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Overview

1. Demand curves 2. The multiplicative/log-linear demand model 3. Price elasticities 4. Demand for groups of items and cross price elasticities 5. Estimating the multiplicative/log-linear demand model 6. Examples of Base Pricing Analysis 7. Appendix: Logarithms and the exponential function

Demand curves

Price Promotions Coupon availability Advertising Season (spring, fall, Christmas, ) Housing value, ...

to various elements of the marketing mix and other variables inuencing consumer behavior

Q

sales units

Both own and the competitors marketing actions will typically affect

demand

Where do demand curves come from? Example: Survey data obtained from full-time MBA students in April 2010

How much are you willing to pay for one ticket for the Soccer World Cup nal 2010 (in U.S. dollars)?

3000

2500

2000

Price

1500

1000

500

10

20

30

40

50

60

70

80

90

100

110

Order willingness to pay in descending order and plot against the rank (highest

price rst, ) 10 students indicated a willingness to pay of $1,000 or higher

5

A demand curve shows the distribution of consumers willingness to pay How does this relate to what they said in micro?

The basic microeconomics model emphasizes a model in which consumers

choose a quantity demanded that is continuous (e.g. .5 units!!!) and they adjust demand downward as price increases. This is a representative consumer model. Not applicable to most products in the marketplace. The more general model emphasizes differences heterogeneity in consumers willingness to pay as a source of downward sloping demand

Modeling demand

Goal:

Infer the relationship between unit sales and prices, promotions, and other

variables from the data using regression analysis

mathematical formulation of demand

This formulation should be exible and have a good chance of tting the demand

relationship present in common data sets

Formula:

Q = a bP

8 7

1.4

6 5 4 3 2

Example:

Q = 40 5 P

1.4

1.4

1 0 0 5 10 15 20 25 30 35 40

is the same for high and low price points

Formula:

Q=AP

8 7

1.4

6 5 4 3 2

Q = 100 P 2

1.4

Example:

Effect of a given price change is larger at low than at high price points

1 0

10

15

20

25

30

35

40

9

Q = AP log(Q) = log(A) + log(P ) log(Q) = log(A) log(P ) log(Q) = log(P )

log log(x y) = log(x) + log(y) (L1) (L3) log(xa ) = a log(x) Dene = log(A)

We will therefore also refer to the multiplicative demand model as the Purpose of this transformation

The parameters and now enter the model linearly model has the form of a linear regression

10

Effect of parameters

6

5 4 3 2

A = 100 A = 150

10

20

30

40

Q

2.5

Parameter : slope increase in makes the demand curve steeper, i.e. more responsive to price

=2

log(P)

1 0 -1 -2 -4 0 4 8 12

=4

log(Q) 11

Price elasticities

in the quantity demanded relative to a given percentage change in price:

%Q price elasticity = = %P

Q1 Q0 Q0 P1 P0 P0

not depend on the level of unit sales or prices The price elasticity is typically negative (why?) Sometimes the absolute value of the price elasticity is reported

Interpretation

Example: Price elasticity is -2.8 A 1% increase in price is associated with a 2.8% decrease in unit sales

Note: The price elasticity can be calculated for any demand curve, not

just the multiplicative demand model

12

Substitutability

Availability of substitutes Actual or perceived quality differences Awareness of substitutes Cost of nding (or switching to) substitutes

Private label orange juice Tropicana/Minute Maid orange juice Orange juice All juices All drinks

13

Store level laundry detergent sales Market (city) level laundry detergent sales

Revenue = P Q

Revenue = P Q

14

15

Q = A P

the parameter has simple and straightforward interpretation it is the absolute value of the price elasticity of demand

The property that one parameter directly measures the price elasticity is

very special and not true for other demand models

16

Use the log-linear representation of the demand model Change price from P0 to P1 sales will change from Q0 to Q1

log(Q1 ) = log(P1 ) log(Q0 ) = log(P0 )

take difference between equations

log(Q) = log(P )

log(Q1 ) log(Q0 ) = [ log(P1 )] [ log(P0 )] log(Q1 ) log(Q0 ) = [log(Q1 ) log(Q0 )] log(Q) = log(P ) = log(Q) %Q log(P ) %P

use logarithm property L*

17

= price elasticity

The multiplicative demand model discussed so far is too simple it does We now generalize the multiplicative demand model

Allow for the effect of competing product prices Predict demand for multiple products or groups of products

Qi = Ai P1 i1 P2 i2 PKiK

not account for the effect of the prices of competing products on demand

The price coefcients ik have two subscripts The rst subscript i refers to the equation, i.e. demand function for product i The second subscript refers to the price of product k that inuences demand for i

18

Q1 = A1 P1 11 P2 12 Q2 = A2 P1 21 P2 22

= log(Ai ) ):

simple multiplicative demand model discussed before:

ik %Qi = %Pk

19

product i is the own price elasticity of i

%Qi ii = %Pi %Qi %Pk (< 0)

ik = (> 0)

effect of price of product k on demand for i

Why are cross price elasticities typically positive? Do you expect that cross-price elasticities are typically symmetric, =

e.g.

12 21 ?

20

Cannibalization of own product sales

Competitive price change will have a large impact on the demand for our product Strong competitive effect

21

log(Q1 ) = 1 + 11 log(P1 ) + 12 log(P2 ) + 1 log(Q2 ) = 2 + 21 log(P1 ) + 22 log(P2 ) + 2

In the case of two products we have two regression equation, one for each

product log(Qi ) is the dependent variable, yi log(P1 ) and log(P2 ) are the independent variables, x1 and x2

General approach

elasticities)

Obtain data on sales units and prices Estimate the regression equations to obtain the specic parameters (price

22

1 .2

9

.4

log(P) .6

.8

9.5

10 log(Q)

10.5

11

11.5

23

Economic Models of Sales, Journal of Marketing Research.

42 studies from the marketing and economics literatures 367 price elasticity estimates Most studies are based on time series data, most use brands Average

Detergents

Durable goods

Food

Toiletries

Drugs

-1.76 -2.77

-2.03

-1.65 -1.38 -1.12

Elasticities

24

the marketing mix and other variables inuencing consumer behavior

Substitutability Competition Cannibalization

Usually ts the data better than the linear demand model Easy to generalize for groups of products

Own price and cross price elasticities measure: The log-linear demand model can be estimated as a regression model

25

Base-Pricing Analysis

1. Scanner data 2. Base pricing analysis 3. Examples

26

Scanner data

Timeline

1972 IRIs InfoScan introduced in 1987

code) level - Honey Nut Cheerios 25.25 oz size Prices and promotions Aggregation levels - Market (Raleigh-Durham) - Chain/account (Kroger) - Store Time - Weekly, monthly, ...

27

IRI

InfoScan 34,000+ stores (store census, not sample) Retail management system (ScanTrack) Scanner (retail audit) data available worldwide Wal-Mart had 14% U.S. grocery market share in 2004

Nielsen

Problem: Wal-Mart no longer shares their POS data (since 2001) Retailer Data Warehouses -- a new source of power in the channel

28

Base price = non-promoted price (everyday shelf price) Purpose of base pricing analysis

Understand competitive inuence of prices on sales Adjust / ne-tune base prices

29

manufacturer approaches IRI

Company sells a national brand Product line: 16 oz, 24 oz, and 32 oz bottle

size (32 oz size has recently been added)

in product line pricing? Is there cannibalization across product sizes (worry about new 32 oz size)? Worry about private label (PL) competition is it possible to assess the extent of the competitive threat? Are the current base price points optimal, or should we change our prices?

30

Scanner data

Demand analysis

Cannibalization?

Price simulations

respect to other sizes in product line

respect to private label products

price price changes

31

0

Note

16 oz

Note: IRI slides p. 11

24 oz

32 oz

standard errors of estimates Always question marketing consultants about statistical precision of results

32

1

16 oz

24 oz

32 oz

0.25 NA

Effect on:

16 oz

24 oz

32 oz

33

PL 24 oz

1

PL 32 oz

0.75

0.5

Effect on:

16 oz

24 oz

32 oz

Note: IRI slides p. 13

34

Goal: Predict prot for each package size k in the product line

protk = Qk [Pk (1 retail margin) V Ck ]

P . . . retail shelf price

V C . . . variable cost Total prot from product line (if we drop the 24 oz pack size):

Data

- Current base prices across all markets - Retailer margin - Variable cost (per unit or case) - Log-linear demand model

35

16 oz base price index 90 90 92 94 96 98 24 oz base price index 100 102 104 106 108 110 92 94 96 98 100 102 104 106 108 110

5,672 5,771 5,866 5,957 6,046 6,131 6,213 6,292 6,369 6,443 6,515 5,756 5,856 5,952 6,045 6,135 6,221 6,304 6,385 6,462 6,538 6,610 5,838 5,939 6,037 6,131 6,222 6,310 6,394 6,476 6,555 6,631 6,705 5,918 6,021 6,121 6,216 6,308 6,397 6,482 6,565 6,645 6,722 6,797 5,998 6,102 6,203 6,299 6,393 6,482 6,569 6,653 6,734 6,812 6,888 6,076 6,181 6,283 6,381 6,476 6,567 6,655 6,740 6,822 6,901 6,978 6,152 6,260 6,363 6,462 6,558 6,650 6,739 6,825 6,908 6,988 7,066 6,228 6,336 6,441 6,541 6,638 6,732 6,822 6,909 6,993 7,074 7,153 6,302 6,412 6,518 6,619 6,718 6,812 6,903 6,992 7,077 7,159 7,239 6,376 6,487 6,594 6,697 6,796 6,892 6,984 7,073 7,160 7,243 7,323 6,448 6,561 6,668 6,773 6,873 6,970 7,064 7,154 7,241 7,325 7,407

Prots in $1,000

36

Prots highest if both prices are increased by 10% Why not increase prices even further?

37

when proposed prices are very different from prices in the data

IRIs client had very limited access to sales and price data and only a

limited understanding of the key pricing issues

Private label competition poses only a very limited threat to the brand There is cannibalization within the product line, but the main offender is not the

new 32 oz size but mainly the 24 oz size - Consider eliminating 24 oz size to save on costs (packaging, distribution, ) Base price points are sub-optimally low

38

Goal:

detergent brand

Examine cannibalization within the Tide product line Examine competitive threat from Wisk Make pricing recommendations Approach

Estimate log-linear demand model using scanner data

39

Foods chain in Chicago over a period of up to 300 weeks

store week acv promoflag q_tide128 p_tide128 q_tide64 p_tide64 q_wisk64 p_wisk64

Store id number Week ACV (all commodity volume), in $1,000 = 1 if any product in the category was on promotion Tide 128 oz: unit sales Tide 128 oz: price ($) Tide 64 oz: unit sales Tide 64 oz: price ($) Wisk 64 oz: unit sales Wisk 64 oz: price ($)

40

Calculate:

41

Straightforward approach: Use log(Q) as dependent variable However: Stores differ in size and hence sales will differ across stores even if the

product prices are the same

Use ACV (all commodity volume) is a measure of store size, dened as the store

revenue from all products sold in $ million per year - Includes the sales of all products (produce, meat, detergents, milk, batteries, etc.), not just the products in the demand model Add log(ACV) as an independent variable in a multiple regression

42

Focus is on the effect of the everyday price, not on the effect of price

promotions Price promotions are typically associated with sales spikes - More details later

category was promoted

43

44

Consumer demographics Consumer preferences Location

The store identity is a categorical variable We control for categorical variables using dummies

units in a data set are called xed effects

Create store xed effects and add them to the regression model

45

Own price elasticity looks much more reasonable Strong competitive effect from Wisk Note

46

Pricing simulations

Goal: Predict the impact on total (product line) prots if we change the

current base prices of one or more of our products model parameters (elasticities) in the product line

We make these predictions using the estimates of the log-linear demand To predict total prots we need to predict the prot for each product k

protk = Qk [Pk (1 retail margin) V Ck ]

V Ck variable cost

the price change

47

product 3

Pk is the price of one of the products before the change, Pk is the price after the change

Correspondingly Qk is demand before the price change, Q is demand k after the price change

48

Change the price of product 1 (Tide 128 oz) by 1 percentage points and

the price of product 2 (Tide 64 oz) by 2 percentage points. The price of product 3, Wisk 64 oz, is unchanged:

P1 = (1 + 1 ) P1 P2 = (1 + 2 ) P2 P3 = P3

12% and cut the price of Tide 64 oz by 7%

log(Pk ) log(Pk ) = log ((1 + k ) Pk ) log(Pk )

49

each product in the product line

Focus on the demand for product 1 (Tide 128 oz) Write down the log-linear demand equation after and before the price

change and take the difference:

log(Q ) = 1 + 11 log(P1 ) + 12 log(P2 ) + 13 log(P3 ) 1

log(Q ) log(Q1 ) = 11 (log(P1 ) log(P1 )) + 12 (log(P2 ) log(P2 )) 1

50

1. To predict the price effect on demand for product i rst estimate the parameters of the log-linear demand model,

3. Consider the price changes

Pk = (1 + k ) Pk

5. The ratio of unit sales of product i after versus before the price changes is Q i = (1 + 1 )i1 (1 + K )iK Qi

51

Cut the base price of Tide 128 oz by 7% and increase the price of Tide 64

oz by 4%

Predicted Tide 128 oz sales ratio after vs before the price changes:

Q = (1 0.07)2.414 (1 + 0.04)0.1591 = 1.20 Q

52

Average Tide 128 oz unit sales are 55.25 at the week/store level

Implies a current annual base volume of 86 52 55.25 =

chain (Dominicks) level (86 stores in the chain)

Base volume after price changes: 1.20 247,078 = 296,494 Average Tide 128 oz price is $8.47 $7.88 after the 7% price cut Tide 128 oz prot after the price changes:

prot(Tide 128 oz) = 296, 494 [7.88 (1 0.25) 128 0.027]

unit sales price retail margin variable cost of 128 oz size

Note: Retail margin at Dominicks = 25% and the per-ounce cost of Tide is 2.7c

53

Understand how the prices of the products in the category inuence demand for

the products that we sell Do the prices of competing products inuence our own sales competition? Do the prices of other products in our product line inuence our own sales cannibalization?

Use data on past prices and sales Use regression analysis to estimate a demand model Can we improve pricing? How should we adjust the prices in our product line?

54

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