Rebates, inventories, and intertemporal price discrimination

RICHARD P. SABA [*] We demonstrate that universally redeemed rebates can increase manufacturer profits by reducing the incentives of downstream retailers to hoard inventories when optimal wholesale prices vary predictably over time. By bypassing retailers and making direct contracts with buyers, the manufacturer can increase the variations in effective prices paid by consumers without concomitantly creating larger incentives for retailers to hold inventories. During profitable, high-demand periods, manufacturer revenues are ordinarily constrained by "competition" from retailer inventories, thus limiting profits. However, by selectively offering rebates to consumers while maintaining high wholesale prices, low-demand periods can be accommodated without inducing retailer hoarding. (JEL D4, L1) General Motors Corp. is emptying its bag of marketing tricks in an all-out effort to force its U.S. market share back up to 30% of light-vehicle sales. That is good news for GM customers, because the manufacturer is offering financing at less than 1% or cash rebates of as much as $3,000 a vehicle. --Wall Street Journal, Sept. 16, 1998 I. INTRODUCTION We tackle a fundamental economic question: if General Motors or any manufacturer wants to increase unit sales, why does the necessary price cut occur indirectly in the form of a rebate? It is well known that in cases of perfect competition or monopoly a tax (or subsidy) on buyers is equivalent to the same tax (or subsidy) on sellers in that each leads to the same net prices and the same equilibrium quantities. A rebate is effectively a subsidy offered to the buyer, whereas a cut in the wholesale price is effectively a subsidy to the seller. Under conditions of perfect competition or monopoly, a manufacturer should be able to achieve identical outcomes in either of the two ways. The challenge is to explain why rebates or coupons are used. Redemption of coupons and rebates is costly to both consumers and issuers, while a price cut of equivalent size can be implemented at a much lower cost. One would expect the price reduction strategy to dominate the strategy of issuing coupons or rebates to all buyers, yet it apparently does not. Throughout the 1990s, for example, Chrysler, Ford, and General Motors consistently offered a more extensive array of consumer-oriented indirect price cuts (via rebates) than dealer incentive programs. [1] The most common explanation for the use of rebates and coupons is that they enable either manufacturers or retailers who possess some monopoly power to engage in third-degree price discrimination. [2] Consumers whose reservation prices lie below the price charged by the manufacturer or retailer are induced to purchase the item by a sufficiently large rebate or coupon. Yet certain aspects of the practice of offering coupons and rebates are inconsistent with the standard price discrimination explanation. Rebates often are given automatically to all customers at the time of purchase. Purchasers of automobiles and other big-ticket items are given the option of applying the rebate to their down payment or receiving the cash. As noted by Hanley [1987] and Higgins [1989], sellers of less costly items recenfly have started providing "instant" rebates or on-package coupons, which can easily be used by all buyers at the time of purchase. These innovations have dramatically lowered redemption costs for consumers and boosted redemption rates. [3] Moreover, Bowman [1980] demonstrates that, holding redemption costs constant, there is a positive relationship between the size of the coupon/rebate and the likelihood of consumer redemption. The implication of this empirical regularity is expressed succinctly by Gerstner and Hess [1991b,p. 5]: "While price discrimination is a reasonable exp lanation for cents-off coupons, for dollars-off rebates such as those given by manufacturers of household appliances it is not. …