Strategy and Tactics of Pricing

Exercise 1: Estimation and Use of Market Response Functions

Purpose: This is an exercise in estimating own-price and cross-price elasticities, and understanding
its implications for market structure and pricing decisions.
Price elasticities provide one possible way to understand the competitive structure of a
market. We can also use cross-price elasticities to understand how much a brand can attract sales
from competing brands (also called a brand’s competitive clout), and how much a brand can lose sales
to competing brands (also called a brand’s competitive vulberability).

Problem: The sales data of 12 SKUs of orange juice in one supermarket for 110 weeks are available
in an EXCEL file. The file name is:

OJData.xls
The entries are:

Column 1 SKU name (Tropicana 64oz., Tropicana 96oz., Florida National 64oz.,
Tropicana 64oz., Minute Maid 64oz., Minute Maid 96oz., Citrus Hill 64oz.,
Citrus Hill 96oz., Tropical Fresh 64 oz., Florida Gold 64 oz., Store Brand
64oz., Store Brand 128 oz.)
Column 2 Serial number of brand (1, 2, ….12)
Column 3 Week (1, 2, 3, …..110)
Column 4 Natural log of weekly sales (in equivalent units).
Columns 5-16. Natural log of the prices of the 12 SKUs in the week.
Columns 17-28. Intensity of feature promotion in the week

As the data has been rescaled to ensure confidentiality of information, please look at the
relative values rather than the absolute values while making inferences based on the raw data. Even
though the data is rescaled, the elasticity estimates remain unbiased.

(a) Prepare summary statistics for the 12 SKUs (including average weekly sales, average price,
average feature intensity). Discuss what you can discern from these summary statistics.

(b) Plot ln(sales) against ln(price) for each of the 12 SKUs. Please state in a few sentences what
you are able to learn from a visual analysis of the 12 graphs.

(c) Using these data, the following model was estimated for each of the 12 SKUs/brands:
ln( Sit ) =  i − ii ln( Pit ) +  ij ln( Pjt ) +  ii PI it −   ij PI jt
j i j i

See the attached SAS output files. Describe the fit of the model for each brand. Note that all
analysis in this exercise are done at the SKU level (that is, for each specific brand-size
combination). The parameter estimates can be seen in the SAS output file.

The notation is:

i = SKU number (1, 2, 3, or 4)

Sit = Sales of SKU i in week t
Pit = Price of SKU i in week t
PIit = Feature intensity of SKU i in week t
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ii , ij ,  ii ,  ij , i = parameters of the model

Note that this model is a Log-Log model. The own-price elasticity for Brand i is ii and cross-
price elasticities are ij 
(d) Prepare a 12x12 matrix of own and cross-price elasticities. Enter in the 12x12 matrix only
coefficients that are statistically significant.
1. Using this matrix, identify which SKU(s) is (are) most vulnerable to promotion activities.
Also identify which SKU(s) has (have) most promotional clout in the market.

𝐶𝑜𝑚𝑝𝑒𝑡𝑖𝑡𝑖𝑣𝑒 𝑉𝑢𝑙𝑛𝑒𝑟𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑆𝐾𝑈 𝑖 = ∑ 𝛽𝑖𝑗

𝑗≠𝑖

𝐶𝑜𝑚𝑝𝑒𝑡𝑖𝑡𝑖𝑣𝑒 𝐶𝑙𝑜𝑢𝑡 𝑜𝑓 𝑆𝐾𝑈 𝑖 = ∑ 𝛽𝑗𝑖

𝑗≠𝑖

In other words, consider arranging the beta coefficients from the regression analysis
done for each brand in one row after another. Then the row total of the beta
coefficients (other than own-price coefficient ii ) gives the vulnerability of the row
SKU to the SKUs listed in the column. On the other hand, a column total of the
coefficients (other than own-price coefficient ii ) gives the column SKU’s clout in the
market. Create a scatter plot of clout by vulnerability and interpret the graph.

2. Tropicana Real was a new product-line extension introduced by Tropicana. Discuss

the impact of this new line extension on its “sister” brands.

3. If you were the store manager and wanted to increase unit sales in the OJ category,
which SKU (brand) would you choose to promote (that is, price promote assuming
the margins are the same for all the brands. (Hint: Note that when the cross-price
elasticities ij are multiplied by sales of the affected brand i it provides an estimate of
the expected change in the sales of brand i in response to a percentage change in the
price by brand j.

Supplementary Reading: If you are interested in the topic, skim Blattberg, R. C. and K. J.
Wisniewski (1989), “Price-Induced Patterns of Competition,” Marketing Science, Vol. 8, No. 4.
(Autumn, 1989), pp. 291-309.
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Clarification notes on constant elasticity models: In this problem set, we are using a constant
elasticity model. To better grasp the intuition behind some of the computations you would be doing
in this problem set, consider the following very simple model and understand its implications.
– Q= 1000*price-2
– Price elasticity of demand= dQ/dp * p/Q
– On differentiating demand with respect to price, we obtain
• dQ/dp = -2*1000*price-2-1
– Price elasticity of demand = dQ/dp * p/Q
= -2*1000*price-2-1 * P/ (1000*price-2)
= -2
– Now it should be easy to see why the beta coefficients are indeed the elasticities of
constant elasticity model.
– A plot of the demand function Q = 1000*price-2 is presented below so that you can
see that the slope of the curve varies though the elasticity is constant. The slope of
the curve is dQ/dp = -2*1000*price-2-1.
1000

800

600
Demand
400

200

0
$1.00
$1.40
$1.80
$2.20
$2.60
$3.00

$3.40

$3.80

$4.20

$4.60

$5.00
Price

– As price elasticity of demand = dQ/dp * p/Q, we can obtain the change in demand
with respect to price (or slope of demand curve) as follows:
• dQ/dp = elasticity * Q/p
– Also note dQ = elasticity*Q*(dp/p). If dp/p =1, then dQ = elasticity*Q. This is the
idea behind the hint provided in problem d(3).
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Clarification notes on the exercise:
– In this exercise, we have taken the log on both sides of the demand function to
obtain a log-log version of the constant elasticity model. A log-log model can be
estimated using ordinary least squares technique.
– Feature promotional intensity is used only as a covariate to control for the effect of
feature on demand. If we had feature/advertising expenditures in dollars we could
have used the log of that variable in the model and then its gamma coefficients
would correspond to the feature elasticity of demand. In the current formulation, the
gamma coefficient measures the response of sales to feature promotion, but it is not
feature elasticity.
– To answer part (a), please convert the ‘natural log of sales’ to ‘actual sales’. Use exp( )
function in Excel to transform log(price) and log(sales) into levels
– Make scatter plots to see relationship between two variables
– Look at R-squared or adj. R-squared for model fit. R-squared gives the % variation
in data explained by the model. The higher R-squared, the better the model fit.
– The p-values corresponding to each beta coefficient of the regression model gives
the probability of the null hypothesis being correct. The null hypothesis is that the
beta coefficient value is zero. Pick a level of statistical significance (say 5% or 10%
and apply it uniformly throughout your analysis).