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«WHY DO SOME PRICES IN THE RETAIL SECTOR DROP WHEN DEMAND RISES? EVIDENCE FROM THE CHILEAN CASE LORETO LIRA* ABSTRACT Internationally, the prices of ...»

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Revista ABANTE, Vol. 10, Nº 2, pp. 151-168 (octubre 2007)

WHY DO SOME PRICES IN THE RETAIL SECTOR

DROP WHEN DEMAND RISES?

EVIDENCE FROM THE CHILEAN CASE

LORETO LIRA*

ABSTRACT

Internationally, the prices of retail products have been seen to drop

during periods of exogenous increases in demand. The purpose of this

paper is to study the generality of this stylized fact by investigating whether this behavior also takes place in Chile, through the monthly prices of a set of retail products with positive demand seasonality. The prices of some products show a drop during their peak idiosyncratic demand. Moreover, tha results are consistent with the loss leaders modeL, according to which prices are proactively reduced by retailers in order to attract buyers to stores.

Keywords: Retailing, Prices, Loss leaders.

JEL Classification: L81, L11, L21.

RESUMEN A nivel internacional se ha visto que los precios de los productos de retail tienden a bajar durante los periodos de aumentos exógenos de demanda. El propósito de este trabajo es investigar si este comportamiento se da en Chile. Para esto se utilizan los precios mensuales de un conjunto de productos de retail con estacionalidad positiva de demanda. Se obtiene que los precios de algunos de estos productos muestran una caída durante sus periodos de peaks idiosincráticos de demanda. Además, los resultados son consistentes con el modelo de Loss Leaders, según el cual los retailers bajan los precios de sus productos en forma proactiva con el fin de generar tráfico al local.

* Facultad de Ciencias Económicas y Empresariales, Universidad de los Andes. Email llira@uandes.cl. I am grateful to Cecilia Cifuentes, Giorgo Sertios, Magdalena Ugarte and Rodrigo Vergara for valuable comments. The usual disclaimer applies.

152 REVISTA ABANTE, VOL. 10, Nº 2 There is growing empirical international evidence that the prices of retail products tend to drop temporarily during seasons of high demand. Once the demand returns to its original level, prices rise. Under the perfect competition models, a positive demand shock helps keep prices the same or pushes them up, but never down. So, this price trend must be explained by imperfect competition models.

The purpose of this article is to investigate whether this effect takes place in the retail sector in Chile and identify which of the imperfect competition models better adapts to the results. The investigation took into account some mass consumer retail products for which there is a clear positive seasonality during the course of the year. The data was taken from the National StatisticsBureau (INE)’s monthly consumer price series for Santiago and the Wholesale Price Index (IPM).

According to Chevalier, Kashyap and Rossi (2003), there are three imperfect competition models that explain this countercycle in prices: the implicitly colluded oligopoly model of Rotemberg and Saloner (1986), where the equilibria in the industry oscillate between cooperative and uncooperative trends, depending on whether demand is low or high; the procyclical demand elasticity model of Warner and Barsky (1995), based on the existence of economies of scale in the search for information; and the theory of the loss leaders according to which retailers offer significant discounts on specific products in order to attract buyers to the store, and thus increase their profits.

The results obtained in this study indicate that as it happens internationally, there are indeed price reductions in products for which there are seasonal rises in demand. When comparing theories, we find that the results are more consistent with the loss leader theory than with the other two competing explanations.

This article is organized as follows: Section I contains a review of literature, Section II describes the methodology and data used, Section III presents the results and Section IV, the conclusion.

–  –  –

There is a growing set of international empirical evidence that registers countercyclical movements in prices. Specifically, the data shows that positive demand shocks are associated with reductions in prices. This price behavior cannot be explained by models of perfect competition unless there are economies of scale in production. If there are economies of scale, a positive demand shock may bring prices down if the implicit production increase results in a cost reduction in companies that facilitates the occurrence of such price reduction. This case is not analyzed in this paper.

There are some price discounting theories that do adequately address some material aspects of consumer and market behavior, but they are incapable of explaining countercyclical price movements. They include the theory of price discrimination of Varian (1980) and the theory of uncertain demand of Lazear (1986). Varian (1980) holds that discounts are a sort of price discrimination among consumers who are more informed or for whom the cost of finding information is lower than for those who are less informed or for whom the cost of being informed is higher.

Lazear (1986) studied the behavior of prices in products with uncertain demand. Since the demand for a product is uncertain, supposing that the retailer has more than one period to set prices, he decides to begin selling initially at high prices, to then lower the prices of the products still unsold in the second period. This strategy of starting with high prices and then dropping them maximizes the expected profits of the retailer and assumes that a price that drops will not rise again. Pashigian and Bowen (1991) apply the Lazear model to fashion products since they are directly associated with products of uncertain demand as fashion products are new and no one knows exactly how consumers will react to them. The retailer begins the season with high prices, to then lower the price for what is left unsold. According to this model, discounts or sales take place towards the end of the season, which means that price movements are procyclical and not countercyclical. Nevertheless, when they measure discounts for seasonal sales using the uncertain demand model of Lazear (1986), they find evidence of the existence of a countercyclical trend in prices in some products (prices tend to drop during periods of high demand), which cannot be explained by Lazear’s theory.





There are three imperfect competition models capable of explaining the phenomenon of countercyclical movements in prices (e.g. theories explaining price reductions during periods of exogenous increases in demand): the theory of a temporary rupture of collusion agreements, by RotembergREVISTA ABANTE, VOL. 10, Nº 2 Saloner (1986); the theory of procyclical elasticity of demand, of Warner and Barsky (1995); and the loss leaders theory.

The theory of the price war in boom periods developed by Rotemberg and Saloner (1986) suggests that companies alternate between being cooperative and uncooperative depending on whether demand is low or high. In periods of high demand, companies tend to steer away from implicit oligopolistic agreements and behave more competitively, with the consequent reduction in prices and margins. This is because in those periods it is more costly to maintain an agreement as the benefits of moving away from the oligopoly increase. Companies that break implicit commitments are willing to face the future penalties since they know that those penalties will be imposed at a time when demand has already fallen to its original level and, therefore, what they risk losing is less than what they gain by breaking free. The authors hold that this behavior is especially valid in situations where prices are a strategic variable and production costs are constant.

They find moderate empirical support for their theory.

The other model of imperfect competition is that of Warner and Barsky (1995), who hold that demand elasticity is procyclical given the existence of economies of scale in the search for information. In periods of intense buying activity (positive demand shocks), consumers are more interested in looking for better than normal prices or discounts as the investment in time and other costs of the search must be distributed among a higher total purchase. Hence, the unit cost of the search falls. In this context, when consumers are more informed, vigilant and price sensitive, retailers tend to lower their prices as they envisage a more elastic demand for their products. Once the positive demand shock is over, the products’ elasticities fall to their original values and prices rise to previous levels. These authors studied the daily prices of eight products from November to February across 17 different stores within a zone in Michigan. They found important discounts in the pre-Christmas period, during week-ends, and on holidays (Thanksgiving). They concluded that discounts are offered in periods when demand is unusually high.

The third model is the loss leaders model. In this model the retailer chooses to offer some products at a low price (close to or even below the marginal cost) in order to attract buyers to the store. It assumes that consumers enter a store attracted by specific discounts and once inside, they buy other additional products, thus increasing the overall profits of the retailer. This theory is sustained on the existence of multi-product enterprise

WHY DO SOME PRICES IN THE RETAIL SECTOR 155

competition, imperfect information on prices, and a complementarity of goods in the purchase by consumers. The latter is grounded on the fact that buying is costly to them given the time this activity consumes. The “onestop” shopping is benefited since there are economies of scale in buying more than one product at a time (Betancourt and Gautschi, 1990). Lal and Matutes (1994) formalize the loss leader argument as traffic generators in a model of two companies, each offering the same two products. They assume that consumers do not know the prices of the products unless they are advertised and that there are economies of scale in buying more than one product at the same time even if they are unrelated. They conclude that, in equilibrium, both firms opt to offer the same product at a price equal to or lower than their marginal cost (loss leader) and to advertise this product, and that consumers have a positive surplus from it even knowing that the unadvertised product will be sold at a higher price.

In selecting products to be treated as loss leaders, retailers must consider what prices consumers look at in making a decision whether or not to enter the store. This is very important to retailers since they understand that consumers are incapable of knowing each of the prices of the products they purchase and, therefore, only remember a limited number of them. A study conducted by McKinsey Quarterly in an enticement product study revealed that 74 percent of consumers base their price assessment of the store on a few products. On average, consumers say they memorize 3.8 prices in making that assessment. Strictly speaking, any product could be loss leader.1 Some seasonal products can be good candidates to be considered loss leaders at their peak moment in demand, because consumers set their eyes on them. If retailers find that these products create traffic to the store, they may decide to offer them at prices close to, or even below, their marginal costs. If this is the case, when sales volumes are high, product prices fall because of the proactive effect of the distributor reducing margins.

Chevalier, Kashyap and Rossi (2003) analyze the movements in the prices of supermarket products in order to detect potential countercyclical The same study by McKinsey Quarterly found that enticement products differ among the Latin American cities analyzed. For example, in Buenos Aires, the enticement product is 1 kilo of Ledesma sugar; in Bogotá, it is 1 liter of soybean oil; in Mexico City, it is 1 liter of regular oil among low-income consumers and Ariel detergent among high-income consumers.

156 REVISTA ABANTE, VOL. 10, Nº 2 variations and test the three alternative models of imperfect competition.

They measure prices weekly for 29 types of products, representing close to 30 percent of total sales in the Dominick’s Finer Food supermarket chain (the second most important chain in Chicago, with 100 stores and a 25 percent market share) for a period of seven and one-half years, taking into account final prices, retailer purchase prices and their margins. They prove the existence of reductions in product prices during periods of seasonal increases in demand. In order to compare the three models empirically, the authors consider the specific implications of each. Although the three predict a drop in prices when there is a generalized increase in demand towards the store, these predictions differ when there are specific increases in demand for certain products and aggregate demand remains low. Only the loss leader theory supposes that the prices of products will drop when there are idiosyncratic increases in demand for those products in particular.

It also assumes that the retailer margins for those specific products will fall as well. The price war theory and the procyclical demand elasticity theory predict generalized reductions in prices and in retailer margins during a boom in aggregate demand, but not a specific boom for specific products.



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