List prices and discounts: The interrelationship between consumer shopping patterns and profitable marketing strategies

This paper illustrates the importance of shopping and marketing strategies when the Bertrand price-setting institution often used to model retail exchange is modified to allow sellers to offer buyer-specific discounts from the list price. Unlike the simple Bertrand game, a variety of shopping and marketing strategies can be rational in this more complex setting. Moreover, different strategy combinations yield distinct predictions: Equilibrium prices may either essentially match those predicted in the absence of buyer-specific discounts, or they may be at the collusive level. Data from laboratory markets with discount opportunities similarly indicate two distinct strategy-dependent behavioral outcomes. Many elements fundamental to the study of marketing have been treated largely as matters of secondary importance in traditional industrial organization theory. For example, aside from a constraint that consumer and producer choices be consistent with rationality, both the psychological factors affecting consumer shopping patterns, as well as the marketing strategies chosen by firms, have typically been ignored. However, the widespread shift in the last two decades to the use of game theory as an analytic framework in industrial organization economics, and to the use of experimental methods as a corresponding empirical device, has led to increased attention to the institutional details characterizing market exchange. In turn, this increased attention to institutional detail has fostered a new appreciation for the importance of factors such as shopping preferences and marketing strategies. The reason is straightforward. When market interactions are formally modeled as a game, a variety of behavioral patterns are often consistent with rationality. Although the choice of these patterns is of often a matter of psychology or preference, price and * This research was supported by the National Science Foundation (grants SBR 9319842 and SBR 9320044). A preliminary version of this paper appears as Davis and Holt, (1994). Data reported in this paper are available at FTP address fido.econlab.arizona.edu. Davis is Associate Professor, Department of Economics, Virginia Commonwealth University, Richmond VA, 23284-4000. Holt is Professor, Department of Economics, University of Virginia, Charlottesville VA, 22903. profit predictions turn on the patterns selected by consumers and producers. Consider, for example, trading where sellers publicly post "list" prices. Institutions of this type characterize a wide variety of retail situations, where sellers advertise prices on a take-it-orleave-it basis. Markets with public list prices account for a considerable volume of trade in the United States each year, and have long been the focus of investigation by economists. Such markets have traditionally been analyzed in the context of a Bertrand model of price competition. Seller and buyer strategies in the Bertrand model are simple and mechanical: Sellers, who compete only on the basis of price, must undercut their competitors in order to make any sales. Buyers, who make decisions only on the basis of the listed prices are concerned only with making a purchase at the lowest posted price. The interaction of these strategies generates a prediction that the market will generate competitive prices and quantities consistent with the intersection of market supply and demand arrays. The standard Bertrand model does not allow sellers to discount from their listed prices. In many naturally occurring markets, however, buyers ask for, and often receive, price concessions. Selective discounting is a common feature in negotiations for major consumer goods, such as housing and automobiles. Producer goods are also sold at discount, particularly when the number of buyers is not large. Indeed, discounting is so widespread in producer goods markets that the absence of sales below list prices is considered unusual. For example, the infrequency of discounts was one of the factors that triggered a Federal Trade Commission investigation of pricing practices of lead-based gasoline additive producers . (Ethyl Corporation, et al. Docket no. 9128. Federal Trade Commission.) Once discounting possibilities are introduced, both consumer shopping patterns and seller marketing strategies play a critical role in determining price and sales predictions. As simple intuition suggests, the ability to offer private, selective discounts makes a market more competitive; given any set of publicly posted prices, competing sellers will feel compelled to offer private discounts on any public posting above the lowest. Private discounting opportunities may also impede the implementation and maintenance of conspiracies, as such opportunities make it difficult for sellers to distinguish price shading by a rival from demand shocks or strategic buyer refusals to purchase. But discounting may make a market less competitive. Suppose, for example, that buyers