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

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 investment) 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 underinvestment. In addition, selecting the national brand manufacturer may create economies of scale that spur innovation.