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Article Excerpt
1. Introduction: Pricing Power and Targeted Price Increases
Firms in many industries experience protracted periods of pricing power, the ability to successfully enact price increases. While pricing power has received little direct attention from academic researchers, the business press has consistently emphasized its importance. Industry Week, The Wall Street Journal, and Fortune have all reported on upswings in pricing power, while The New York Times placed it among the main qualities sought by savvy investors. (1) When firms have substantial pricing power, they must grapple with the prospect of instituting price increases and whether such increases should be targeted in some way. In this article, we investigate whether, and under what competitive conditions, firms should consider imposing price increases on some segment as opposed to across-the-board.
Even within popular press accounts of targeted price increases (TPI), opinions differ on their suitability and sustainability. For example, a study of British television mergers concluded that targeted price increases, defined explicitly as "giving less good terms to some customers and better terms to others," were not feasible because any incremental revenue would be "outweighed by the disincentive in terms of potential loss of business" (http://www.competition-commission.org.uk/rep_pub/reports/2003/fulltext/482c6.pdf). Even the Federal Trade Commission (FTC), concerned about abuse of pricing power in certain industries to enact targeted price increases, investigated the phenomenon; yet it reached precisely the opposite conclusion. As part of a major investigation of vacation package pricing policies, the FTC's analysis indicated it is indeed possible for firms to benefit by imposing a TPI policy. In fact, it singled out targeted price increases among important areas for additional empirical research, calling for "detailed industry data." The Boston Consulting Group evidently agrees that TPI can be a useful tactic, claiming a 1% price increase to specific segments can boost incremental profits fourfold over comparable cuts in overhead and fixed costs. Operations Management Consultants Inc.'s "top recommendation" for increasing profitability is that firms learn to employ TPI policies.
Based on such anecdotal and economic evidence, one might wonder why TPI policies are not more broadly adopted. Amazon.com offers the classic cautionary tale, having faced allegations that it imposed higher prices on some customers based on their purchase and site visit histories; when consumer and advocacy groups complained vociferously, the practice was abandoned. Garbarino and Lee (2003) point out that while TPI-like policies can intrinsically enhance firm profitability, consumers nevertheless react strongly against them. Their experimental results show such policies erode consumer trust, largely because they are considered unfair. Some firms apparently know this and keep their targeting pricing policies under wraps. For example, a federal lawsuit against Rite-Aid revealed its practice of imposing unadvertised surcharges on certain customers, including those who had not shopped at the store before. Apparently the company believed this practice would be viewed negatively, even though it was (loyal) continuing customers who, relatively speaking, benefited from such price increases.
As these varied examples suggest, there is little consensus on whether TPI is a reasonable or sustainable practice. Compounding such questions about the practice itself are contingent ones regarding which consumers, if any, should be thus targeted. At the heart of the matter is whether consumers will react in a "rational" way to having their prices raised (or seeing it happen to others), with rationality narrowly construed as making the best economic choice amongst available options. Here, we take up this question, providing a model that addresses whether (if at all) TPI should be instituted and, further, which segment(s) should be thus favored. Our model comprises not only the "rational" effects of "Loyalty" (to one's current provider) and "Switching" (to another), but also "behaviorist" effects born of emotional reactions to how one is treated: "Betrayal" when one's own firm treats other customers better and "Jealousy" when another firm treats its own customers better than your firm treats you (Feinberg et al. 2002).
We study environments in which pricing power allows firms to potentially enact price increases. As such, a major goal of this paper is to expand the repertoire of promotional policies available to firms when pricing power can be profitably exercised. Specifically, we attempt to answer the following questions:
* Under TPI, will consumers perceive "same price as before" as a price deal to them, just because a price to the other segment is raised, i.e., will there be a positive impact of imposing a price increase selectively on the other segment?
* Are TPI effects similar to those of targeted price decrease (TPD) policies?
* In an environment of increasing prices, if a firm offers "some consumers (and not others) the same price as before" versus offers "all consumers get the same price as before," would the response of the favored consumers be the same in the two situations?
* How does TPI affect firm profits, that is, how do the various effects stemming from TPI act in concert to alter profit levels?
* What can be said about competitive equilibria? Specifically, when they propose price increases, should firms offer deals to Loyals, to Switchers, or to neither segment?
* Will equilibria differ if "behaviorist" (Betrayal, Jealousy) effects are not accounted for?
* How does the degree of market share asymmetry affect a firm's decision to impose selective or across-the-board increases and, if the former, which segment should be favored?
* How does level of market knowledge about prices offered to the other segment affect resulting equilibria?
Procedurally, our approach integrates multiple methodologies to better understand the impact of targeted pricing policies. We show that although the "behaviorist" effects of Jealousy and Betrayal exist in both settings, they cannot be presumed symmetric and such differences can affect a firm's strategic choices. Our analysis further demonstrates that across-the-board price increases are not always the best way to exercise a firm's pricing power. Indeed, price-increase environments can offer opportunities to profitably implement targeted pricing, and we explore the tactical imperatives of a firm's being able to avail itself of them. We also find that competitive equilibria vary substantially with the proportion of "aware and care" consumers, those who find out about price deals offered to others and are potentially influenced by them.
The remainder of the paper is organized as follows. We first examine prior literature from marketing, economics, psychology, and behavioral decision theory which speaks to the issue of targeted price increases. This allows us to develop a Markovian framework to examine the purchase and profit impacts of various targeted pricing policies, and we estimate the model's parameters based on data collected in a laboratory experiment. These estimated parameter values are then used within a game theory model built upon the Markovian framework; together, these allow for an analysis of competitive equilibria for a two-firm market. It is this competitive analysis which offers specific responses to each of the questions raised above. We conclude with a discussion of how the model applies to real-world promotional policies and how it could be further enhanced relative to current retailing practice.
2. Prior Literature
Much prior research on targeted pricing has focused on whether it tends to increase or decrease price competition. Specifically, it has examined welfare implications of customized pricing and whether changes in consumer behavior induced by targeted pricing lead to socially optimal equilibria (Thisse and Vives 1988, Shaffer and Zhang 1995). Markets with high consumer switching costs are especially concerned with implications of targeted pricing: Firms in these markets must trade off the relative merits of charging a high price to everyone (greater unit profits with some potential attrition among the customer base) against charging a low price to everyone and thereby attracting new customers (Klemperer 1987, 1995). Targeted promotions provide a means to bypass such a tradeoff because they facilitate charging different prices to these two segments of consumers. Subsequent research has suggested that when following a policy of targeted pricing, a firm should invariably target Switchers (Chen 1997, Taylor 2003). While Shaffer and Zhang (2000) suggest that targeting Switchers need not be optimal, their results indicate that it is never prudent for all competing firms to target loyal customers unless the cost of targeting prompts competing firms to resort to randomized promotions (Shaffer and Zhang 2002).
All these papers consider an environment where prices are stable and there are no imperatives to increase price. They also assume that a consumer's brand preference is dependent only on absolute prices offered to him and not on prices offered to other consumers; in short, that relative prices have negligible effects on consumer behavior. However, literature from social psychology and behavioral decision theory suggests that "relative" prices (i.e., price to you versus price to someone else) may also affect behavior. More specifically, research on relative deprivation, perceived fairness, and equity (e.g., Adams 1965, Greenberg 1986, Stark and Taylor 1989) suggests that perceptions of fairness in a broad spectrum of economic interactions do not take place in a vacuum of perfect objectivity. Rather, they are assessed relative to standard comparison values derived, in large part, from how others are treated.
Consumers' perceptions of fairness, specifically, have been addressed by research in marketing and psychology. For example, even if objective price levels are within the range considered normal, if they are not deemed equitable, then consumers may consider them "unfair" and refuse to accept them (Kahneman et al. 1986a, b; Martins and Monroe 1994; Urbany et al. 1989; Campbell 1999). Bolton et al. (2003) study price unfairness directly, finding that consumers often view prices as lying well above what is "fair" and are overly sensitive to such referents as prior and competitor price levels. Nunes and Park (2003) present a great deal of evidence that perceptions of price levels are strongly frame dependent. In line with these findings, Feinberg et al. (2002) formulate a "behaviorist" approach to targeted promotions which allows for consumers being influenced by prices that other consumers are offered and of which they themselves cannot avail. They show that behaviorist effects of Betrayal and Jealousy result in decidedly different promotion policies than a "rationalist" model which does not allow for such effects. Their paper examines environments of constant prices where firms consider to whom they should offer price decreases. As such, their analysis does not apply when a firm considers price hikes and can allow some (segment of) customers to remain at their current price level.
In short, based on these prior analyses, nothing can be said about the profit implications of targeted price increases or whether they can be more profitable than across-the-board increases. In the next section, we build a Markov model for consumer promotional response to address these issues.
3. Model
Similar to many prior studies in marketing and economics, we analyze a market consisting of two brands, X and Y (i.e., sold by Firms X and Y, respectively). We adopt a (first-order) Markovian framework and operationalize market segments based on consumers' most recent purchase. Thus, "Loyals" are those who purchased from the firm in the last period, while "Switchers" purchased from the other firm in the last period. In this manner, there are two market segments for each firm, Loyals for Firm X (who are Switchers for Firm Y) and Switchers for Firm X (who are Loyals for Firm Y). Note that this definition of Switchers differs from another fairly common use of "Switcher" (e.g., Lal 1990), where a segment of consumers always buys from Firm X (Loyals for X), another always buys from Firm Y (Loyals for Y), and a third segment switches between the two firms based on price (Switchers). Also, in our model, there is no absolute Loyalty--all consumers can potentially switch. These terms thus act as labels for the immediately prior purchase and do not refer to an intrinsic propensity to switch between the two brands.
So that terminology is not open to interpretation, we adhere to the following conventions. Phrases such as "charges a higher price" mean that a firm charges a price compared to...
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