European Journal of Operational Research 228 (2013) 418–426

Contents lists available at SciVerse ScienceDirect

European Journal of Operational Research

journal homepage: www.elsevier.com/locate/ejor

Innovative Applications of O.R.

Consumer price sensitivity in the retail industry: Latitude of acceptance

with heterogeneous demand
Esteban Casado a, Juan-Carlos Ferrer b,⇑
a
Pricing UC, Pontificia Universidad Católica de Chile, Chile
b
School of Engineering, Pontificia Universidad Católica de Chile, Chile

a r t i c l e i n f o a b s t r a c t

Article history: Estimating the effect of price changes on demand is an essential task for retailers. This study proposes a
Received 24 February 2011 methodology based on consumer utility for modeling the price thresholds phenomenon that allows for
Accepted 7 January 2013 threshold asymmetry, incorporates consumer heterogeneity and uses weekly aggregated brand-level data.
Available online 8 February 2013
Unlike other studies based on consumer utility models, which generate results only for the price elasticity
of market share, a methodology for estimating price elasticity of demand is also included. Data on fast-
Keywords: moving goods (detergents, toilet paper, soft drinks, meats, liquid juices and yogurts) supplied by a major
Pricing
retail chain are used to demonstrate the existence of price thresholds and their effects on price elasticity.
Latitude of acceptance
Price elasticity of demand
In every case it was found that within the thresholds or latitude of acceptance, consumers are relatively
Price threshold less sensitive to price variations while beyond them a higher sensitivity was observed. In some cases a
Reference price product brand was classified as inelastic within the latitude of acceptance and elastic outside of it.
Ó 2013 Elsevier B.V. All rights reserved.

1. Introduction point of comparison (Kopalle et al., 1996). Kalyanaram and Winer

Estimating the effect of price changes on demand is an essential
aspect of pricing decisions in the retail trade, particularly for cate-
gory, brand, and product managers. The importance of ensuring
these decisions are well founded stems from the significant and
usually immediate impact of price variations on sales and profits
(Mercer, 1993; Bucklin and Gupta, 1999; Pauler and Dick, 2006).
Discounting too deeply to boost sales, or raising prices more than
some minimum detectable amount that would prompt consumers
to stop buying, are just two of the errors that decision-makers try
to avoid. Knowing the price elasticities of demand for their prod-
ucts is therefore of great interest to retailers, but sufficiently accu-
rate methods of obtaining such data are lacking. This article
proposes improvements over existing approaches that we believe
can make a genuine contribution to retail decision-making.
The price elasticity of demand is an indicator of how much de-
mand varies when price changes. It has been demonstrated empir-
ically that consumers are often relatively insensitive to price
increases or decreases within a certain range.
The thresholds at which consumer sensitivity to price variations
changes are located around a point called the reference price. The
literature suggests that demand for a good depends not only on the
magnitude of the observed price but also on its distance from this
⇑ Corresponding author. Address: Casilla 306, Correo 22 Santiago 782-0436,
Chile. Tel.: +56 2 354 4272; fax: +56 2 552 1608.
E-mail address: jferrer@ing.puc.cl (J.-C. Ferrer).
(1995) have proven that a reference price does exist, and suggest
that consumers do consider it when making purchase decisions.
They have also demonstrated that it is based on a product’s histor-
ical prices. The reference price can be defined as a ‘‘fair price’’ that
represents a consumer’s willingness to pay (Kamen and Toman,
1970). Some authors also propose that the reference price emerges
as a benchmark based on the prices of competing or substitute
products. Although there is evidence that both approaches are va-
lid (Pauwels et al., 2007), the view of reference price as an internal
standard based on a product’s historical prices is the one that will
be adopted here. Our focus will therefore be confined to estimating
the change in own price elasticity as price deviates from the refer-
ence level, without measuring the substitution effect in detail.
As for the thresholds themselves, in the case of price decreases
the point at which consumer price sensitivity varies is known as
the gain threshold while in the case of price increases, it is known
as the loss threshold (Kalwani and Yim, 1992). This terminology re-
flects the positive and negative impacts of these phenomena on
consumer utility.
As can be seen in Fig. 1, the price thresholds define three regions
of price elasticity: the base elasticity region bounded by the
thresholds, hereafter also called the latitude of acceptance; the re-
gion beyond the gain threshold; and the region beyond the loss
threshold.
The latitude of acceptance can be understood as the region over
which price elasticity either is almost zero (Kalyanaram and Little,
1994) or is constant but not necessarily zero (Pauwels et al., 2007).

0377-2217/$ - see front matter Ó 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.ejor.2013.01.010
 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426
60%
40%
20%
Demand % Change
0%
-40% -30% -20% -10%
-20%
-40%
-60%
% deviation from the reference price
Fig. 1. Price elasticity regions defined by gain and loss thresholds.
Since the first definition is just a special case of the second, our
analysis will assume the latter.
According to the literature, beyond the thresholds the price
elasticity or consumer price sensitivity can either increase (ampli-
fication) or decrease (attenuation). Pauwels et al. (2007) suggests
that the amplification effect beyond the thresholds is due to an
acceptance of price increases and decreases, as posited by the
adaptation level (Helson, 1964) and assimilation-contrast (Sherif
et al., 1958) theories. They also note that in some cases, price elas-
ticity attenuation may be the result of saturation effects caused by
many different phenomena, e.g., consumers’ storage or consump-
tion capacity limits or their tendency to mentally adjust high prices
to reasonable levels in order to justify their purchase, for example,
of luxury goods.
Similarly, Kalyanaram and Little (1994) posit that the existence
of price thresholds is based fundamentally on three theories: adap-
tation level theory, assimilation-contrast theory and prospect the-
ory (Kahneman and Tversky, 1979). In the consumer price context,
adaptation level theory would suggest that in order for a price to
be compared, it must first be noticed as different. Assimilation-
contrast theory would then imply that once this occurs, the price
is compared to a reference point. The consumer must consider
the difference to be significant before they will react. Finally, pros-
pect theory would hold that individuals react to different degrees
in the face of stimuli that are equal in intensity but opposite in
direction (price increases and decreases).
On the basis of these theories and the two above-mentioned
studies, other papers such as Kalwani and Yim (1992), Gupta and
Cooper (1992), Han et al. (2001), and Krider and Han (2004) have
empirically proved the existence of price thresholds using either
consumer utility models or formulations that explain sales vol-
umes variations through variations in prices.
Kalyanaram and Little (1994) and Han et al. (2001) specify con-
sumer utility models that incorporate the effects of regions of price
insensitivity on price variations. The earlier of the two studies
analyzes the phenomenon for given widths of the latitude of
419
0% 10% 20% 30% 40%
acceptance and considers the region of insensitivity for increases
and that for decreases to be symmetrical around the reference
price, meaning that the price variation noticed by consumers is
the same in either case. The later study relaxes these characteris-
tics by considering stochastic thresholds and allows the two subre-
gions on either side of the reference price making up the latitude of
acceptance to be asymmetrical, thus supporting prospect theory.
Using empirical data on coffee as a product category, they con-
cluded that consumers react earlier to price increases than to price
decreases, implying that the gain threshold is larger than the loss
threshold. They also found that beyond the thresholds, consumer
price sensitivity was very similar. Though both models offer an
effective approach to the problem, they do not provide an empiri-
cal analysis of the effects of the thresholds on price elasticity and
have high data requirements in terms of customer identification
and purchase information.
Pauwels et al. (2007) use aggregate data from 20 categories of
fast-moving goods to develop a model that empirically determines
elasticities assuming the existence of thresholds for both price in-
creases and decreases and asymmetry of the two latitude of accep-
tance subregions in which elasticity is constant. Aggregating the
results obtained for each of the categories, they conclude that the
threshold is greater for gains than for losses and that beyond the
gain threshold, price sensitivity is amplified while beyond the loss
threshold it is attenuated. Although the model has relatively light
data requirements it does not consider the effect of consumer het-
erogeneity, a major drawback given that the theories behind the
price threshold phenomenon originate in psychological analyses
of consumer behavior.
The present study proposes a methodology based on consumer
utility and incorporating consumer heterogeneity for modeling the
price threshold phenomenon using aggregated store data. Our
model determines price thresholds by finding the first point be-
yond which changes in own price elasticity are observed. As op-
posed to other works based on similar methodologies, this
approach includes estimation of price elasticity.
420 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426

Our hypothesis is that there are ranges of price variation over The reference price rjst, which is common to all consumers, is
which consumer reaction is constant, and may even be totally expressed as
inelastic. For the types of products that will be analyzed, we expect
that heterogeneity will be significant and that for small thresholds, rjst ¼ kr jsðt1Þ þ ð1  kÞpjsðt1Þ ;
consumer reaction to price variations will be amplified outside the
latitude of acceptance. where k is a smoothing constant, thus giving a different weight to
The remainder of this paper is organized as follows: Section 2 the most recent price. Since under the methodology to be described,
explains in detail the proposed discrete choice model. Section 3 de- simultaneous calibration is not possible, the value of k is an input of
scribes an estimation methodology that incorporates consumer the model.
heterogeneity and calculates price elasticity. Section 4 presents a Variable Igjst is defined as
real-world application of the model and analyzes its results. Final-
(
ly, Section 5 sets out the conclusions and some possible extensions 1 ifr jst  pjst > sgjst ;
of our work. Igjst ¼ ð4Þ
0 otherwise;

2. Model description It thus equals 1 if the difference between the reference and the
observed price is greater than the distance from the reference price
The proposed formulation is a random coefficient discrete to the gain threshold. Analogously, variable Iljst is defined as
choice model (Nevo, 2000a) that assumes consumers act rationally (
and choose the product brand that gives them the greatest satisfac- 1 if pjst  r jst > sljst ;
tion. It also assumes a linear utility function over the brand’s price
Iljst ¼ ð5Þ
0 otherwise;
that includes a component common to all consumers (d) and an-
other component specific to each individual (l). The latter in turn It thus equals 1 if the difference between the observed and the
incorporates a term related to price increases and decreases, thus reference price is greater than the distance from the reference price
capturing the effect of price thresholds. Using the iterative process to the loss threshold.
developed by Berry et al. (1995) to numerically estimate from an In (4) and (5), sgjst and sljst represent the distances between the
initial value the actual common utility level, that is, the level at reference price and the gain and loss thresholds, respectively. They
which real and estimated market share are equal, the model can can then be expressed in terms of the percentage gain and loss
be calibrated using aggregate store data. thresholds Dg%jst and Dl%jst , respectively, as
The utility of individual i when choosing brand j 2 G in store
s 2 S over period t 2 T, is defined as sgjst ¼ Dg%jst rjst ; ð6Þ
U ijst ¼ djst þ lijst þ eijst ;
for gains, and
where djst is the component common to all consumers, and lijst is
the component representing the amount by which each individual sljst ¼ Dl%jst rjst ; ð7Þ
i’s own utility exceeds or falls short of djst.
Assuming that the errors eijst are i.i.d. Gumbel, the probability for losses.
that individual i chooses brand j in store s over period t can be for- The intrinsic utility of each consumer ui and the parameters x1i,
mulated by a multinomial logit model as x2i and x3i are defined as
eðdjst þlijst Þ X
Prijst ¼ P ðdkst þlikst Þ
: ð1Þ ui ¼ pd D0id þ pv 0 v 0i ;
k2G e
d2D0
X
Letting pjst be the observed price for brand j in store s over per- x1i ¼ pd Dpid þ pv 1 v pi ;
iod t, djst can be defined as d2D p
X
djst ¼ apjst þ bj dj þ bs ds þ bt dt þ njst ; ð2Þ x2i ¼ pd Dgid þ pv 2 v gi ;
d2Dg
where dj, ds and dt are binary variables that represent the brand, X
x3i ¼ pd Dlid þ pv 3 v li ;
store (i.e., branch) and period, respectively, thus capturing the ef-
d2Dl
fects of characteristics peculiar to each brand, geographic location
and time of year. njst, by contrast, captures all the omitted and where D0, Dp, Dg and Dl are the observable consumer characteristics
non-observable characteristics of brand j in store s over period t that are incorporated as shocks to the intrinsic utility, price, price
(e.g., promotions and display). This term allows the model to correct decrease and price increase terms, respectively. The observable
for the endogenous nature of price, which is reflected in the corre- characteristics include income, age and education level, and their
lation between it and njst. The reason for correcting for price endo- distribution can be obtained from a population census or socioeco-
geneity explicitly, and the methodology for doing so, is discussed in nomic household survey. Variable v represents all the non-observa-
the following section. ble consumer characteristics that cannot be measured but that in
The individual component of consumer utility lijst depends on some way affect consumer choice. For the sake of simplicity but
all of the variables whose perception varies from one individual without loss of generality, we follow Nevo (2000a) and Song and
to another. In the present case these consist of the observed price Chintagunta (2006) in assuming that v follows a standard normal
and how much it deviates from the reference price. Thus, lijst is de- distribution. Analogously to the observable characteristics, v0, vp,
fined as vg and vl are the simulations that interact with the intrinsic utility,
lijst ¼ ui þ x1i pjst þ x2i ðrjst  pjst ÞIgjst þ x3i ðpjst  rjst ÞIljst ; ð3Þ price, price decrease and price increase terms, respectively.
Finally, using the consumer utility model defined by (1)–(3), the
where ui is the intrinsic utility of consumer i and the last two terms, different parameters can be estimated for each individual simu-
x2i ðrjst  pjst ÞIgjst and x3i ðpjst  rjst ÞIljst , capture the effects of price de- lated, thus satisfying our objective of taking heterogeneity into
creases and increases, respectively (Han et al., 2001). account.
 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426 421

3. Methodology Step 2: Numerically estimate the real value of d that equates the
observed market shares (S) with the estimated values (s)
3.1. Estimation of parameters using the method in Berry et al. (1995). Note that the com-
puted value of d depends on H2.
To incorporate the price threshold effect, the estimation meth- Step 3: Calculate the common utility component parameters as a
odology requires initial values for Dg%jst and Dl%jst . function of H2, using the first order condition with respect
By including the ‘‘non-purchase’’ option, the market share of a to H1, as follows:
brand can be modeled as the probability it will be chosen at either  1
the individual or the aggregate level. If we assume without loss of fa; bj ; bs ; bt g ¼ H1 ¼ X 01 ZU1 Z 0 X 1 X 01 ZU1 Z 0 dðH2 Þ;
generality that for the ‘‘non-purchase’’ choice or outside good where X1 is the matrix of independent variables in the common
d0st + li0st = 0 (Berry et al., 1995), the market share for individual utility component d, Z is the matrix of instrumental variables and
i of brand j in store s during period t is given by U = (Z0 Z) is the weighting matrix required by GMM for over-identi-
eðdjst þlijst Þ fied models assuming homoscedasticity. If this assumption were
sijst ¼ P ðdkst þlikst Þ
; dropped, an estimator would have to be found for H2 and U would
1þ k2Gf0g e
then have to be recalculated incorporating the error term and iter-
and the aggregate market share of brand j in the same store and ating until some convergence criterion were reached (Baum et al.,
period is defined as 2003). But given the considerable increase in estimation time this
would imply and the lack of empirical evidence that it would ben-
1X N
1X N
eðdjst þlijst Þ efit the model, spherical errors will be assumed.
sjst ¼ sijst ¼ P ;
N i¼1 N i¼1 1 þ k2Gf0g eðdkst þlikst Þ Step 4: Calculate the error term:

where N is the number of individuals. If consumer heterogeneity is njst ðH2 Þ ¼ dðH2 Þ  X 1 H1 :

not included (lijst = 0), we get
  Step 5: Minimize the quadratic form of the error calculated in the
sjst previous step:
log ¼ djst ¼ apjst þ bj dj þ bs ds þ bt dt þ njst ;
s0st
b 2GMM ¼ arg minðn0 ðH2 ÞZU1 Z 0 njst ðH2 ÞÞ:
H jst
which can be estimated using ordinary least squares (OLS). How- H2
ever, to correct for price endogeneity, as is done in the most recent
research, the instrumental variables method (Song and Chin-
To check that the instrumental variables are not correlated to the
tagunta, 2006) must be used to ensure unbiased estimators. Valid
error term, apply Hansen’s J test. This test is widely used to verify
instruments for the price of brand j in store s over period t are
the suitability of a model when estimating with GMM (Baum
the cost and the average prices for the same brand at the retailer’s
et al., 2003). The statistic is the value of the GMM’s objective at
other stores over the same period (Nevo, 2000b). In our case, to
the optimum. Thus, under the null hypothesis
avoid endogeneity problems arising from store planning decisions b 2GMM Þ  v2 ;
Jð H LK
the prices for the same product in the same period at the other
stores were used. where L is the number of exogenous variables, including instru-
Estimation using the generalized method of moments (GMMs) ments, and K is the number of endogenous variables. In the present
due to Berry et al. (1995) requires that the non-observable vari- case, K = 1, so the model is not rejected if
ables term njst be calculated as a function of the rest of the indepen- b 2GMM Þ 6 v2 ;
Jð H L1
dent variables. In the multinomial logit model this can be done
analytically, but including each individual’s own parameters com- at a given level of significance.
plicates the estimation process. For this reason Berry et al. (1995)
propose an iterative method based on the contraction mapping 3.2. Calculation of elasticities
theorem, which can find the value of d that equates the real market
share to the estimated share, and thus the non-observable vari- Besides the advantage of incorporating heterogeneity, the mod-
ables term. el generates a more precise elasticities matrix than the multino-
Using the algorithm given by Nevo (2000a), the steps in the esti- mial logit formulation. This is because the lijst term incorporates
mation are as follows: the correlation between choices due to the individual consumers’
demographic characteristics, with the result that the cross-effects
Step 0: Prepare the data, including the information on consumers’ among similar products within a single category are greater.
observable and non-observable characteristics, instrumen-
tal variables, and market shares including the ‘‘non-pur- 3.2.1. Market share price elasticity
chase’’ choice. Possible good instruments can be Our methodology also incorporates the effect of thresholds
determined by a linear regression model in which the when estimating the market share price elasticity of brand j 2 G
dependent variable is the one assumed to have endogene- with respect to the price of brand k 2 G in store s 2 S in period t.
ity problems (Baum et al., 2003), in this case price, and the This elasticity is expressed as
independent variables are those expected to be highly cor- 8
related with the dependent variable but not with the error > X
N
>
>
pjst 1
aikst sijst ð1  sijst Þ if j ¼ k
term of the common utility component. Before calculating > sjst
< N
S i¼1
market shares, total expected market size must be esti- gjkst ¼
>
> X
N
mated for the category under analysis (Song and Chin- >
> p 1
aikst sijst sikst otherwise;
:  skst
jst N
tagunta, 2006). i¼1
Step 1: Given a pair of values for Dg%jst and Dl%jst , choose initial val-
ues for the parameters where aikst is given by

H2 ¼ fpd 8 d 2 fD0 ; Dp ; Dg ; Dl g; pv 0 ; pv 1 ; pv 2 ; pv 3 g: aikst ¼ a þ x1i  x2i Igkst þ x3i Ilkst : ð8Þ

422 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426

It would be desirable to formulate an analytic proposition sj

s0j ðV G  V 0G Þ ¼ sj V G ) s0j ¼ : 
regarding the effect of thresholds on consumer sensitivity to price 1  s0
variations that predicted in which cases price elasticity would be This normalized market share expression must be used since
amplified or attenuated. This would require certain assumptions the available data are for consumption rather than demand.
about the signs of the parameters associated with price increases
and decreases beyond the thresholds. Given the model definition, Given the definitions in (9), (11) and (12), the price elasticity of
however, in which x2i and x3i are perturbations representing devi- demand of brand j with respect to the price of brand k, where j,
ations from the common utility level, these signs cannot be in- k 2 G can be defined as
ferred. Nevertheless, some conclusions should be possible on the 0 0
@V jst pkst @sjst V Gst pkst
basis of the empirical results of the model. gVjkst ¼ ¼ : ð15Þ
@pkst V jst @pkst s0jst V 0Gst
3.2.2. Price elasticity of demand from which we obtain
Unlike Berry et al. (1995), Nevo (2000a), and Song and Chin- " #
tagunta (2006), whose price elasticity results are confined to mar- @s0jst 1 X p  @sist @s0st  0 2

V ist 0 0
ket share, we present a methodology that also estimates price g jkst ¼ pkst þ bp s þ s þ bp skst ;
@pkst s0jst s
i2G ist
@pkst ist @pkst ist
elasticity of demand.
ð16Þ
Definition 1. Aggregate sales of category G; V 0G , are defined as the where @sist
is given by
@pkst
difference between category sales including potential buyers VG 8 N
and non-sales V0G. Thus, > X
>
> 1
aikst sijst ð1  sijst Þ if j ¼ k;
>N
<
V 0G ¼ V G  V 0G : ð9Þ @sjst
¼
i¼1
@pk > > XN
To find an analytic expression for price elasticity of demand, we >
> 1
aikst sijst sikst otherwise:
:N
model the aggregate sales of a given category in order to obtain an i¼1
expression for the sales of each brand as a function of its (the
brand’s) market share. This is done using a log-linear regression
3.3. Estimation of the thresholds
model (Ferrer et al., 2009) whose explanatory variables include
factors such as price as well as seasonal and store variables. Thus,
G is the sales-weighted average price (SWAP) of the category, dt The model as described so far is capable of estimating price
if p
elasticity for each of the three regions given a pair of thresholds.
is a dummy variable that captures period effects and ds is a dummy
In this section we explain the methodology for finding the thresh-
variable capturing store effects, the aggregated sales of category G
olds that mark off a latitude of acceptance whose elasticity is sig-
in store s over period t is formulated as
nificantly different from each of the regions beyond it.
  The methodology consists of three stages. In the first stage the
log V 0Gst ¼ b0 þ bp p
G þ ct dt þ cs ds þ fGst ; ð10Þ
minimum and average absolute differences are calculated between
where fGst is an error term incorporating the effects of the non-ob- the diagonal vector of the matrix of elasticities beyond the gain
servable and omitted variables. threshold (Mge) and the diagonal vector of the base elasticity ma-
The sales-weighted average price of category G can be written trix (Mbe). Thus
as
X Minge ¼ minðjdiagðMge Þ  diagðMbe ÞjÞ; 8e 2 E;
G ¼
p s0j pj ; ð11Þ
j2G
and

where s0j is the market share of brand j without the ‘‘non-purchase’’
option. A weighted average is used as there may be major differ-
ences in brand prices and therefore market shares within a cate-
gory, in which case a simple average would be less representative.
Definition 2. Given the definition of aggregate sales of category G
in (9), the market share without the ‘‘non-purchase’’ option is
defined as
sj
s0j ¼ ; 8j 2 G;
1  s0
where s0 is the ‘‘non-purchase’’ market share for the same category.
Av g ge ¼ Av erageðjdiagðMge Þ  diagðMbe ÞjÞ; 8e 2 E;
where E is the set of thresholds pairs for which the model is cali-
brated. The analogous calculation is also performed with the loss
threshold to find Minle and Avgle.
The second stage consists in grouping the small and large differ-
ences between the two diagonal vectors calculated in the first
stage to determine the point at which the difference between the
two matrices starts to be considerable. This grouping is carried
out using k-means (Hartigan and Wong, 1979), a non-supervised
ð12Þ
clustering algorithm that takes as input the number of desired
clusters or groupings for the dataset and determines the centroid
of each one. Once this has been done for each of the four vectors,

Table 1
Proof. Given the definition of V 0G in (9), and omitting store and
Product category by cluster, number of brands and sales-weighted average price.
period sub-indexes, s0j can be expressed as
Category Cluster No. of brands SWAP (USD) Unit of measure
Vj
s0j ¼ ) V j ¼ s0j V 0G : ð13Þ Detergent A 6 3.66 kg
V 0G B 6 3.86 kg

The market share of brand j 2 G including the ‘‘non-purchase’’ Toilet paper A 4 0.48 Un
option can be written as B 5 0.48 Un
Soft drinks A 8 0.74 Lt
Vj Meat A 5 6.72 kg
sj ¼ ) V j ¼ sj V G ð14Þ
VG Fruit juice B 6 1.01 Lt
Yogurt B 6 0.23 Un
Combining (13) and (14) we obtain
 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426 423

Table 2
Market shares of brands by product category, excluding ‘‘non-purchase’’ option.

Brand Detergent Cluster Detergent Cluster T. Paper Cluster T. Paper Cluster Soft Drinks Cluster Meat Cluster A F. Juice Cluster B Yogurt Cluster
A (%) B (%) A (%) B (%) A (%) (%) (%) B (%)
1 19 13 18 13 10 9 10 14
2 11 17 56 60 8 12 10 12
3 8 12 10 6 16 23 5 10
4 36 34 16 11 6 42 19 11
5 5 10 – 10 28 14 37 26
6 21 14 – – 12 – 19 26
7 – – – – 10 – – –
8 – – – – 10 – – –

the ‘‘significance’’ level is defined as their simple mean. The mini-
mum ‘‘significance’’ level is denoted x and the average level y. Thus,
in this stage the pairs of ‘‘significance’’ levels (xg, yg) and (xl, yl) must
be determined for gains and losses, respectively.
Finally, the third stage determines the pair or pairs of thresh-
olds that meet the ‘‘significance’’ conditions for the minimum
and average absolute differences between the two elasticity matrix
diagonals. Thus, the pair of thresholds belonging to experiment e⁄
will be significant if the following conditions are satisfied:
Minge P xg ^ Av g ge P yg
and
matrices and a good fit, in which case other selection criteria must
be resorted to. If more than one pair of significant thresholds is
found, the pair chosen will be the one whose model has the lowest
objective function value or the optimal error level. If the ‘‘tie’’ per-
sists, the model with the lowest thresholds should be chosen given
that the ultimate objective is to find the point at which consumer
reaction to price increases or decreases starts to change.
4. Real-world application
4.1. Data

Minle P xl ^ Av g le P yl ; The data for our case study was supplied by a large supermarket
chain with a major presence in Chile’s retail sector. The analysis fo-
for gains and losses, respectively. cused on 15 stores grouped by geographic region into two clusters
The application of the above methodology may generate more of 10 and 5 stores each, one denominated A and the other B. Our
than one model that has significant differences in the elasticity model was applied to six categories of staple products (powder
detergent, toilet paper, soft drinks, meat, yogurt, and fruit juice)
in each cluster using sales data for the year 2008. Within each cat-
Table 3
Sales-weighted average price coefficients in the log-lineal regression.
egory, brands were chosen that were likely to be substitutes in or-
der to capture cross price elasticity within the latitude of
Category Cluster Period (Weeks) SWAP parameter R2 acceptance. However, since we are interested in determining the
Detergent A 52 1.58E03⁄ 0.94 effect of the thresholds with respect to brands’ own prices, substi-
B 17 1.04E03⁄ 0.93 tution effects beyond the thresholds are not computed.
T. Paper A 17 2.27E02⁄ 0.90 Tables 1 and 2 summarize various characteristics of the product
B 52 1.23E02⁄ 0.93 categories and brands analyzed such as sales-weighted average
Soft drinks A 44 2.39E03⁄ 0.95 price, units of measurement and market shares (excluding the
Meat A 44 6.88E04⁄ 0.97 ‘‘non-purchase’’ option).
Fruit juice B 52 2.24E03⁄ 0.92
The data used to represent consumer heterogeneity relate spe-
Yogurt B 52 1.62E03 0.93
cifically to a number of observable demographic characteristics,
⁄
Significant at 95% confidence level. including education (years of schooling), income, age, and size of

Table 4
Values for model selection criteria (critical values are shown in parentheses).

Item Detergent Cluster Detergent Cluster T. Paper Cluster T. Paper Cluster Soft Drinks Cluster Meat Cluster F. Juice Cluster Yogurt Cluster
A B A B A A B B

Dg% 20% 15% 15% 10% 10% 10% 15% 45%

Dl% 10% 5% 30% 25% 50% 30% 10% 50%
R2 0.89 0.93 0.68 0.37 0.92 0.78 0.85 0.94
a 7.27⁄ 13.55⁄ 10.35⁄ 14.56⁄ 3.88 4.02⁄ 2.21 37.07⁄
2
J (v ) 13.13 16.62 1.93E05 5.20E06 4.45 1.01E07 9.85 0.33
(105.26) (90.53) (46.19) (44.99) (93.95) (81.38) (91.67) (87.11)
Ming(xg) 0.07 0.15 0.28 0.19 0.10 0.18 0.01 0.15
(0.04) (0.09) (0.21) (0.08) (0.07) (0.16) (0.01) (0.10)
Avgg(yg) 0.28 0.42 0.87 0.56 0.17 0.37 0.06 1.19
(0.22) (0.27) (0.63) (0.30) (0.15) (0.32) (0.02) (0.70)
Minl(xl) 0.07 0.35 0.28 0.19 0.09 0.18 0.01 0.15
(0.06) (0.09) (0.20) (0.06) (0.07) (0.17) (0.01) (0.11)
Avgl(yl) 0.28 0.59 0.87 0.56 0.17 0.38 0.07 1.21
(0.24) (0.29) (0.64) (0.30) (0.15) (0.34) (0.02) (0.71)
⁄
Significant at 95% confidence level.
424 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426

household. They were drawn from the 2006 CASEN survey taken except toilet paper in Cluster B, the lowest among the good results
by the Chilean government. Following Nevo (2000a) and Song being those for toilet paper in Cluster A and meat. In terms of the
and Chintagunta (2006), a random sample of 20 individuals was ta- sign and significance of the price parameter in the common utility
ken in each geographic region, where a store was located. For the component (a), the sign was as expected in all cases but for two
non-observable characteristics, variables were simulated assuming products (soft drinks and fruit juice) price turned out not to be sig-
a standard normal distribution. For the intrinsic utility (ui) and the nificant with confidence levels of 16% and 64%, respectively. Never-
price term in the individual utility component, values were gener- theless, the estimated parameter in these cases will still be used to
ated that varied by brand and store but remained constant over the calculate elasticities since the price variable must be included. All
52 weeks of 2008. For the price variation terms r  p and p  r, val- of the chosen models satisfy the condition that there be significant
ues were generated that varied only by store while remaining con- differences between the own price elasticities beyond the thresh-
stant for different brands and weeks. This was done because the olds and those within them.
proposed model can determine a threshold for the category, which The estimated thresholds all turned out to be asymmetric
is inherited by the brands within it. around the reference price, i.e., in every case, Dg% – Dl% . Although
The model was calibrated separately for each category using it might have been expected that consumers would react sooner
MATLAB, based on the source code provided by Nevo (2000a) but to price increases than decreases, i.e., Dg% > Dl% (prospect theory),
adding the price increase and decrease thresholds plus the routines this in fact occurred only in three cases: the two detergent clusters
that estimate price elasticity over each of the regions determined and fruit juices. For all the others, Dg% < Dl% , which may mean that
by the thresholds. The entire estimation process was executed on
a computer with a 2.8 GHz processor and 2 GB of RAM, and took
an average of ten hours for each category-cluster combination. Table 6
Estimated own price elasticities of demand in the three regions defined by the
thresholds. The columns headed gb, gg and gl show the elasticities between the gain
4.2. Calculation of the elasticities and estimation of the thresholds and loss thresholds, beyond the gain threshold and beyond the loss threshold,
respectively. ‘‘Inc.’’ is the % elasticity increase beyond the loss threshold.
To calculate price elasticity of demand for a particular brand
Category Cluster Brand gVb gVg gVl Inc. (%)
using a model that estimates its market share, the aggregate sales
for all categories must first be estimated in order to obtain the Detergent A 1 0.917 1.103 1.103 20
2 2.132 2.371 2.371 11
expression for the sales of each brand as a function of that market
3 2.583 2.819 2.821 9
share. The results of this previous step and the corresponding per- 4 1.291 1.989 1.989 54
iod analyzed are shown in Table 3. 5 1.307 1.376 1.376 5
In the case of toilet paper, only the last 17 weeks of the year 6 0.974 1.202 1.201 23
were considered because its price had risen significantly the week Detergent B 1 1.533 1.749 2.026 14
preceding this period. For meat and soft drinks, eight weeks of the 2 2.901 3.416 3.414 17
year were excluded to eliminate the distorting effect of certain hol- 3 4.695 5.227 5.232 11
4 2.287 3.259 3.271 42
idays such as Chile’s Independence Day and Christmas when the 5 2.058 2.221 2.403 7
effect of price on demand for these categories is atypical. 6 0.988 1.134 1.679 14
As can be seen in Table 3, all the SWAP parameters were signif- Soft drinks A 1 1.637 1.809 1.809 10
icant at the 95% confidence level except in the case of yogurt, 2 2.058 2.242 2.242 8
where it was significant at the 55% confidence level. Furthermore, 3 1.621 1.918 1.918 18
the R squared statistic shows that all of the models provided a very 4 1.647 1.745 1.745 5
5 0.398 0.536 0.536 34
good fit. The SWAP parameters were found in every case to be neg-
6 1.136 1.283 1.283 12
ative, which is what would be intuitively expected since a price in- 7 1.761 1.946 1.946 10
crease in any category should lead to a drop in demand. 8 1.576 1.739 1.741 10
T. Paper A 1 6.417 7.548 7.548 17
4.3. Results 2 1.477 2.982 2.982 102
3 4.109 4.109 4.109 0
4 2.998 2.998 2.994 0
Eight models were calibrated with the initial value for both H2
T. paper B 1 6.425 7.399 7.399 15
and k = 0.2. For each of them a pair of price thresholds were found
2 0.801 1.747 1.749 118
beyond which consumer reactions varied significantly. The esti- 3 4.319 4.508 4.508 4
mated values for the model selection criteria discussed in the pre- 4 2.936 3.316 3.306 13
vious section are summarized in Table 4 for each category-cluster 5 2.008 2.324 2.324 16
combination. Meat A 1 2.332 2.616 2.616 12
As these results show, all the calibrated models displayed satis- 2 2.044 2.229 2.229 9
factory goodness of fit on Hansen’s J test. The R2 goodness-of-fit 3 1.964 2.376 2.376 21
4 0.874 1.572 1.612 80
measure for model (2) indicated high values for all categories 5 1.246 1.528 1.551 23
Fruit Juice B 1 1.102 1.218 1.218 10
Table 5 2 0.311 0.339 0.339 9
Detergent price elasticities of demand (Cluster B). The rows and columns are demand 3 0.401 0.411 0.420 3
and price, respectively, of the various brands. 4 0.107 0.129 0.130 21
5 0.277 0.426 0.426 54
P1 P2 P3 P4 P5 P6 6 0.255 0.304 0.304 19
B1 1.533 0.579 0.468 1.134 0.198 0.199 Yogurt B 1 3.486 3.841 3.841 10
B2 0.239 2.901 0.464 1.151 0.197 0.199 2 5.274 6.093 6.093 16
B3 0.228 0.535 4.695 1.113 0.191 0.195 3 2.252 2.405 2.405 7
B4 0.237 0.565 0.551 2.287 0.207 0.203 4 2.036 2.239 2.362 10
B5 0.241 0.542 0.483 1.179 2.058 0.199 5 4.249 5.219 5.221 23
B6 0.231 0.535 0.469 1.086 0.193 0.988 6 7.809 12.459 12.459 56
 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426 425

the demand faced by the retailer in these cases is loyal to brands.
This differs from the results found by Han et al. (2001) and Pauwels
et al. (2007), in which the threshold was greater for gains than for
losses when the reference price was defined in terms of the brands’
historical price trends.
An example of the price elasticity of demand matrix found for
the detergent category within the latitude of acceptance is shown
in Table 5. It reflects both own effects and the cross-effects of sub-
stitute brands.
The price elasticities of demand in each of the regions defined
by the thresholds for each category are displayed in Table 6. The
expected amplification effect on the elasticities beyond the gain
and loss thresholds is clearly visible. In approximately 50% of the
cases the increase was greater than 15%, and in more than 70% of
cases it was greater than 10%. In a few instances, the increase
was more than 50%. These results are consistent with those re-
ported by Pauwels et al. (2007) on 20 categories of fast-moving
consumer goods for gains but not for losses.
The discrepancies between our results and those found in the
literature could possibly be explained by idiosyncratic differences
between the markets studied or differences in the types of prod-
ucts covered.
Although in all cases the thresholds turned out to be asymmet-
ric, the variation in individuals’ price sensitivities beyond them
was very similar for any single brand. This is consistent with the
result obtained by Han et al. (2001) in their analysis of the coffee
category. However, the variation in sensitivity for different catego-
ries and for brands within a single category differed in magnitude
while maintaining their direction (amplification).
Given that a product is considered to be insensitive to price if
the absolute value of its elasticity is less than one, the results in Ta-
ble 6 show that some brands are inelastic within the latitude of
acceptance but elastic outside of it. This is the case, for example,
with the brands of toilet paper and meat that have the highest
market share in their category (60% and 42%, respectively). Armed
with this information, a decision-maker would know that a dis-
count on toilet paper would have to be greater than 10% to have
a significant impact on demand, or that for price hikes of up to
25% the percentage variation in demand for the product would
be less than the percentage increase in the price.
Another evident result is that, with the exception of the soft
drink category, the greatest variation in price elasticity of demand
between the latitude of acceptance and the regions beyond it oc-
curs with brands that have the greatest market shares within their
category. An example of this is the detergent category (Cluster A).
While its elasticities beyond the thresholds increased in absolute
terms by an average of 0.28, brand 4 experienced an amplification
of 0.7. This effect must be taken into account when defining policy
on discounts going beyond the latitude of acceptance, since in
addition to the effects on demand there could also be unpredict-
able impacts on market shares.
As regards consumer heterogeneity, the parameter estimates
for the interactions between the brand variables (price, price in-
crease, price decrease) and the demographic variables are shown
in Table 7. The parameters for various of the interactions were
found to be significant at 95%, 90% and 85% confidence levels,
which supports the hypothesis that consumer characteristics influ-
ence the price thresholds and their effect on elasticity.
4.4. Sensitivity analysis
To verify the stability of the results presented above when mod-
el inputs are varied, a sensitivity analysis was conducted on the
reference price smoothing parameter k and the initial value se-
lected for the error term minimization routine. For the smoothing
parameter the model was calibrated over values of k between 0.1
and 1, while for the initial values H2 it was iterated for simulated
vectors following a standard normal distribution.
In both cases, the value of the objective function at the opti-
mum and the value of the elasticities were found to be sensitive.
However, the objective function value maintained its order of mag-
nitude while the sensitivity ranking of the brands within each cat-
egory remained unchanged. The ranking of the elasticity variations
also did not vary, and in all cases price sensitivity was lower within
the latitude of acceptance.
For the initial values of H2, an experiment was conducted with
toilet paper (cluster A) using 50 different random starting points.
The histograms for the gain and loss thresholds chosen at each
iteration are shown in Fig. 2a and b. Although the values chosen
were not always the same, in both cases their distribution is

Table 7
Parameter estimates for interactions between brand variables and demographic variables.

Interaction Estimated coefficient

Common Demographic Detergent Detergent T. Paper T. Paper Soft Drinks Meat F. Juice Yogurt
variable variable Cluster A Cluster B Cluster A Cluster B Cluster A Cluster A Cluster B Cluster B
v 0.229 5.397⁄⁄⁄ 4.040 5.307⁄ 0.325 0.129 0.372 3.395⁄
Age 0.198 3.236 3.720⁄ 5.545⁄ 0.537 0.894 3.421 4.704⁄
p Income 0.839 5.409⁄⁄⁄ 1.163 1.392 3.341 1.823⁄⁄ 0.971 17.059⁄
Education 2.292 4.863⁄ 1.091 5.061⁄ 1.540 1.289⁄⁄⁄ 0.096 27.948⁄
Household 0.139 0.537 0.804 4.646⁄ 0.627 1.121 0.854 3.297⁄
Members
v 0.669 8.180⁄ 1.355 15.998⁄ 4.047⁄ 2.556⁄ 7.912 58.854⁄
Age 1.691 1.592 1.200 0.182 0.936 1.487⁄ 0.252 12.590⁄
rp Income 0.673 0.345 1.464 5.101⁄ 0.211 2.209⁄ 4.232⁄ 3.574⁄
Education 0.201 0.299 1.928 0.807 1.604 0.384 0.817 26.344⁄
Household 0.688 1.685 1.406 2.411 1.142 0.286 2.945 0.469
Members
v 0.325 1.262 9.590⁄ 44.603⁄ 3.958⁄ 8.263⁄ 35.865⁄ 133.446⁄
Age 0.883 0.002 3.869⁄ 1.743⁄ 0.852 1.496⁄ 3.224 33.996⁄
pr Income 2.319 4.238 0.076 0.052 1.174 1.359⁄ 4.121⁄⁄ 7.066⁄
Education 0.893 7.165⁄ 0.963 1.854 0.636⁄⁄⁄ 2.064⁄ 0.802 23.572⁄
Household 0.091 1.707 1.673 1.992 0.350 3.035⁄ 0.752 15.964⁄
Members
⁄
Significant at 95% confidence level.
⁄⁄
Significant at 90% confidence level.
⁄⁄⁄
Significant at 85% confidence level.
426 E. Casado, J.-C. Ferrer / European Journal of Operational Research 228 (2013) 418–426
Fig. 2. Histogram of thresholds for different starting values of H2.
concentrated around certain levels. In the case of the gain thresh-
old, 64% of the values were a 15% discount while for the loss
threshold, 72% of the values were a price increase between 25%
and 35%.
These results demonstrate that using iterative methodologies
on the model’s inputs generates more robust values for the true
threshold levels and the consumer price sensitivities within each
of the regions they define.
5. Conclusions
A consumer utility model was developed that determines the
price thresholds beyond which consumers change their reactions
to variations in the prices of consumer goods. The proposed model
detects the existence and impact of price thresholds on elasticity of
demand at the product brand level. Unlike existing formulations in
the literature, the model estimates the thresholds using aggregate
data for brands and takes into account consumer heterogeneity
and its effects on price elasticity.
Tests conducted on eight product category-cluster combina-
tions using real-world data demonstrated that there were signifi-
cant differences in price elasticity of demand beyond the price
thresholds. These differences should be considered by retail man-
agers when making decisions about increases or decreases in
prices. The test results also showed that within the latitude of
acceptance, individual consumers are less sensitive to price varia-
tions. This factor must also be taken into account by retail deci-
sion-makers to avoid either overestimating or underestimating
the effects of a given price change. In the case of brands classified
as inelastic between the thresholds but elastic beyond them, it may
be advisable for retailers intending to increase the price to do so in
stages, each one for an amount less than the threshold, to reduce
the impact on demand. In general, differences in products’ elastic-
ity classification between the latitude of acceptance and the re-
gions beyond it can have a major impact when price elasticity of
demand is used to create sensitivity rankings due to the lack of a
constant elasticity over all price variation levels.
It was also shown empirically that price thresholds may be
asymmetric. For most of the products, the threshold for gains
was found to be smaller than that for losses. This may have been
due to a high degree of consumer loyalty to the particular brands
selected for study.
The proposed model provides a good approximation for classi-
fying brands within a category based on their price thresholds.
The methodology adopted for the study assumed that brands in-
herit the estimated threshold of the product category they belong
to. An interesting extension of this work would therefore be to esti-
mate thresholds for specific brands, which would improve the
price sensitivity predictions. This could be done making the thresh-
olds a function of such variables as price volatility and own and
competing brand promotions (Han et al., 2001).
Another possible extension would be to free the elasticity val-
ues of their dependence on the initial value of the minimization
routine and the reference price. This might be achieved by iterating
on different values in order to find some metric based on a combi-
nation of results or by incorporating a minimization routine that
finds a global optimum and simultaneously calibrates the price
attenuation parameter.
References
Baum, F., Schaffer, M., Stillman, S., 2003. Instrumental variables and GMM:
estimation and testing. Stata Journal 3 (1), 1–31.
Berry, S., Levinsohn, J., Pakes, A., 1995. Automobile prices in market equilibrium.
Econometrica 63 (4), 841–890.
Bucklin, R., Gupta, S., 1999. Commercial use of UPC scanner data: Industry and
academic perspectives. Marketing Science 18 (3), 247–273.
Ferrer, J., Flores, E., Leon, P., Olivares, F., Oyarzún, D., 2009. Pricing Opportunities in
Category Management Under Cross Effects Consideration. Working Paper,
School of Industrial Engineering, Pontificia Universidad Católica de Chile.
Gupta, S., Cooper, L., 1992. The discounting of discounts and promotion thresholds.
Journal of Consumer Research: An Interdisciplinary Quarterly 19 (3), 401–411.
Han, S., Gupta, S., Lehmann, D., 2001. Consumer price sensitivity and price
thresholds. Journal of Retailing 77 (4), 435–456.
Hartigan, J.A., Wong, M.A., 1979. Algorithm as 136: a k-means clustering algorithm.
Journal of the Royal Statistical Society 28 (1), 100–108.
Helson, H., 1964. Adaptation-level theory. Harper and Row, New York.
Kahneman, D., Tversky, A., 1979. Prospect theory: an analysis of decision under risk.
Econometrica 47 (2), 263–291.
Kalwani, M.U., Yim, C.K., 1992. Consumer price and promotion expectations: an
experimental study. Journal of Marketing Research 29 (1), 90–100.
Kalyanaram, G., Little, J., 1994. An empirical-analysis of latitude of price acceptance
in consumer package goods. Journal of Consumer Research 21 (3), 408–418.
Kalyanaram, G., Winer, R., 1995. Empirical generalizations from reference price
research. Marketing Science 14 (3, Part 2), G161–G169.
Kamen, J., Toman, R., 1970. Psychophysics of prices. Journal of Marketing Research 7
(1), 27–35.
Kopalle, P.K., Rao, A.G., Assuncao, J.L., 1996. Asymmetric reference price effects and
dynamic pricing policies. Marketing Science 15 (1), 60–85.
Krider, R., Han, S., 2004. Promotion thresholds: price change insensitivity or risk
hurdle? Canadian Journal of Administrative Sciences 21 (3), 255–271.
Mercer, A., 1993. Developments in implementable retailing research. European
Journal of Operational Research 68 (1), 1–8.
Nevo, A., 2000a. A practitioner’s guide to estimation of random-coefficients logit
models of demand. Journal of Economics & Management Strategy 9 (4), 513–
548.
Nevo, A., 2000b. Mergers with differentiated products: the case of ready-to-eat
cereal. RAND Journal of Economics 31 (3), 395–421.
Pauler, G., Dick, A., 2006. Maximizing profit of a food retailing chain by targeting
and promoting valuable customers using loyalty card and scanner data.
European Journal of Operational Research 174 (2), 1260–1280.
Pauwels, K., Srinivasan, S., Franses, P., 2007. When do price thresholds matter in
retail categories? Marketing Science 26 (1), 83–100.
Sherif, M., Taub, D., Hovland, C.I., 1958. Assimilation and contrast effects of
anchoring stimuli on judgements. Journal of Experimental Psychology 55 (2),
150–155.
Song, I., Chintagunta, P., 2006. Measuring cross-category price effects with
aggregate store data. Management Science 52 (10), 1594–1609.