilers re offering processed products with less sodium, etc. The present study uses two bcon cse study exmples: ) pckged sliced regulr bcon; nd b) pckged less-slt bcon. For the ctegory of sliced bcon the most common helth ttribute is less slt. A retiler would hve three potentil production options to produce the product. But s resercher, we do not know which production rrngement retiler is using. Therefore, the present study predicts the strtegic competitive behviors between the nd under different production rrngements. Above models derived re pplied on the vilble dt, nd the model which fits best is considered to be the best representtion of the competitive interction between nd, nd production rrngement of. In the cse of bcon, retilers use following lterntive production rrngements for products:. The retiler owns the met processing fcility (Sfewy ). Sfewy s nnul report shows tht bout 4 percent of products re mnufctured t the compny-owned fcility.. Some bcon producers supply bcon products only to the retiler. 3. Some mnufcturers produce both nd bcon products (Slvge ). Tble 5 shows the descriptive sttistics of nd regulr nd helthy bcon. In the present study we deflted the retil price using consumer price index, the wholesle price using n industry price index, nd the input cost using frm price index (Sttistics nd ). Tble 5 compres verge retil nd promotionl prices etc. This comprison helps us to understnd how retiler nd mnufcturer price their regulr nd verticl differentited bcon products.

22 Promotionl price is the price ccounting for the promotionl discounts, coupons nd sving through membership crds, wheres shelf price is defined s the price printed on the shelf of the product t the retil store. When the product is not on promotion, the shelf price nd promotion price re identicl. Results show tht both regulr nd helthy brnds re more expensive thn regulr nd helthy brnds respectively. The verge wholesle price of s nd s lso shows tht the is expensive in both product ctegories. Tble 5 shows the verge price difference between s nd s, retil mrgins, promotionl frequency nd promotionl depth for selected nd products t the ndin retil level. The second nd third rows of tble 5 show the difference between the verge shelf nd promotionl prices of nd products. The next two rows show the retiler mrgin (difference between shelf price nd wholesle price) for nd helthy nd regulr bcon. We study the promotionl ctivities of s nd s where the min vribles of interest re promotionl frequency nd promotionl depth. The promotionl frequency shows the number of times given product remins on promotion nd the promotionl depth mesures the extent of the shelf price reduction during the promotion (Volpe ). The lst two rows show the percentge difference between nd promotionl frequency nd the difference between nd promotionl depth, respectively. The differences between nd shelf prices vry considerbly between helthy nd regulr bcon. These vlues show tht the is more expensive thn the respective product. The highest price difference exists for regulr bcon t $3.3 pckge. Previous literture concluded tht the price of cn be expected to be higher thn its counterprt (Dhr nd Hoch, 997; Ailwdi et l. ; Volpe, ). The difference between the promotionl price of nd products shows tht promotionl price difference is higher in the regulr bcon ctegory (i.e., $.39) s compred to helthy bcon (i.e., $.59). This shows tht the producers re offering more discounts on their products thn the retilers do on products. Retiler mrgins for nd products vry between helthy nd regulr bcon, s shown in tble 5. Hoch nd Bnerji (993) nd Steiner (4) stted tht products re expected to be less expensive thn their substitutes nd yield higher retil mrgins. The dt show tht the dollr retil mrgin of bcon is higher thn bcon but the percentge retil mrgin of

23 is higher thn helthy bcon. The reson for the higher dollr retil mrgin for s is tht the hs higher shelf price thn the. Tble 5: Price Difference, Retil Mrgin, Promotionl Frequency nd Promotionl Depth for nd Bcon Products Prticulrs Item Helthy Bcon Regulr Bcon Price Difference Between nd Retiler Mrgin for nd Product Difference Between nd promotionl Frequency & Promotionl Depth Shelf Price. 3.3 Promotionl Price b Product.6.4 Product Promotionl Frequency c Promotionl Depth d.4.84 All prices re in ndin $ nd promotionl frequency is in percentge. Shelf price: Price printed on the shelf of the product t the retil store. b Promotionl price: Price ccounting for the promotionl discounts, coupons nd sving through membership crds c Promotionl frequency: It shows the number of times given product remins on promotion. d Promotion depth: It mesures the extent of the shelf price reduction during the promotion. Promotionl frequency vries considerbly between regulr nd helthy bcon products. Positive vlues show tht the products remin on promotion more often thn the product. In the cse of regulr sliced bcon, the promotionl frequency is 9. percent, indicting tht the product is on promotion bout 9. percent more thn the regulr bcon. Anderson nd Simester (4) reported tht more frequent promotionl progrms increse customer loylty in the long term. Our dt revel tht the highest promotionl depth cn be found in the sliced bcon ctegory, where the price difference stnds t $.84. The mnufcturer offers more promotions thn the mnufcturer of the substitute products. Ro (99) obtined similr results; he concluded tht s offer more promotionl depth thn s to keep consumers from trying products. RESULTS AND DISUSSION Tble 6 summrizes the results of the hypothesis tests of whether price competition differs for different product ctegories under different production rrngements. For the

24 nlysis purpose, demnd nd price rection equtions re estimted s system. In this regrd the Full Informtion Mximum Likelihood (FIML) method is pplied nd the model which gives lowest vlues for Akike Informtion riterion (AI) nd Schwrz Informtion riterion (SI) is considered s the best model (Gujrti nd Sngeeth 7; Greene 8). Tble 6: Vlues of SI nd AI for Testing ompetitive Gmes of Regulr nd Helthy Bcon Retiler owns mnufcturer Retiler production produces both & outsources Prticulrs fcility brnd for retiler products SI AI b SI AI b SI AI b Regulr Bcon Mnufcturer Behves s Leder & retiler behves s follower Retiler behves s leder & mnufcturer s follower Retiler nd mnufcturer behves s Bertrnd mnner Helthy Bcon Mnufcturer Behves s Leder & retiler behves s follower Retiler behves s leder & mnufcturer s follower Retiler nd mnufcturer behves s Bertrnd mnner Schwrz Informtion riterion (SI) b Akike Informtion riterion (AI) Tble 6 shows considerble vritions in the competitive behvior of nd for regulr nd the helthy bcon products. Similr results re reported by Putsis nd Dhr (998); 3

25 however, they used horizontl price competition between nd without considering the production rrngements of the retiler s brnd. The study shows leder follower competitive behvior for helthy bcon. Kdiyli et l. (996) stte tht there is greter likelihood of leder follower behvior when firms interct repetedly. An interesting question is which firm behves s leder nd which s follower. In this regrd, the lowest vlues of AI nd SI show tht the retiler behves s leder nd the mnufcturer s follower for helthy bcon when the retiler owns the production fcility. Kdiyli et l. (996) report tht leder follower behvior is more profit-enhncing for the leder thn the Bertrnd Nsh price behvior. Theoreticl models lso show tht the retiler erns the highest profit when it behves s leder nd the lowest when it behves s follower. The totl industry erns less profit in leder-follower thn in Bertrnd behvior. Results of the study indicte Bertrnd Nsh competition for regulr bcon when the retiler outsources production. We selected the best representtion of the mrket by using the informtion criteri which gives us the lowest vlue. The estimtes for these gmes, for the helthy nd the regulr bcon cses re given in tbles 7. A Wld test is pplied to determine how nd promotion dummies jointly ffect the demnd. The test sttistic shows tht ll the promotionl dummy vribles hve jointly significnt impct on the demnd for s nd s regrdless of how the s re produced. The study shows tht own price hs negtive impct on the nd in both product ctegories, s expected from economic theory (Kdiyli et l. 996; otterill nd Smson ; Hung et l. 3; Akby nd Jones 5). The cross price of shows positive impct on the demnd of for regulr bcon, it indictes s the price of goes up then the demnd of will increse. However, ll the other cross prices show complementry behvior. Own nd cross promotionl responses vry depending on type of product. The own promotionl dummy vrible for bcon shows positive impct on the demnd of regulr bcon. The own promotionl dummy vrible indictes tht when the helthy bcon is on promotion, the demnd of will decrese. The promotionl dummy for is equl to when the is on promotion nd zero otherwise nd promotion is equl to when the brnd is on promotion nd zero otherwise. 4

26 Vrible Tble 7: Best Fitted Gme of Helthy nd Regulr Bcon Helthy Bcon Regulr Bcon Retiler owns production fcility Retiler behve s leder Q Intercept 73.7 (.598) ** Price (.46) ** Price (.38) ** Sles Promotion -6.7 Dummy () (.) ** Sles Promotion Dummy () (.88) ** Wld Test for ll promotionl dummies Q b (.65) ** (.53) ** (.46) ** (.) ** (.86) ** Retiler outsources product Bertrnd Behvior Q 3.86 (.) ** (.) **.34 (.) ** (.6) ** -.8 (.9) ** Q b 5.5** 39.6** (.9) ** (.3) ** (.) ** (.83) **.3 (.96) ** ** represents sttisticl significnce t % level of significnce. Heteroskedsticity consistent stndrd errors re in prentheses. Q = Quntity of, b Q = Quntity of The reson for this behvior could be tht when the product is on promotion, consumers perceive tht the product is of poor qulity or my be close to expire. In the cse of helthy bcon, both promotionl dummy vribles (own promotionl dummy nd cross promotionl dummy vrible) show negtive impct on the demnd of nd. There cn be vrious resons for such reltionship. Firstly, it my be due to strong ssocition in the promotionl ctivity between nd. So whenever, is on promotion then is lso on promotion nd vice vers. Secondly, consumers my perceive negtively between the qulity of the product nd promotionl ctivity nd whenever the product is on promotion then the qulity my be poor. Thirdly, the promotionl benefits my be vilble to only those consumers who buy lrge quntity of the product, for exmple, get one free with pck of four. The consumer my not be willing to buy four units in order to get benefit of n dditionl unit. In this cse, promotionl ctivity does not hs desirble effect on the demnd of the product. Finlly, since we do not hve detiled informtion of promotion (promotionl expenditure, promotionl instruments) nd 5

27 other mrketing instruments tht re used simultneously, it is quite possible tht the mrketing instruments (dvertising) used by the rivl brnd hs bigger effect reltive to the product promotion nd s result promotion hs negtive impct on the demnd of the product. Elsticity Results The own price elsticity shows tht consumers re more responsive to the price chnge s compred to the price chnge in helthy bcon when the retiler owns the production fcility (see tble 8). The consumers perceive tht the product qulity is higher, s products re more expensive thn the products. Previous literture shows tht price reduction benefits high qulity brnds more thn low qulity brnds (Sivkumr nd Rj 997; Hung et l. ). A s cross price hs positive impct on the demnd for regulr bcon when retiler outsources product. This positive sign is s expected, bsed on economic theory (otterill nd Putsis ; Hung et l. 3; Akby nd Jones 5), nd shows tht the products re substitutes. Tble 8: Estimted Own nd ross Price Elsticities of Regulr nd Helthy Bcon Helthy Bcon Regulr Bcon Retiler owns production fcility Retiler outsources product Retiler behves s leder Bertrnd behvior Q Q Q Q P -.97** -.69** -.8** ** P -.547** -.49**.3** -.337** ** represents sttisticl significnce t % level of significnce. P = Price, P = Price, Q = Quntity, Q = Quntity However, the other cross price elsticities re negtive, showing tht the nd helthy bcon re complementry in nture (s shown in tble 8). Deton (987) lso reports complementry reltionship between dry fish nd fresh fish. A number of other studies found similr behvior (Kdiyli et l. 996; Guo et l. 999). These cross price elsticities demonstrte tht n increse in the price will decrese demnd for the product. These estimtes indicte tht whenever consumers buy helthy bcon, they lso buy the. This 6

28 behvior is consistent for both products (regulr bcon nd helthy bcon). A plusible explntion cn be tht s the price of goes up, it results in n increse in the price gp between nd. Sethurmn (9) lso finds negtive reltionship between demnd nd the price gp between nd. ONLUSIONS The present study develops theoreticl model of nd competition by ssuming different production rrngements for the retiler s brnd (). Furthermore, this study develops nd estimtes different models to understnd the ndin retil level pricing behvior of nd helthy nd regulr bcon product ctegories produced under different rrngements. For this purpose, the NNM pproch is used to identify pricing competition. This study contributes to develop modeling frmework by estimting different competitive behviors of s nd s produced under different rrngements (retiler owns production fcility of, mnufcturer produces both nd products, nd retiler outsources the product from locl mrket). This study lso extends the literture by pplying the NNM pproch in food products t the ndin retil level ssuming different rrngements for producing s. The theoreticl model shows tht retiler erns the highest profit when it behves s leder nd mkes the lest profit when it behves s follower; similr reltionship holds for the mnufcturer under different production rrngements. The totl industry profit is highest when the retiler nd mnufcturer behve in Bertrnd Nsh mnner. The empiricl results of the present study show tht there is no consistent pttern of competition between s nd s cross different food product ctegories. The pttern of competition lso vries depending on how the product is produced. The present study concludes tht the retiler behves s price leder nd the mnufcturer s follower for helthy bcon products when the retiler owns the production fcility, while the competitive behvior is different for regulr bcon. nd products compete in Bertrnd fshion for regulr bcon when the retiler outsources the product. These different competitive interctions re consistent with the findings of previous economic studies. The results of the study suggest tht reserchers should not ssume rbitrry type of competitive interction while doing the nlysis nd mking conclusions. If the ssumptions regrding the competitive 7

29 interction re wrong, it will result in wrong conclusions. The conclusions from these studies should be evluted considering the ssumptions tht the studies mke regrding the strtegic competitive interction between mnufcturer nd retiler. Study results show tht there is leder follower behvior for production rrngements when the retiler owns the production fcility. Mrsden nd Wheln (9) indicte tht welfre is mximized when both retiler nd mnufcturer behve in Bertrnd mnner rther thn leder-follower reltionship. For both brnds to behve in Bertrnd mnner, government should ply role by setting competition stndrds to mximize consumer welfre. The theoreticl model lso shows tht totl industry profit is highest when the retiler nd the mnufcturer behve in Bertrnd Nsh mnner reltive to the leder-follower mnner. The Bertrnd Nsh behvior increses competition between brnds ( nd ) which hs some tngible benefits for consumers s lower prices, qulity improvement of the product, more choice nd better service. This study hs some limittions. First, it uses scnner dt, which provide product level informtion, but this dtset lcks consumers demogrphic informtion. If the focus is to better understnd consumer preferences for nd products, nd how demogrphic informtion ffects the competitive pricing strtegy between s nd s cross different product ctegories, then demogrphic informtion should be incorported in the demnd specifictions for s nd s. Another limittion of the present study is the use of liner demnd model. It my be rgued tht other nonliner demnd models re more pproprite thn the liner model but it is very difficult if not impossible to specify such competitive models. However, liner model is widely ccepted in the economic literture due to its trctbility (Kdiyli et l. 996; Roy et l. 6). The present study nlyzed competition between the nd for two products, not for the entire product line, while t the retil level ech competing firm supplies complete product line. Due to the non-vilbility of dt for other products offered by the sme producer in its product line we used only one product from its entire product line. The sme holds for the retiler, so the competitive behvior nlyzed is bsed on only one nd product from n entire nd product line. In other words, the conclusions nd implictions drwn from this study re bsed on only two products, not on complete product line. 8