Rational Retail Pricing

The manager of a typical grocery store has upward of 30,000 products on her shelves, giving rise to upward of 30,000 questions: What price to charge for each product? Basic marketplace principles suggest that retailers may not realize potential profit margins if they cannot respond nimbly to fluctuations in consumer demand. Yet despite the potential to enhance profitability, many retailers do not find demand-based pricing worthwhile. Why?

“If there’s one thing you would assume from basic marketing principles, it’s that prices should be adapted to changing demand conditions,” said Vincent Nijs (Assistant Professor of Marketing at the Kellogg School of Management).

Although price rigidity, or “stickiness,” is one of the most fundamental issues in pricing and economics, Nijs believes it has been underexplored in marketing. He and colleagues Shuba Srinivasan (Associate Professor of Marketing at the University of California, Riverside) and Koen Pauwels (Associate Professor of Business Administration at Dartmouth College) undertook an exploration of the market forces that influence retailer pricing behavior. Two of the most important drivers they uncovered were demand-based pricing and past-price dependence. Demand-based pricing reflects changes in consumer demand for a product. Past-price dependence occurs when retailers repeat previous pricing patterns regardless of changes in cost, demand, or the competitive environment.

In 2007 the researchers established that demand-based pricing is linked to higher gross profit margins for retailers. They also found that higher levels of past-price dependence are associated with lower profit margins, but established that this pricing strategy is used extensively anyway. In a new work published in the Journal of Marketing, the researchers developed a conceptual framework to examine the circumstances under which retailers reuse established pricing patterns for products ranging from cereal to soap.

The researchers found that retailers make price adjustment decisions based on factors such as the proportion of households that buy the product, whether the product is an expensive, “big-ticket” item, and the likelihood that consumers will react negatively to sudden price changes.

Costs and Benefits
To begin their analysis, the research team categorized the costs and benefits of demand-based pricing for the retailer as either consumer-driven or firm-driven. They relied on product characteristics to draw inferences about the nature of these costs and benefits.

Consumer-driven benefits are reflected by characteristics such as the proportion of households that buy the product and the sensitivity of those shoppers to price changes.

The market share of a retailer’s private label in a category reflects firm-driven benefits. For example, a strong private label, such as Whole Foods Market’s 365 Everyday Value line of products, affords a retailer higher profit margins and a stronger negotiating position in relation to manufacturers in the category. These benefits spur retailers to focus on demand-based pricing for categories in which “store brands” enjoy substantial market shares.

Consumer-driven costs of price adjustment are measured by the relative expensiveness of an item. For example, retailers tend to rely heavily on past-pricing patterns for costly goods as consumers may react more negatively to sudden price drops or increases. Shoppers might view these changes as unfair or associate price discounts for high-priced items with a reduction in quality.

Firm-driven costs are seen in the number of unique items, or stock-keeping units (SKUs), in a category. For example, the team found that a Chicago-area Dominick’s grocery store carried 96 varieties of oatmeal but more than 2,500 shampoo SKUs. The researchers suggest that the relative complexity of adjusting prices for so many different items creates barriers to the store’s adoption of demand-based pricing strategies for the shampoo category.

Comparison Shopping
Nijs and colleagues quantified the relative impact of these costs and benefits on retailer pricing by modeling sales, prices, and costs for top-selling brands in 24 product categories at 85 stores in the Dominick’s chain. Their model measured the extent to which demand-based pricing and past-price dependence drove a retailer’s pricing decisions.

For example, the researchers considered the relative influence of the two strategies in the pricing of analgesics. They found that 10.7 percent of the variation in prices could be attributed to demand-based pricing, but 48.7 percent of the variation was a result of past-price dependence. If the stores could increase the use of demand-based pricing by roughly 10 percent while slightly reducing past-price dependence, they could increase the average weekly gross profit margin for analgesics by more than $200.

The team also weighed the relative importance of features that might impede or encourage retailers in attempts to improve profit margin. They found that retailers change prices more aggressively following fluctuations in demand for products found in relatively large numbers of households. Retailers also pursue demand-based pricing when their private labels command larger shares of the market, or when shoppers are particularly sensitive to changes in price. Demand-based pricing is less influential in categories that feature expensive items or a large number of different products.

Rationale for Retailers
These findings offer retailers a way to systematically review the allocation of pricing resources across categories based on expected costs and benefits. The study quantifies the gross profit margin impact of emphasizing or minimizing demand-based pricing or past-price dependence. Using in-house cost data, retailers could re-evaluate the cost effectiveness of their pricing approaches for different categories and brands.

The results bear significance not just to retailers but to manufacturers as well, says Nijs. The model suggests that some manufacturer trade promotions are less likely to be passed on to consumers due to retailers’ reliance on past pricing patterns. The researchers also identify areas in which manufacturers can help retailers limit costs or enhance benefits of demand-based pricing. For example, knowledgeable manufacturers and retailers can collaborate on pricing decisions for categories with many SKUs in a way that leads to a win-win situation for both.

The study also contributes to an ongoing debate in economics and marketing on the rationality of past-price dependence. While previous research points to a negative impact of past-price dependence on gross profit margins, Nijs’s estimates demonstrate that retailers weigh the costs and benefits of pricing strategies in a process that seems anything but irrational.

“Researchers generally assume that retailers should flexibly adapt prices to changes in demand conditions and the cost of goods,” said Nijs. “However, we find that if the cost of adapting prices exceeds the benefits, they won’t. Our empirical methodology can be used in decision-support systems to identify product categories that afford retailers the biggest bang for their buck from demand-based pricing.”