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The Inverse Relationship Between Manufacturer and Retailer Margins: A Theory

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Author Info

  • Rajiv Lal

    (Stanford University)

  • Chakravarthi Narasimhan

    (Washington University)

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    Abstract

    Our objective in this paper is to explain the relationship between a manufacturer's brand advertising and its impact on wholesale and retail margins in consumer goods markets. We construct a model of re-tailers and manufacturers, and using tools from game theory explain why under some conditions a manufacturer's advertising can squeeze, i.e., lower, the retail margin while simultaneously increasing the wholesale margin. Our paper should be of interest to applied analytical and empirical researchers in marketing as well as managers interested in understanding the strategic impact of brand advertising on margins. The consumer goods retail market is characterized by intense rivalry among retailers competing for a share of the consumer dollar. Retailers carry many products, and on any given purchase occasion a typical consumer buys a subset of the vast number of items a retailer has on its shelf. In general consumers are ignorant about the prices of all the products they want to buy and consequently select a retailer to shop at based on the advertised prices of a subset of the products they intend to buy. Given this, retailers tend to compete more aggressively based on the prices of a selected set of items by advertising these prices to consumers. The items that the retailers select to compete on are those that most consumers desire and value highly. Since the profit from any customer is the sum of profits from advertised and unadvertised items, the intensity of retail competition, as evident from the prices of these items, increases with the amount the consumer will expend on the unadvertised items once at the store. This aggressiveness therefore translates into lower retail margins on these selected items since the retailers expect that consumers, once inside a store, will buy non-advertised products as well on which the retailers make money. Thus manufacturers who are more adept at using “pull” strategies to enhance the popularity of their product, obtain d significant competitive advantage vis à vis others. The positioning of the product and the image conveyed through advertising act as drivers in creating this advantage which results in higher wholesale prices that these manufacturers can charge the retailers. There are several key insights from our analysis. Our model explains why retail and wholesale margins can move in opposite directions and also suggests when—in those retail markets where consumers shop for a basket of goods. Our analysis also reveals that retailers make higher margins on unadvertised products and less on advertised products. Furthermore it shows the power of a popular brand where its popularity can be enhanced through brand advertising. From a managerial standpoint we also show that the effectiveness of advertising should not be narrowly interpreted in terms of increase in share or awareness but should include the ability to charge a higher wholesale price. Finally our analysis sheds light on extant, and provides guidance to future, empirical work in this area.

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    File URL: http://dx.doi.org/10.1287/mksc.15.2.132
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    Bibliographic Info

    Article provided by INFORMS in its journal Marketing Science.

    Volume (Year): 15 (1996)
    Issue (Month): 2 ()
    Pages: 132-151

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    Handle: RePEc:inm:ormksc:v:15:y:1996:i:2:p:132-151

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    Related research

    Keywords: advertising; wholesale and retail margins; channel competition;

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    Cited by:
    1. Anne Coughlan & S. Choi & Wujin Chu & Charles Ingene & Sridhar Moorthy & V. Padmanabhan & Jagmohan Raju & David Soberman & Richard Staelin & Z. Zhang, 2010. "Marketing modeling reality and the realities of marketing modeling," Marketing Letters, Springer, vol. 21(3), pages 317-333, September.
    2. Stefan Buehler & Dennis L. Gaertner, 2009. "Making Sense of Non-Binding Retail-Price Recommendations," SOI - Working Papers 0902, Socioeconomic Institute - University of Zurich.
    3. Srinivasan, S. & Pauwels, K.H. & Hanssens, D.M. & Dekimpe, M.G., 2002. "Do Promotions Benefit Manufacturers, Retailers or Both?," ERIM Report Series Research in Management ERS-2002-21-MKT, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
    4. Robert Barsky & Mark Bergen & Shantanu Dutta & Daniel Levy, 2001. "What Can the Price Gap between Branded and Private Label Products Tell Us about Markups?," NBER Working Papers 8426, National Bureau of Economic Research, Inc.
    5. Noriaki Matsushima & Akira Miyaoka, 2013. "Who benefits from resale-below-cost laws?," ISER Discussion Paper 0875, Institute of Social and Economic Research, Osaka University.
    6. Kostas Axarloglou, 2007. "Thick markets, market competition and pricing dynamics: evidence from retailers," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 28(7), pages 669-677.
    7. Draganska, Michaela & Klapper, Daniel, 2006. "Retail Environment and Manufacturer Competitive Intensity," Research Papers 1953, Stanford University, Graduate School of Business.

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