Prices: Issues in Theory, Practice, and Public Policy [Reprint 2016 ed.] 9781512805871

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PRICES: Issues in Theory, Practice, and Public Policy

CONTRIBUTORS R. Μ. Cyert and Μ. I. Kamien

James R. Nelson

William J. Baumol

Alfred R. Oxenfeldt

Ronald E. Frank

Almarin Phillips

Lawrence Friedman

James Tobin

Paul E. Green

Ralph Turvey

Ε. T. Grether

Sidney Weintraub

Myron L. Joseph

Oliver E. Williamson

L. R. Klein

A. W. Zelomek

PRICES: Issues in Theory, Practice, and Public Policy

Edited by Almarin Phillips and Oliver E. Williamson

Ί. University of Pennsylvania Press Philadelphia

© 1967 by the Trustees of the University of Pennsylvania Library of Congress Catalog Card Number: 67-26222

7559

Printed in the United States of America

PREFACE The essays in this volume were presented at a conference at the University of Pennsylvania in October 1966. The conference was organized under the general guidelines that the papers should deal with recent developments in both the micro- and macro-economics of pricing, including theoretical as well as empirical aspects. Since this virtually constituted an invitation to range freely over the entire pricing spectrum, it was decided to focus the conference around several (albeit broad) themes. The first group of essays (Chapters 1-3) deal with the pricing implications of recent developments in the theory of the firm literature. Theories of the firm that take the form of behavioral, managerial, and inter-firm analyses are successively surveyed. Wage-price guidelines, in theory and in practice, are the subject of the next set of essays (Chapters 4-7). The issues and the essays here involve both political and economic considerations. Tradeoffs between inflation and unemployment naturally dominate the economic side of these analyses, while a sequential decision-making process characterizes the political side of wage-price guidelines implementation. The third group of essays (Chapters 8-10) are concerned with pricing in regulated industries, with special attention to marginal cost pricing. Regulation, almost of necessity, forces the analyst to deal in a "second-best" world. Some of the ways in which this is manifested and suggestions for minimizing the distortions that regulation experiences are dealt with in these chapters. Marketing models and empirical studies of pricing behavior are the subject of the fourth set of essays (Chapters 11-13). Closely related are the final group of essays (Chapters 14-16), in which the rationality properties of business-pricing decisions and the implications of pricing practices for antitrust enforcement are considered. The issues identified here have obvious relevance for matters dealt with in the first set of essays, which brings us full circle. If a common view on pricing emerges from these papers it is that an eclectic approach to pricing theories, practices, and policies, appears at this stage to be appropriate. Neither neoclassical theory nor recent amendments, extensions, or alternatives to it appear individually rich enough to embrace the full range of variety that pricing behavior affords. This is perhaps especially true when dealing with the oligopolistic and regulated sectors, which is also the arena in which the political input is most significant. Those who prefer "unified" theory will not find this result appealing, but there are other conferences and other times when the case for unified theory can be made.

The conference was sponsored by Merck and Company through the Wharton School of Finance and Commerce. We wish to take this opportunity to acknowledge that sponsorship and the related support that Merck and Company executives gave to the conference. A L M A R I N PHILLIPS OLIVER E . WILLIAMSON

Philadelphia, November

1967

CONTENTS PREFACE J

BEHAVIORAL RULES AND THE THEORY OF THE FIRM R . M . CYF.RT AND Μ . I. KAMIEN

Carnegie Institute of Technology 9

A DYNAMIC STOCHASTIC THEORY OF BEHAVIOR OLIVER E . WILLIAMSON

1 MANAGERIAL

University of Pennsylvania -3

11

A N ATTEMPT TO SYNTHESIZE SOME THEORIES OF THE FIRM ALMARIN PHILLIPS

University of Pennsylvania 4

32

REQUIEM FOR A LIGHTWEIGHT: A CRITICAL HISTORICAL SKETCH MYRON L . JOSEPH

Carnegie Institute of Technology 5

IN DEFENSE O F WAGE-PRICE GUIDEPOSTS . . . . SIDNEY WEINTRAUB

45 PLUS

University of Pennsylvania 6

WAGE A N D PRICE DETERMINATION IN MACROECONOMETRICS L . R . KLEIN

University of Pennsylvania 7

UNEMPLOYMENT AND THE CRUEL DILEMMA JAMES TOBIN

101

REASONABLE RULES FOR RATE REGULATION: PLAUSIBLE POLICIES FOR A N IMPERFECT W O R L D WILLIAM J . BAUMOL

Princeton University Q

82

INFLATION:

Yale University Ö

63

108

PRACTICAL PROBLEMS OF MARGINAL-COST PRICING IN PUBLIC ENTERPRISE: E N G L A N D RALPH TURVEY

National Board for Prices and Incomes

124

10

P R A C T I C A L P R O B L E M S O F M A R G I N A L C O S T P R I C I N G IN PUBLIC ENTERPRISE: T H E UNITED STATES JAMES R . NELSON

Amherst College 1 1

12

13

14

1 5

16

APPLICATIONS OF DECISION THEORY PRICING STRATEGY PAUL E . G R E E N UNIVERSITY OF PENNSYLVANIA

IN

141

MARKET MODELING: A CASE HISTORY RONALD E . FRANK UNIVERSITY OF PENNSYLVANIA PSYCHOLOGICAL PRICING IN T H E FOOD LAWRENCE FRIEDMAN Μ & Μ CANDY COMPANY

168 INDUSTRY 187

BUSINESS PRICING: T H E IRRATIONAL USE O F IRRATIONAL RULES OF THUMB A . W . ZELOMEK INTERNATIONAL STATISTICAL BUREAU AND UNIVERSITY OF VIRGINIA T H E U N D E R L Y I N G RATIONALITY O F BUSINESS DECISIONS ALFRED R . OXENFELDT COLUMBIA UNIVERSITY PRICING PRACTICES A N D ANTITRUST Ε . T . GRETHER UNIVERSITY OF CALIFORNIA AT BERKELEY INDEX

135

202

PRICING

214

228

247

PRICES : Issues in Theory, Practice, and Public Policy

CHAPTER ONE BEHAVIORAL RULES AND THE THEORY OF THE FIRM by R. M. Cyert and Μ. I. Kamien The neoclassical theory of the firm as synthesized by Samuelson is an example of the use of deductive arguments to arrive at meaningful theorems in economics.1 Starting with only a few explicit assumptions, a number of interesting theorems and corollaries are derived. The theorems describe a set of optimal-decision rules which a profit-maximizing firm should follow to determine its levels of outputs and inputs given market price. Failure to follow these rules will not only diminish profit but will make it impossible for the firms to survive under the free entry market conditions assumed. If it does follow them, the firm has no problem of dealing with uncertainty because nothing is uncertain in the model posited. The received theory of the firm is a useful and significant intellectual contribution. It has enabled economists to explain many kinds of behavior in the world and has, in general, served as a framework for both scientific work and policy recommendations. Our aim in this paper is to nurture a growing body of work which aims at developing a theory of the firm that will lead to confirmable propositions explaining the behavior of the firm in noncompetitive markets. At the heart of our paper is the judgment that the firm is an adaptive mechanism operated by human beings with limited information-processing capabilities. We propose to look at the firm under conditions which are less restrictive than those of the neoclassical theory. We will relax the assumption of certain knowledge of market environment and the internal technological conditions. In process we hope to provide an explanation for use of behavioral rules (rules of thumb) by firms for pricing and output decisions. We begin with the proposition that profit is, at the very least, a major objective of the firm. The task is to devise an analytic model which explains how the firm makes its decisions in the face of uncertainty so as to earn profits enabling it to survive and grow. Herbert Simon's work on satisficing and R. A. Gordon's references to satisfactory profits are attempts to develop decision criteria in an environment that more closely resembles the real world than does the classical model.2 ' P. A. Samuelson, Foundations of Economic Analysis (Cambridge, Mass.: 1947), pp. 57-89. ! R. A. Gordon, Business Leadership in the Large Corporation (Berkeley, Calif.: 1961) and H. A. Simon, "A Behavioral Model of Rational Choice," Quarterly Journal of Economics, Vol. 64 (1955), pp. 99-118, reprinted in H. A. Simon, Models of Man: Social and Rational (New York: 1957).

2

Prices: Issues in Theory, Practice, and Public Policy BEHAVIORAL RULES

Without going into the other objectives of the firm and the other obstacles to profit-maximization, it is reasonable to suppose that the firm devises approximate solutions for the attainment of its goals. The approximating procedures are often referred to as behavioral rules. These rules presumably evolve through confrontation with similar situations over time and some experimentation. The firm may discover some simple relationships between the price it sets and sales volume, market share, and profit by trying several different price levels. Or the behavioral rules may be based on customary procedure in the given industry. An example of this might be the mark-up above cost.3 Behavioral rules not only serve to approximate the optimal procedure for achieving certain objectives but also help preserve internal stability within the firm. Recognition of the separation of ownership and control in a modern corporation requires that the managers of such a firm be viewed collectively as an organization. We know from organization theory that the internal stability of a decision-making organization is enhanced by the ability to transform decision processes into programmed behavior. Behavioral rules are a form of programmed decision-making. RELATIONSHIP OF BEHAVIORAL THEORY AND DYNAMICS

While the behavioral approach to the theory of the firm appears promising, its achievements to date have been limited. For the most part, this can be attributed to the infancy of the approach. The tools required for better exploitation of the method have not yet been fully developed. Moreover, an economist venturing into this area must acquaint himself with the rudiments of organization theory, while the organization theorist must learn some basic economics. These difficulties aside, the behavioral theory of the firm lacks most, in terms of completeness, a dynamics (although this may be interpreted as an overstatement, since in the behavioral approach no clear delineation between statistics and dynamics has yet been made). Again, if we reflect on the development of classical economic theory, this is not too surprising. Even now the definition of economic dynamics is a somewhat elusive concept. In particular, the accepted definition appears to be "a system is dynamical if its behavior over time is determined by functional equations in which variables at different points in time are involved in an essential way." 4 But what of dynamics in the behavioral approach? How does time enter in an essential way in the decision-making processes of the firm as conceived 5

See, for example, R. M. Cyert and J. G. March, A Behavioral Theory of the Firm (Englewood Cliffs, N. J.: 1963), Chap. 7. ' Samuelson, op. cit., p. 314.

R. Μ. Cyert and Μ. I. Kamien

3

in the behavioral theory. We believe it does this in two ways. In the first place, recognition of the future compounds the uncertainties that the firm must presently face. Not only does the firm often lack knowledge of the shape of its present cost and demand functions but it must also contemplate the possibility that these functions might change over time. Secondly, time enters in an essential way into the behavioral theory approach to the firm through the evolution of its decision rules. The behavioral decision rules ordinarily use past values of the relevant variables for determining the current values of these variables. The rules are altered in the sense of their functional form or exclusion of certain variables and the inclusion of other variables in their stead on the basis of how well these rules perform in meeting the desired objectives. The time element imposes a need forflexibilityin the formation of behavioral rules, or, in other words, to allow learning to take place. This is not the case, for example, with regard to behavior posited for the suppliers in the naive cobweb model. The supplier always determines his production level on the basis of last period's prices despite the fact that he may often be ruined by following this rule. The same type of stereotyped behavior is displayed by the competitors in the Cournot duopoly model. We should in fact expect the firm not only to revise its behavioral rules on the basis of past experience but also to do this at an increasing rate. The learning process itself has to be learned, and we might assume that it improves with experience. This point has not as yet, it seems, been incorporated into the study of behavioral rules. Baumol and Quandt, for example, rely on initially short reaction time or certain values of elasticities of demand and cost in order to obtain stable learning behavioral rules.6 A more complete analysis would incorporate the notion that the reaction time itself changes over time, presumably getting shorter. Time enters into the behavioral approach, as the medium through which complete adjustments to the environment take place. This is the distinction in adjustment which necessitates the definitions of a short run and a long run. In the classical theory the short run differs from the long run in that in the latter case the firm is capable of altering all its factors of production, whereas in the former case it cannot. It seems to us, in the light of what has been said above, that the analogous concept in the behavioral approach should be that in the short run the firm cannot cause all decision processes to be of the programmed variety, whereas in the long run it can. An immediate consequence of this definition is that the firm's reaction time to an exogeneous change in its environment would be more rapid in the long run than in the short run. Of course, as long as some uncertainty exists, and the future ' W. J. Baumol and R. E. Quandt, "Rules of Thumb and Optimally Imperfect Decisions," American Economic Review, Vol. 54 (March 1964), pp. 23-46.

4

Prices: Issues in Theory, Practice, and Public Policy

will assure this, reaction time will not become zero but rather approach this limit asymptotically. Focusing our attention on the definitions of long run and short run proposed above should also enable us to understand and explain economic phenomena which have not been satisfactorily explained by the classical theory. The most prominent of these is the behavior of oligopolistic firms and price movements in such markets. Several attempts have been made to explain the constancy of prices over long periods of time despite changes in technology and input costs. Also, when price changes do take place they are typically initiated by one firm and almost immediately followed by the other firms. The common explanation offered is collusion among these firms. Sometimes, of course, this is the case. However, at other times evidence to support the collusion hypothesis cannot be found, and we must suppose that the goings on are an inherent feature of this type of market organization. Among the other better-known explanations of the behavior of firms in oligopolistic markets are the kinked demand curve model, the dominant-firm model, and the game theoretic approach. Unfortunately none of these provides a commonly accepted explanation of oligopoly behavior. While the notion of the kinked demand curve is appealing at first glance, it fails to explain the simultaneous increase in prices often observed in actual oligopolistic markets, e.g., the recent advances in steel prices and automobile prices. The firms in the model behave asymmetrically with regard to a change in the price initiated by one of the firms. If any firm lowers prices, the rest will all follow. This is basically a defensive act. On the other hand, firms will not follow a price increase. This behavior appears to be more of an aggressive nature. Putting it another way, the firms appear to regard their relationship to the market as a zero-sum game. They always fail to recognize that higher profits might be obtained by cooperating. In terms of the dynamics described above, the explanation of the same phenomena might go something like this. At the inception of the industry in which there are many small firms a great deal of learning and formation of behavioral rules has to take place. As the industry progresses through time behavioral rules are developed and refined. Some firms leave the industry because they cannot compete successfully. Consolidations may be the result of learning that economies of scale exist. Over time the remaining firms develop more refined rules. The amount of information shared in common by these firms becomes large. Each can anticipate to a great extent the actions of his competitors and recognize the basis on which a competitor makes a move. Response time decreases. The end result is seemingly simultaneous, since each firm over time becomes like the other firms and is affected in the same way by external changes (e.g., increases in prices of raw materials).

R. Μ. Cyert and Μ. J. Kamien

5

AN ILLUSTRATIVE MODEL

We now return to the main focus of our paper, namely the evolution of behavioral rules. Some of the arguments set forth above can best be clarified with a simple price-setting model exhibiting the way in which behavioral rules, learning, and time enter into the description of firm behavior. The model we present below is meant to convey the spirit of the methodology we think appropriate for the study of the firm rather than a description of actual behavior. We posit a firm which sells a single product in a market consisting of many firms selling products of varying degrees of substitutability. In other words, some of the firms are lesser competitors to the firm in question than others. The important feature of this market situation is that the relevant firm does not regard only one or a few rivals directly responsive to its pricing decisions. The responses are instead diffused among its several competitors. Let us suppose further that the firm's cost function is of the form

(1)

C(q) = cq

where с is a positive constant, and that its demand curve is describable by the equation

(2)

q = a — bp

where a, b > 0, providing that its rivals maintain current prices. Consequently, the firm's profit as a function of price is (3) v(P) = (a + bc)p — bp* — ca, or lettering α = —b, β = (a -f- be), and γ = —ca we can rewrite ( 3 ) as (4) *(p) = a pi + ßp + y Now

(5)

ir'(p) = 2ap — β

(6)

*"(p) =2a < 0

and

which indicates that v(p) is concave. If the firm knows the values of the parameters β, β, у, it can determine the optimal price directly by setting » ' ( p ) = 0. If we designate the optimal price by p*, then in this instance, ρ* = —β/2a. If the firm knows only that the profit function v(p) is unimodal, it can arrive at the optimal price in a series of steps by means of a sequential search procedure. A simple rule such as that to increase (decrease) price by 10 per cent as long as the resulting increment to profit is positive and to stop the first time incremental profit is zero or negative will achieve the desired objective or at least come very close. Suppose, however, the true increment in profits stemming from a change in price is confounded by extraneous events as, for instance, income fluctuations, price changes in related products not in the given market, and price movements within the industry which are exogenous to the firm under consideration. In this case, neither of the above procedures will necessarily

Prices: Issues in Theory, Practice, and Public Policy

6

yield p*. Formally, this situation can be described by incorporating an error term into expression (2), thereby altering ( 4 ) . Thus (2) becomes (2') q=a-bp+e where e represents an error term, and (4) becomes (4) π (p) = oqP" + ßp + у+ ер. Then (5) η·(ρ) = 2οφ + β + ε wherein, we implicitly assume that de/dp = 0. In other words, changes in the error term e are independent of changes in price p. We also assume that the firm has a point estimate of the parameter a from past experience and that this estimate is considered to be fairly reliable. Moreover, we assume that a remains fixed so that changes in с serve merely to shift expression ( 5 ' ) up and down. The firm now seeks to locate the "optimal" price. We purposely leave "optimal" undefined at this point to emphasize, for reasons that will become apparent below, the multiplicity of meanings that can be associated with the term. Finally, we suppose that the firm has no knowledge of the expected value of e. Instead, E[t\ is a random variable. The firm does, however, believe that £ W is distributed according to some distribution function g(0- By setting price at different levels and observing the outcome, the firm revises its prior distribution function g(0 to conform with the new information obtained. In this manner the firm learns and adapts itself to the environment. To be more specific, let us assume that the firm structures this problem in terms of two decisions, viz., (7)

D

l • Pt

D

2'Pt

where

= =

i1+r)pt_x 0-r)Pt-1

O^r^l.

The firm may raise price by r per cent above last period's price, decision £>,, or lower price by r per cent from last period's price, D >· We let иг denote the probability that decision I>i will result in a positive increment to profit, and consequently (1-йi) is the probability that decision D, will result in a decrease in profit. Similarly, we let u2 denote the probability that decision D2 will lead to an increase in profit, and therefore that (7-w 2 ) is the probability that decision D2 reduces profit. We further designate an increase in profit, regardless of its magnitude, by 1 and a reduction in profit by - 1 . It should be noted that the probabilities щ and u2 are taken to be independent of the current price level. The firm does not know these probabilities but does believe that they are generated by the distribution functions (ξ) and #2 © respectively.

R .

Μ .

Cyert

and

Μ .

I.

7

Kamien

We may envision the firm under these circumstances as, say, making decision D u observing the outcome and then updating its prior beliefs regarding (ξ) and #2 (£)· This behavior could be described by Bayes's formula. In particular, suppose that after τ decisions have been made, к have been of the Di type and that the number of times profit increased thereafter was L On the basis of this information the firm's revised distribution should be according to Bayes's formula. (8)

/iGlM^is'o-öHpiß)

where /](£ \k,t) is defined as the probability that «ι lies between I and ξ+ d% given к and I and where Кг is a normalizing factor chosen so that

Now, given that τ decisions have been made, net profits have increased j times in all, and decision I>i has been chosen k times before with / subsequent successes, we can deduce that decision Z>2 must have been chosen ( τ - k ) times before and yielded 1/2 ( r + / ) - / . successes. Thus, defining f2 (ξ I Tt j, k, I) as the probability that u2 lies between % and d% it follows that f2 (ξ I r, j, k,I) = Κ2ξ1 / 2 ( r + / W ( 7

(9)

/2(г+/)+ * g 2 ( | ) .

where K2 has a similar interpretation as K^ If we further suppose that the firm chooses as its initial distributions the uniform distributions *l(Ö=l J?2®=1 0ν.

The nonlinear modification is undoubtedly of great importance as we near extremes of activity with either nearly full employment (rapidly rising wage rate and price) or very high levels of unemployment (rapidly falling wage rates and prices). We are usually functioning in an interior range where linear approximations are tolerably good, but we attach much significance to the extremes because that is the place where careful analysis is most urgently required. At least two amendments, apart from lag structures, have been suggested for this relationship. One suggests the inclusion of a profit variable and the other the inclusion of a productivity variable. If this equation is to represent the macroeconomics of bargaining table behavior, it is argued that relevant considerations in such sessions would be recent profit behavior and recent growth in productivity. It cannot be denied that there is a statistical correlation between wage changes on the one hand and profit changes or productivity changes on the other hand, yet these correlations do not justify our introducing these variables directly into the structural equation of the wage bargain. If we do not include these two additional variables in the wage bargaining equation as such but make algebraic substitutions and transform this equation into a partially reduced form, we may derive relationships showing a positive association between wage changes and profits or productivity. Indeed, simulation solutions of complete systems do show all these variables moving in the same direction, but we are not primarily interested in derived relationships; we are interested in structural relationships. There must be some special aspects of profit and productivity variables, not already contained in unemployment or price-change variables, that contribute toward an explanation of wage changes. These special aspects are not as apparent as advocates of inclusion of these variables would claim, but that is not to 1

A. W. Phillips, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," Economica, Nov. 1958.

88

Prices: Issues in Theory, Practice, and Public Policy

rule out their plausibility as candidates for generalization of the wage equations. Our skeleton system is not complete, because with the wage-rate equation we have introduced a new variable, namely, labor force, or the other part of the unemployment variable. The employment side of this variable is available to us as labor requirements from the production function, as indicated above. Labor force is usually given as a labor-participation-rate equation, showing how many in the population (exogenous?) desire to participate in the active labor force. While economic theory might specify that this relationship should be a function of the real-wage rate, the most significant empirical relationship that can be established is that of a cyclical participation rate such that the rate rises as the unemployment rate falls. When there is a high demand for labor (low unemployment), labor force expands, especially through inclusion of more students, wives, and some retired people, who represent the elastic portion of the working population. Members of these groups appear to be reluctant to enter the labor force unless there is a perceptible shortage of personnel. At the other end, they tend to withdraw from the active work force when available openings are scarce. In addition to labor force and unemployment, we introduce a total population variable, Np and write . u t μ J— =0„ Ο + r01 l JL— _ pt Ft

where U{ = LF{ -N{. Our skeleton system thus consists of ( 1 ) a price-mark-up equation (labor-demand or factor-share equation), (2) a wage-bargain equation, and (3) a labor-force-participation equation. Given labor requirements and effective demand, these three equations serve to explain price level, wage rate, and labor force. In each case there are different economic actors or agents at work. Price-determination (or labor demand) is a businessproduction decision; wage determination is a joint business (employer)household (employee) bargain; and labor supply is a consumer household decision. In structural analysis, at the levels of statistical estimation and economic application, it is of great importance to maintain the right association between a group of relevant economic agents and the decisions for which they are responsible. This will help us to avoid confusion between reduced forms and structural relationships.

A B R I E F S U R V E Y OF M A C R O E C O N O M E T R I C

APPLICATIONS

The above skeleton system has been applied in some form or other in a variety of models, each with its own special circumstances. These are re-

L. R. Klein

89

viewed here to acquaint students with a variety of situations before we take up some new paths of analysis for the United States economy. 3 THE BROOKINGS MODEL: The price and wage equations (by industrial sector) set up by C. Schultze and J. Tryon follow the skeleton layout, but there are some significant modifications and extensions. The priceformation equations are not pure mark-up relations over unit labor costs. There is a distinction in the relation between actual and trend values of unit labor costs, and in one case there is an accounting for raw material prices. More important, however, is the inclusion of a direct measure of demand pressure by using a variable showing the ratio between inventory stocks and sales. This is a significant modification of the price-formation equation in the skeleton model. The wage-rate equations are of a standard Phillips curve variety in having a nonlinear relationship between wage change and unemployment: the percentage change in wage rates is a linear function of the reciprocal of the unemployment rate. It also includes a profit-rate variable. As for timing, this relationship is stated in terms of 4-quarter changes; wage changes are made to lag behind price changes; and wage changes are to reverse behind previous 4-quarter changes. Lagged wage changes are negatively associated with present wage changes, indicating that large increases tend to be followed by relatively small changes and vice versa. Although a fairly elaborate set of age-sex participation-rate equations have been constructed for this model by S. Lebergott, a conventional overall relationship between labor-force participation and unemployment rate has been used in recent simulation calculations with the model. 4 A MODEL OF THE UNITED KINGDOM : Noteworthy deviations in the treatment of wages and prices in this model, as compared with the skeleton system, are the inclusion of variables to represent import costs in addition to wage costs for price determination and the distinction between wage rates and earnings in the equation of wage determination. The price-determination equation contains a mark-up on the wage rate (earnings) but is modified to allow for import-price levels as well. This is a particular aspect of price formation that must be taken into account when dealing with the open economy. Also the rate of indirect taxation, especially the purchase tax, has been an important factor in determining United Kingdom final market prices. Therefore, this variable must also be included. The wage equation is special, as mentioned above, because its dependent variable is wage-rate change instead of earnings change. It has a special lag structure originally suggested by L. A. Dicks-Mireaux and J. C. R. 3

J. S. Duesenberry, G. Fromm, L. R. Klein, and E. Kuh (eds.), The Brookings Quarterly Econometric Model of the United States (Chicago: 1965). * L. R. Klein, R. J. Ball, A. Hazlewood, and P. Vandome, An Econometric Model of the United Kingdom (Oxford: 1961).

90

Prices: Issues in Theory, Practice, and Public Policy

Dow/' They recommend relating the 4-quarter change in wage rates to average unemployment of the past 4 quarters and the average 4-quarter change in price level (averaged over the previous 4 quarters). This particular equation has not been estimated in a nonlinear Phillips-type specification, although that would be possible. A dummy variable to account for political party differentials at the seat of government is also used. To explain the "wage drift," measured as the difference between wage rate and wage earnings, we use an equation dependent on hours worked (time payment) and productivity (i.e. work payment). Finally, labor force is set as a function of unemployment. Thus it is seen that, except for special country differences that take into account such things as the open economy, the wage drift, a particular lag structure, and similar considerations, we have the same basic set of wage- and pricedetermining relations found in other models. A JAPANESE MODEL: Japan is much like the United Kingdom in the sense of being an open, island economy, although there are many other aspects of difference (and also similarity) between the two cases. We have found, in modeling Japan, the same general set of wage- and price-determining relationships. 6 Price is a mark-up on unit labor costs and unit import costs. The productivity of labor and of imports are explicitly taken into account here. These productivity factors were not included in the original United Kingdom model formulation but do appear, in more recent studies, to be significant. Also, the same kind of wage-change equation is used for Japan. The explanatory variables are price change and unemployment. There are no nonlinearities used in these particular equations. Labor-force participation, instead of depending explicitly on unemployment, is a pure trend. HYPERINFLATION IN BRAZIL: The general model outlined in skeleton form in the previous section has a long history in macroeconometrics and plays an important role in current model construction. It is not, however, universal. In the case of the emerging economies, it is by no means certain that the same forces are at work in wage and price formation and an accepted set of structural equations has not been developed as they apparently have for the industrial economies. Models for the underdeveloped countries have not been widely published and are not as well known. There are, however, many such models available in working papers and memoranda of international bodies and research institutes. In many cases the data are sparse and weak. For this reason testing and examining of alter5

L. A. Dicks-Mireaux and J. C. R. D o w , ' T h e Determinants of Wage Inflation: United Kingdom 1946-56," Journal of the Royal Statistical Society, Series A ( G e n eral), Vol. 122 ( 1 9 5 9 ) , pp. 145-184. * L. R. Klein and Y. Shinkai, "An Econometric Model of Japan," International Economic Review, Vol. 4 (Jan. 1963), pp. 1-28.

91

L. R. Klein

native hypotheses have been severely limited. We have a case, however, in which the above approach may not be satisfactory. In some studies of Brazilian econometrics undertaken at the Wharton School, we find that price determination cannot be divorced from monetary expansion in a conventional quantity theory of money explanation. 7 The available data, by years, 1948-1964, lead to an estimated equation Μ — = 1.77 + .277X p (.02) If suitable wage, employment, and labor-force data were available, it is possible that some more of the relationships in our skeleton system could be studied. We do have statistics of wage payments and gross domestic product. These can be associated in the form wN = —2.46 + 304PX, (.004) but we cannot transform this equation to the mark-up formulation, because we lack separate statistics on wage rates and employment. This equation, unfortunately, cannot be estimated from data after 1960, the take-off date for the greatest inflationary surge in Brazil. The wage-payment series was available to us only until 1960. It is unlikely that labor-participation-rate or wage-determination equations would take the form given in our skeleton model, but this does not preclude the simultaneous validation of a wage-share equation and a quantity equation. In a situation like this, it would seem that the quantity equation takes over the principal job of explaining the absolute level of prices. When the price level gets out of hand, as in Brazil (1960-1966), it seems hard to deny the close association between money supply and pricel level. There is still a question of causal interpretation, i.e., whether money supply is expanded to accommodate the rising price level or whether monetary expansion is the main initiating factor, but we lean toward the latter interpretation until more data become available to examine alternative hypotheses.

SOME N E W

DIRECTIONS

Short-run forecasting models now being actively used in current analysis of economic fluctuations follow the general lines laid out in the skeleton system, but new ideas have been injected in order to deal with problems that become more apparent as we push against the capacity ceiling. In the Wharton Econometric Forecasting Unit (E.F.U.) model, the equation for price level is 8 7 These studies are being carried out by Miss Denise de Souza and Mr. M. Marzouk. " Numbers in parentheses below coefficients are estimated sampling errors.

92

Prices: Issues in Theory, Practice, and Public Policy Pm

=-.170

+

.542

+

(.089) V X '

+ .606 I

ς

iP

m

m

. 2 4 6 C p + .0435 (.036)

(.006)

)i

(.070) 4 i = 1 This modifies the original formulation in a few respects. It deals with an explanation of the manufacturing price level Pm rather than the general wN price level. Correspondingly - — represents unit labor costs in manufacΛ. turing. Secondly an index of capacity utilization is included as an extra variable to represent price pressure from the demand side.9 During the Korean War, there were unusual speculative excesses. These are accounted for by the dummy variable bkK, which is unity in 1950.3-1951.1 and otherwise zero. Finally we have a lagged adjustment of prices and include the average price of the past 4 quarters as an additional variable. The equations for wage determination are split into two parts—one for manufacturing and one for nonmanufacturing (nonfarm). Since nonmanufacturing wages are assumed to follow the lead of manufacturing wages, we shall concentrate attention on the latter. Our equation is Ш

т

-

wr

m-4

=

050

+

·14«

ΤΣ

(.023) 4

Wn-U«)

,·

Д

+ 4.824 (Рс_\-Рс_л) (•521)

- .195

(wr

. -

(.070)

Wrm

g). m

"

8

This equation of manufacturing wage rates follows the lag structure first suggested by Dicks-Mireaux and Dow, but it also includes the lag response term ( w r m _ 4 —vvr m _gj suggested by Schultze and Tryon in the Brookings model. The price-change variable refers to consumer prices, P

c-1 ~pc-4 • It is the variable Un — U* that requires some explanation.

* In the O.B.E. model, there is even stronger pressure allowed for by using a high power of capacity-utilization multiplied by sales change over the past 2 quarters. In the notation of that model, the term is 9.2 . - 1

(τ)С

(ίοΔιχ-'f Dollars

Product X discounted cash flow under capital cost of 10 per cent annually

End of Year

162

Prices: Issues in Theory,

Practice, and Public

Policy

commercialization at all, at the present time. In other words, given commercialization "now," the Case A pricing strategy and 25-million-pound initial plant size represented the best tactical combination. But as revealed in our first conditional pay-off matrix, if the pessimistic forecast materialized and if the venture were continued (even under the best tactical alternatives) unprofitable operations would result, i.e., discounted cash flow was negative. It became apparent then that two questions still had to be answered: ( 1 ) given the desirability of acting "now" (and adopting the best tactical alternatives), should the product be commercialized or not; or ( 2 ) should this strategic decision be delayed, pending the accumulation of better information about the occurrence of the admissible levels of potential sales? That is, first the prior probabilities associated with the 3 forecasts had to be applied to the conditional pay-offs and, second, the worthwhileness of delaying the decision had to be evaluated. DECIDE NOW vs. DELAY: The fact that only three "points" of the underlying time distribution of potential sales were available suggested two alternatives: ( 1 ) determination of probabilities through some type of curvefitting;11 ( 2 ) more direct investigation through further interviews with the personnel supplying the alternative forecasts. In view of our lack of a good basis for choosing an appropriate theoretical distribution, we chose the latter opinion. Essentially our procedure was to have the product manager and his chief end-use experts assign subjective probabilities (in the nature of betting odds) to each of the forecasts. Each end use was handled separately and the subjective probabilities assigned to each market were weighted by the unit sales potential for each end use, leading to a set of probabilities covering forecasts of the total market to be served by Product X. Calculation of both the relevant states of nature and prior probabilities proceeded as follows: 1. Each end-use expert was asked to specify his best single estimate of sales potential (net of anticipated competitive impact) over the planning period for his particular market. 2. Next each respondent was asked to construct a 90-per-cent "confidence band" around the most probable forecast. 3. Next the respondent was given interpolated sales figures and asked to state his betting odds that sales would equal or exceed each figure. 4. In this manner a crude probability distribution of potential sales was constructed. The forecasts labeled "most probable," "optimistic," and pessimistic" really represented partial expectations derived from the probability distribution. That is, a probability mass function was constructed from the underlying density function. 11

T h i s is essentially the procedure f o l l o w e d in the original P.E.R.T. f o r m u l a t i o n ( f o r problems arising in a different substantive a r e a ) .

Paul Ε. Green

163

When the prior probabilities were applied to the conditional pay-offs, an expected monetary value of $7.8 million (discounted cash flow) resulted. However, if the pessimistic forecast did materilize, a significant loss would result. This loss entailed operating the commercial facility 3 years (until it was assumed that pessimistic conditions would really be prevailing) and then closing down the plant and taking a tax loss on the undepreciated value of the equipment. The costs of uncertainty (by the Bayesian approach) if the decision were delayed 1 more year turned out to equal $4.2 million. However, the costs of an additional year of process and market development amounted to $2.6 million. Put another way, a year's delay would require obtaining information of a very high (virtually 90 per cent) reliability in order to justify this alternative. The nature of this analysis is shown in Figure 11-8. RECEPTION OF STUDY R E S U L T S : At this point we were ready to relate the substance of the study finding to Product X's development manager. In essence, the results indicated that: ( 1 ) if the decision were to be made "now," commercialization offered the better option and, tactically, the Case A pricing policy with 25-million-pound initial plant was the best alternative; and ( 2 ) if the decision were delayed 1 year, pending the receipt of additional market test data, a reliability level of 9 0 per cent would have to be attached to the new information in order to make this option equal in desirability to the "commercialize now" alternative. When these findings were reviewed by development management, it is of interest to note that the tactical conclusion (viz., given commercialization, the "best" option to take is the Case A pricing policy with 25-million-pound initial facility) was accepted by Product X's development group. However, less unanimity existed with respect to the wisdom of commercializing "now" vj·. delay of this decision until 1 year hence. Although the group felt that a reliability level of 90 per cent (required to make the delay strategy break even with the "act now" strategy) would hardly be attainable, management did not feel confident enough to proceed on the marketing data which currently existed. Assuming the model adequately reflected the real situation, management's adoption of the 1-year delay option could perhaps be viewed as either ( 1 ) an imputed subjective probability attached to the "pessimistic" forecast, which was higher than the 0.35 probability used in the analysis, or ( 2 ) a utility function which was nonlinear with money. When management was asked what reliability through a 1-year delay, they intuitively felt that a could be obtained. This imputation then implied of 0.50 had really been assigned to the occurrence cast (given, of course, the suitability of the model

level might be achieved reliability of 70 per cent that a subjective weight of the "pessimistic" forein other respects).

Ё1 з •о о

£»1

Ρ

•α -α £ я w 5. XI3

s 2Is§ Ε υ c

э о

о .2

et О* О

(Л ш

165

Paul Ε. Green G E N E R A L O B S E R V A T I O N S ON A P P L I C A T I O N S OF D E C I S I O N

THEORY

As the preceding applications illustrate, decision theory hardly offers a foolproof device for arriving at "right" decisions. Indeed, the assertion "right" can rarely, if ever, be tested in a business setting. However, some useful insights into the worthwhileness of these techniques have been gained. First, it would appear that use of decision-theory model does force the planner to structure his judgments in a reasonably orderly fashion as well as requiring him to make explicit the nature of his uncertainties. Second, decision theory coupled with sensitivity analyses and computer simulation provides a useful "if . . . then" model in determining the conditional pay-off matrices themselves. Factors which had appeared important prior to conducting actual studies frequently lose significance in terms of their impact on final pay-off. Third, by calculating posterior probabilities on the basis of new information, estimates can be improved over time. That is, in decision problems where actions can be deferred pending the receipt of new data, both preposterior and posterior analyses can be made regarding the value of additional information and incorporation of the new information, respectively. Fourth, some of the techniques of value theory, e.g., von Neumann— Morgenstern utility functions, may be helpful in treating the risk aspects of marketing strategies. Our own industrial work along these lines indicates that it is frequently dangerous to assume that utility is linear with monetary measures of effectiveness, even in corporate decisions where the resources of the firm are not unduly strained. An important consideration is the individual decision-maker's attitudes toward risk insofar as some types of wrong decisions (e.g., opportunity losses) carry less impact on personal careers then other types of errors where accounting controls are more commonly in use. Finally, extension of the decision-theory approach to deal with multistage problems under uncertainty constitutes a powerful analytical tool for future application. This is not to assert, however, that Bayesian decision is not without limitations—either for dealing with pricing problems specifically or managerial decision-making generally. At the least, one could offer the following criticisms of Bayesian methods: 1. Bayesian counterparts to many of the sampling and inference techniques of traditional statistics are still in the evolutionary stage of development. 2. Bayesian procedures frequently require more computation than their counterpart Neyman-Pearson methods. 3. In actual business applications, difficulties are encountered in measuring prior distributions and conditional pay-offs.

166

Prices: Issues in Theory, Practice, and Public Policy

4. Computational complexities are also introduced in dealing with "manyact, many-state" problems, as, for example, sequential decision problems. With regard to the first two criticisms, it is fair to say that research is currently being conducted on such topics as Bayesian regression models and stratified sampling procedures. Moreover, the use of conjugate distributions allows the analyst to reduce otherwise (pragmatically) intractable problems to manageable proportions. Still, in many realistic market-planning and samplesize-estimation problems, computer routines are almost a necessity. It is interesting to note that reported marketing applications (such as those described earlier) have almost invariably used computer routines in some phase of the computations. With respect to the latter two criticisms, measurement and computational problems arise as well. If the manager can only express his judgments "vaguely" or—worse yet—allows his general optimism (or pessimism) to pervade the probability estimation process, subsequent computations will be suspect. The analyst may wish to employ sensitivity analysis in which probabilities and conditional pay-offs are deliberately changed in order to ascertain the effect on expected values. Current research by Fishburn 12 and others has been addressed to the problem of dealing with cases in which probabilities (or outcomes) may only be expressed ordinally or in terms of some bounded interval. Moreover, the use of "sufficient" statistical estimation frequently provides a useful way to reduce cumbersome problems to some practical level of computation. The problems attendant on obtaining appropriate data input for business applications of Bayesian statistics are also serious. Bayesian analysis is a prescriptive technique for the consistent decision-maker. Unfortunately, in the real world, such ideal decision-makers are rarely found. To a large extent, of course, this problem is true of all models, whether or not personalistic probability is a part of the framework. It is the idiosyncratic nature of prior probabilities—as obtained in practice, not idealized in a model—that worries many analysts desiring to apply Bayesian concepts. While it is true that for fairly "diffuse" prior distributions, sample data will tend to swamp initially divergent views (leading to similar posterior distributions), some uneasiness naturally attaches to the use of personalistic models. The author shares this uneasiness but sees no "objective" way out. One can, of course, obtain prior probabilities independently from several executives (who, presumably, have similar knowledge of the problem) and check for interrespondent agreement. One can also conduct sensitivity analyses or utilize some of the approaches described by Fishburn. Still the problem of model validation is ever present. In summary, the author is still sanguine about the future outlook for 12

P. C. Fishburn, Decision

and Value Theory

( N e w York: 1964).

Paul Ε. Green

167

Bayesian models in research and business applications. The need surely exists, however, for extended study of human judgment as an important phenomenon for scientific investigation. This research is needed, not only for a better understanding of the behavioral implications of Bayesian analysis but for decision models in general. That such study can be fruitfully conducted has been demonstrated by the recent book edited by Shelly and Bryan. 1 ' The same problems expressed above are, of course, associated with applications of Bayesian theory to pricing analysis. And, it seems to me, the same defense must be adopted. Estimating demand schedules by whatever means—experimentation, time series, cross-sectional models—still leaves the analyst with a (frequently large) residue of uncertainty. As such, good decision-making is not a case of replacing managerial judgment by marketing research "facts," but augmenting it by objective analysis. Bayesian decision theory can enable the executive to marshal these judgments systematically and trace through their implications. The question of whether the invocation of such "consistent" procedures helps or hinders the decision process is still moot.

13

M. W. Shelly and G. L. Bryan (eds.), Human York: 1964).

Judgments

and Optimally

(New

CHAPTER TWELVE MARKET MODELING—A CASE HISTORY by Ronald E. Frank INTRODUCTION

One of the primary objectives of the study discussed in this paper is to develop an artificial test market (a model) which contains sufficient detail to serve as the basis for evaluating the short-run effects of a given brand's promotional activities on customer behavior. The study is being conducted jointly by Professor William Massy, Graduate School of Business, Stanford University, and the author. The particular brand involved is one of the major brands (hereafter referred to as Brand M ) in a frequently purchased consumer-product category. The product in question is used by the vast majority of families in the United States. Purchases occur at the rate of several a month for many users. The product is sold through supermarkets and receives a significant amount of promotion at both the manufacturer and retailer levels. Figure 12-1 presents the product's marketing system. Consumers are faced with retail-price, dealing, advertising, and in-store promotional activity for each brand in the market as well as with the dealing and advertising activities of manufacturers. If one is to gain an understanding of how manufacturer behavior influences the consumer (other than by his direct promotions), it is necessary to look behind the existing retail promotional activity and ask how manufacturer prices and allowances, together with the state of retail inventories and competition, influence the retailer's decisions as to the price, dealing, and retail-advertising activity appropriate for a given brand. For analytical purposes we have found it useful to think of this system in terms of two subsystems, namely, the retailer and the consumer. We initially faced the task of developing models that characterize the response patterns of (1) retailers to manufacturers and ( 2 ) consumers to retailers and manufacturers.

A

Q U E S T I O N OF R E S E A R C H

STRATEGY

The need for quantifying the relationship between the promotional activities of a manufacturer and the behavior of retailers and consumers has long been a subject of importance to both academicians and practicing businessmen. Though a great deal has been written on the subject, until recently the literature has been rather barren in results.

Ronald Ε. Frank

169 FIGURE 1 2 - 1 . The marketing system for Brand M.

Not only are studies of the effect of pricing, dealing, advertising and in-store promotional activity few and far between; in addition, those that have been published are often done at too high a level of aggregation to be useful for a wide range of "real" applications. For example, it is customary to build demand models of consumer behavior which assumes that all customers are homogeneous with respect to their responses to changes in a brand's marketing program. This is true in spite of the fact that the marketing programs of many firms are predicated on the assumption that their customers are heterogeneous with respect to their responses to the firm's promotional activities. Since 1963 only 2 papers have appeared 1 which study the responses of different market segments (e.g., brand-loyal vs. nonloyal customers of a brand) to changes in various components of a firm's marketing program. Many of the reported applications of operations research to marketing with which we are familiar are based on one of the following two methods for sidestepping the problem caused by our lack of hard knowledge about these response patterns: 1

R. E. Frank and W. Massy, "Market Segmentation and the Effectiveness of a Brand's Price and Dealing Policies," Journal of Business, Vol. 38 (April 1965), pp. 186-200; W. Massy and R. E. Frank, "Short Term Price and Dealing Effects in Selected Market Segments," Journal of Marketing Research, Vol. 2 (May 1965), pp. 171-185.

170

Prices: Issues in Theory,

Practice, and Public

Policy

1. The "Let us assume a response function" method. When done well, this approach begins with a search for behavioral data that are available in the literature and from the cooperating firm (if a n y ) . Then the analyst subjectively integrates his findings into a set of mathematical formulations which he hopes will provide a reasonable approximation to the relevant behavioral phenomena upon which operations analysis must be based. Unfortunately, some published "decision-making models" fail even to indicate that a comprehensive search for relevant behavioral materials has been undertaken prior to making assumptions about the form of the model. 2. T h e "Let management assume a response function" method. Here the analyst admits at the outset of his study that he lacks the detailed knowledge that is needed to make effective predictions. Rather than employing what may be essentially ad hoc assumptions, he asks management to assist him in his task by suggesting the nature of market responses that are likely to ensue if the firm adopts a given strategy. The analyst interprets these comments—perhaps by employing mathematical or probabilistic methods—and uses them as the behavioral components of his normative model. This approach is often used in operations research ( O . R . ) studies based on "Bayesian Decision Theory," as illustrated by the work of Paul Green.Both of these approaches may be useful. The first is probably as old as the field of operations research itself. In marketing, it may provide an effective way to formulate general principles, in much the same way as the economic theory of the firm provides generalized guidance for decisionmakers by espousing the notions of marginality and time discounting. U n fortunately, the available evidence indicates that the amount of generalizable knowledge about the behavior of marketing units is not sufficient to models to be constructed that can provide concrete guidance to managers in specific decision-making situations. (This criticism probably does not apply to many of the other fields in which operations research is currently being applied.) The second approach to model formulation is serviceable because it offers managers a way to participate in the O.R. process in their "natural" manner—i.e., essentially through the application of intuition and judgment. The highest order of judgment will always be necessary in making marketing decisions, so that the combining of intuitive and analytical skills will remain of very great importance. Nevertheless, we must recognize that by relying entirely on the intuitive specification of response relations, the analyst does not bring the full power of the scientific method to bear on his problem. 2

P. E. G r e e n , "Bayesian Decision T h e o r y in Pricing Strategy," Journal Vol. 27 (Jan. 1963), pp. 5-14.

of

Marketing,

Ronald

Ε.

Frank

171

Put another way, the second approach to response estimation (i.e., let managers do it) may improve the process of management decision-making, but it does not promise lo revolutionize it in the way that O.R. is revolutionizing other fields in which it has been applied. As Martin Starr has so aptly put it (and we strongly agree): Until we have sufficient relevant information—converted into realistic distributions and parameters—our simulation models of consumer behavior will remain abstractions: fascinating to those who conceive them, fantastic to those who misconstrue them, frustrating to those who would use them. 3

The primary objectives of the discussion which follows are to present (1) the model which we have developed for estimating the effect of a change in Brand M's pricing, dealing, and retail advertising activities as well as those of competing brands on Brand M's market share; (2) results as to the nature and degree of differential response to Brand M's promotional activities among selected market segments; (3) a few highlights from our analysis of the "interface" between manufacturers and retailers. It is our intention that this study will serve as an example of the type of research strategy that we feel has the best chance of leading to the gradual accumulation of knowledge aimed at developing the type of realistic distributions and parameters the absence of which was bemoaned both by Starr and by ourselves. The section which follows describes the data upon which the study was based. This is followed by a presentation of the results and a concluding discussion outlining the next round of research. THE

DATA

Our analysis is based on two sources of data. The first source consists of 101 consecutive weeks of purchasing history, taken with respect to a single product class, for families who are members of the Market Research Corporation of America's Consumer Panel in a particular metropolitan area. These data consist of a record for each purchase in the product class under study as reported by each household in the panel during the relevant time period. Each purchase record included the household's code number, the date of purchase, the brand, the number of units, the package size, the price paid, the store where it was purchased, and the type of deal involved, if any. As used in the panel, the deal measure is defined to include any special arrangements whereby the customer receives a price discount from merchandise at point of sale for the product. Two-for-one sales, special ' Μ. K. Starr, "Computers: The Marketing Laboratory," in Models, and Marketing (Englewood Cliffs, N. J.: 1965), p. 79.

Measurement

172

Prices: Issues in Theory, Practice, and Public Policy

retail price cuts, and premiums made good by the grocer would be classified as deals, for example. In addition, we obtained a sample of retail advertising activity. Our sample included each of the major newspapers in the metropolitan area under study, which covered approximately 9 0 per cent of the retail food lineage placed during the 101-week period of the study. F o r each retail advertisement placed for the product in question we obtained information as to the brand, package size, price, size of advertisement (in square inches), and type and magnitude of special promotion involved, if any. THE MODEL

T h e model used in the study is a distributed lag equation in several variables. That is, each of the explanatory variables is assumed to exert an influence that begins in the current time period ( w e e k ) , continues or changes direction in the next few periods, and then gradually dies away. T h e basic estimating equation is hyperbolic in form, but if all variables are understood to have been transformed to logarithms before estimation, it can be written as a classical linear regression.

St = α 0

+ a\Pt+

"/r-1+

agFt + ν ν ΐ

+ a\(f\-t

a4 Dt+

a \ 1Nt + a

a5 Dt-1+

1 1

a(Pt-2+

+

a

-f

D

t

+

a 13 yV /-2 + al4 0At

+

a\5OAt-l+a\6OAt-2+

a j jESf + a j gESf_ j+

j

Since the variables have been transformed to logarithms, it is possible to interpret the parameters αϊ through αι 6 as elasticities. E a c h of them represents the percentage change in the market share of Brand Μ that, on the average, has been associated with a 1 per cent change in the particular explanatory variable, other things remaining the same. T h e variables are defined briefly b e l o w : 4 § t = Log. of Brand M's market share in the current week. V l = Log. of Brand M's market share in the previous week. P( = Log. of an index of Brand M ' s base price relative to the base ' The variable definitions as well as the description of the model and the reporting of results are presented in summary form in this paper. For a considerably more detailed discussion of the topics covered, see R. E. Frank and W. Massy, "Estimating the Effects of Short Term Promotional Strategy in Selected Market Segments," in Promotional Decisions Using Mathematical Models (New York: 1967).

Ronald Ε. Frank

173

prices of all the other brands in the market, for the current week. A base price is defined as the "normal" shelf price for the brand, i.e., the shelf price where no deals or other special price offers ρ ι ι are in evidence. t Log. of the base price index for the previous week and the Ρ t—2 second week back, respectively. D( = Log. of an index of Brand M's deal magnitude relative to the deal magnitudes of all the other brands in the market, for the current week. A deal magnitude is defined as the difference between the brand's base price and the price at which it is offered in connection with the deal or special. That is, the deal magnitude is the amount of discount from the base price. Dt-1

) jy ν = Log. of the deal magnitude index for the previous week and the 2 ) second week back. PD{ = Log. of the proportion of Brand M's sales, in units, that were moved under some kind of customer-recognized deal, during the current week·. Ft = Log. of the total retail advertising area for feature advertisements for Brand Μ for the current week. Feature advertisements are those which exceed a certain specified size.

/

Ρ

> = Log. of retail advertising area for feature advertisements for the ) previous week and the second week back. Nt Nt-l>

2) OAt

— Log. of retail advertising area for nonfeature advertisements for Brand Μ for the current and two preceding weeks. = Log. of retail advertising area, regardless of advertisement size, for all competing brands in the market in the current week.

0At-\)

Q^ J> = Log. of retail advertising area for all other competing brands in the previous week and in the second week back. ES( = Log. of the market share that Brand Μ would receive if those families in the sample who actually purchased during the current week bought brands in proportion to their long-run purchase probability vectors, and no one else bought at all. That is, ES is the expected share for Brand M, given that only those families that bought in Week t are in the market. E^t— 1 = Log. of the expected share for Brand Μ in the previous week. The lagged terms (those with Μ or t-2 subscripts) serve as a basis for

174

Prices: Issues in Theory,

Practice, and Public

Policy

measuring the carry-over effects of each of the policy variables. NONCOMPARABILITY

OF

PRICE,

DEAL,

AND

RETAIL

ADVERTISING

ELASTICITIES: Variations in deal coverage introduce difficulties in the interpretation of the price, deal, and retail advertising elasticities that are not offset by the use of our PD variable. A deal of specified magnitude that is available in 10 per cent of the stores in a given area can hardly be expected to affect the over-all market share for its brand (measured over all the stores in the metropolitan area) to the same extent as an equivalent deal offered in 50 per cent of the stores. Including a deal coverage variable in the estimating equation has the effect of holding coverage constant at its average value in the sample, but does not eliminate the "leverage" effect just mentioned. Therefore, price, deal, and retail advertising elasticities reported in this paper do not refer to results that may be expected in any particular situation, but rather are based on average conditions for the market as a whole— given the observed incidences of dealing for Brand M. Thus the relative efficacy of price, dealing, and retail advertising strategies, for either manufacturers or retailers, cannot be compared on the basis of the results given in this paper. Rather, our work is aimed at determining the timing of the price, advertising, and dealing effects, taken separately, and their differences among market segments, as indicated in our opening paragraphs. THE

RESULTS

Three sets of results are reported, namely those ( 1 ) covering the basic model which was developed, using all households included in our sample (hereafter called the over-all share model); ( 2 ) contrasting the response of selected subsets of customers, that is, specific market segments; ( 3 ) describing the highlights of our analysis of the relationship between manufacturer, promotion, and retail advertising behavior. OVER-ALL SHARE MODEL: The results of our analysis, using the aforementioned model relating to pricing, dealing, and retail advertising of Brand Μ and its competitors to Brand M's market share, are presented in Table 12-1. A price change in a given week has a marked immediate response, but leads to offsetting effects in the following weeks. In contrast, there is nowhere near as marked an offset to change in dealing activity. The same is true for feature and nonfeature retail advertising. The effects of both variables become unimportant after the third or fourth week following the event. Consumers probably react differently to a direct price cut as opposed to a deal or to retail advertising. While the consumer-identified deal is more likely to be accompanied by in-store displays and other devices for capturing attention than is a cut in "shelf price," the increased level of awareness

TABLE 1 2 - 1 . Coefficients, t-ratios and Adjusted Elasticities

pt Pt-1 Pt~

2

Regression Coefficients (and t-ratios)

Adjusted Elasticities'

- 1 . 8 2 8 (4.12) .414 ( .88) .225 ( .52)

-1.828 .265 .247

.036(1.77) .029(1.54) .009 ( .46)

.036 .032 .006

Dt Dt-1 Dt-2

-

-

PDt

.004 ( .12)

.004

Ft

.020 (3.54) .008(1.20) .003 ( .54)

.020 .010 .002

Ft-1 Ft-2

-

Nt Nt-1

-

Nl-2

OAt °At-1 0At2

-

ES( ESt-1

5

/-l

R2 R2c

-

-

.008(1.09) .007 ( .96) .004 ( .54)

-

-

.057(1.16) .073(1.56) .019 ( .39) .969(5.17) .161 ( .73)

-

.082 ( .71)

.057 .078 .013 .969 .081 -

.67 .60

-

LRPEh LRDEb LRFEb LRNEb LROAEb a

.008 .006 .003

-1.294 .061 .028 .005 - .121

Adjusted to take into account the assumption of the exponential decay in the effect of a given variable on Brand M's market share over time. For calculation procedures, see Frank and Massy, "Estimating the Effects of Short Term Promotional Strategy in Selected Market Segments," in op. cit. ^Long-run elasticities for price (LRPE), dealing (LRDEj, feature advertising and nonfeatuie advertising (LRNE) by Brand Μ and advertising by competing brands (LROAE). These represent a measure of the net response of market share to a change in a given policy variable, after taking into account the current effects, while assuming that both current and carry-over effects are subject to an exponential decay over time.

c

Adjusted for small sample size.

176

Prices: Issues in Theory, Practice, and Public Policy

is likely to be offset by the knowledge that deals are a relatively routine phenomenon in the market. A change in shelf price may be a salient event for the consumer, while an equivalent change in deal magnitude may not be as important. Thus a relatively larger fraction of customers could be drawn from competitive brands with a shelf-price cut than with a more routine deal. But extra customer saliency attributed to price changes is not achieved without evoking a similar reaction on the part of retailers and competitors. Dealing is a normal practice and thus leads to little, if any, extraordinary modification of retailer or competitor pricing practices, but a shelf-price change seems quite likely to produce price adjustments on the part of these other actors in the market. Two opposing possibilities can be noted: (1) a shelf-price decrease for Brand Μ in a given group of stores may lead to a similar reduction on the part of competitive stores in subsequent weeks; and ( 2 ) a decrease in Brand M's price may lead to cuts in the prices for other brands in the same or other stores. The estimated carry-over effects reflect the most customary competitive behavior as far as retail price and deal magnitude setting are concerned, so these two chains of events would lead to large coefficients with signs which are the same as the current effects and of opposite sign, respectively. The empirical evidence indicates that competitive retaliation is a more important phenomenon than price leadership with respect to a given brand among stores for the market under study. This seems to be a reasonable conclusion, given the fact that private brands are an important component of the total market. Stores might be expected to retaliate against a competitor's price cut on Brand Μ by reducing the price of their own private brand. Price retaliation thus negates some of the favorable effects of shelf-price manipulation. These results suggest that while changes in shelf price do stimulate consumer demand, the rapid retaliation of prices for other brands blunts the edge of this competitive tool. In contrast, deals may tend to be "old hat" for many consumers, but this very fact serves to mitigate the sharpness of competitive reaction. The effect of a 1 per cent increase in feature advertising activity at time t is to increase Brand M's market share at both time t and time f-f-1, though there is a slight negative offset associated with the two-week carryover effect. The initial impact of nonfeature advertising is also positive; however, its elasticity at time t is only 40 per cent of that for feature advertising activity. The nonfeature carry-over effect from week t to week f + 1 is almost as strong in absolute magnitude as that for feature advertising, but it is opposite in sign. In terms of long-run elasticity (Table 12-1), a 1 per cent increase in Brand M's feature-advertising activity has 5.6 times the effect

Ronald Ε. Frank

177

on its market share as a similar change in nonfeature activity. Thus, there appears to be more of a response associated with large retail advertisements than with small advertisements. These hypotheses cannot be tested through the use of a single equation model. The behavior of consumers and retailers must be untangled by building and testing separate structural models of the purchasing and price-dealing behavior of these principal actors of the marketing system. The possibility of building such a model, based in part on the present results, will be discussed in a later section. SELECTED MARKET SEGMENTS: The idea that markets are not homogeneous has been in existence for some time. While economists have often been able to neglect intramarket differences when considering aggregate phenomena, businessmen have long recognized that policies should be individually tailored to as many of the individual strata or segments within their particular market as possible. Wendell R. Smith has summed up these concepts as follows: Segmentation is based upon developments on the demand size of the market and represents a rational and more precise adjustment of product and marketing effort to consumer or user requirements. In the language of the economist, segmentation is disaggregative in its effects and tends to bring about recognition of several demand schedules where only one was recognized before.5 He indicates that lack of homogeneity in demand may be caused by different customs, a desire for variety, or basic differences in needs on the part of various consumer groups. Imperfections in the retail market, or "shopping errors" as he calls them, can also yield market segments with different demand characteristics. The key idea in the quotation is that there may be several distinct demand schedules operating in a given market. Many attempts to study market segmentation have concentrated upon disaggregation based on differences in the level of demand, but the full implications of a segmentation strategy can be understood only if differences in the sensitivity of sales to various kinds of promotional efforts can be measured. However segments are defined, efforts should be made to estimate promotional elasticities for each of them. If this can be done, and to the extent that promotional efforts aimed at the individual segments are under some degree of separate control by management, the marginal analysis models of microeconomic theory provide decision rules for improving sales and profits." ь

W. Smith, "Product Differentiation and Market Segmentation as Alternative Market Strategies," Journal of Marketing, Vol. 21 (July 1956), pp. 3-8. "See, for example, E. W. Clemens, "Price Discrimination and the Multiple Product Firm," The Review of Economic Statistics, Vol. 19 (1950-1951), pp. 1-4.

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The availability of large samples of consumer-panel data opens up the possibility of studying individual market segments in depth. The purchaseby-purchase records for a diverse group of families are available, and they can be sorted into any desired set of segments before being aggregated into time series. Thus the time series for market share, price, deals, and any other panel-based variables can be obtained separately for the individual segments, subject only to the restriction that the sample of purchase records for each week in every segment be large enough to permit analysis. In the section to follow, market segmentation was attempted on the basis of household purchasing and socioeconomic characteristics. The specific segment definitions used in the study are: 1. Household socioeconomic characteristics. A. Households with low education vs. highly educated housewives. B. Households with unemployed vs. employed housewives. C. Low- vs. high-income households. D. Small vs. large households. E. Households with younger vs. older housewives. 2. Household purchasing characteristics. A. Long-run propensity to purchase Brand Μ—households loyal vs. those not loyal to Brand M. B. Light vs. heavy users of the product. Income, household size, wife's age, wife's employment status, and wife's education are frequently used as a basis for grouping customers and defining market segments. Income and education are surrogates for social class, while wife's age and family size are related to the household's stage in the life cycle. Occupation, which is also related to social class, could not be included in the present analysis because our sample size did not permit us to break down the occupational categories found in the data into meaningful groups. Loyalty to Brand Μ and total consumption are included in the analysis because they are used more often than any other purchasing statistics as bases for market segmentation. Marketing literature abounds with references to contrasts involving each of these dimensions. In spite of this fact, there is virtually no published analysis for the effects of this characteristic on household response to policy variables such as pricing, dealing, and retail advertising. In each case the sample of households was divided into two groups on the basis of their relative standing on the socioeconomic dimension being investigated. For example, all families who earned more than $6,000 per year were assigned to the "high-income group" and, conversely, families earning equal to or less than $6,000 were assigned to the "low-income group." For each group they next computed a weekly time series of Brand M's market share, its price relative to the prices of competing brands, the magnitude of its dealing

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relative to competing brands, the extent of its dealing coverage and the magnitude of its retail advertising as well as that of competitors. Using the aforementioned distributed-lag model, these two sets of time series were used as the basis for estimating the current and long-run effects on weekly market share for Brand Μ of the changes in the pricing, dealing and retail advertising activity of both Brand Μ and its competitors. The break points for each socioeconomic characteristic are presented in Table 12-2. A family is designated as a "loyal" Brand Μ customer if it bought more of Brand Μ than any other single brand over the 2-year period covered by the data (i.e., Brand Μ was the family's modal brand). This is a well-known definition for brand loyalty, having been first used by Cunningham 7 in his pioneering quantitative study of the phenomenon. Light users of the product are defined as those households who purchased less than or as much as a certain specified annual amount during the period of the investigation. Heavy buyers are correspondingly those who purchased more than the rate specified. The rate is set so that approximately onehalf the number of ounces purchased in the market during the 101-week period are purchased by those households that are defined as light users. The principal findings resulting from the analysis were as follows: 1. Socioeconomic Characteristics A. Housewife Education. For the most part differences in the response pattern of low- vs. high-education households were consistent with Table 12-2. Break Points, Per Cent of Households and Ounces Bought in Low Segment for Each Socioeconomic Characteristic Socioeconomic Characteristics Income Household Size Housewife Age Employment Education a

Ь

Break Point

Low Ounces Bought Per Cent3

Low Households Per Cent

$6,000 2 Persons

38.8 61.5

48.5 58.5

42 years 0b 12 years

45.4 69.7 73.6

45.8 69.0 70.0

Hoiseholds belonging to the low segment have a value in terms of the relevant socioeconomic characteristic equal to or less than the one stated in this problem.

"0* (zero) stands for a household with an unemployed wife, while 1 is the code for a hoisehold when the wife is employed.

T

R. Cunningham, "Brand Loyalty—What, Where, How Much," Harvard Review Vol. 34 (Jan.-Feb. 1956), pp. 116-128.

Business

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Prices: Issues in Theory, Practice, and Public Policy with the notion that higher levels of education tend to be associated with both a faster rate and a greater degree of adaptive activity in the face of change. The long-run effects of changes in Brand M's pricing, dealing, and feature retail advertising activity were greater for the highly educated market segment. In addition, the current response to market share in the highly educated market segment to changes in pricing, dealing, feature, nonfeature retail advertising was consistently greater than that for the low-education segment. The differences in the responses of these two groups to promotion, while not significant at the 0.95 level, were significant at the 0.90 level, so that one may be fairly confident that the two education groups respond differently (though the differences involved are slight). B. Housewife Employment. Households with unemployed housewives were more responsive to both current and long-run changes in price. Unemployed housewives may be more interested in the home, better informed and/or in a more flexible position to spend the shopping time necessary to take advantage of price offers. There appears to be no clear-cut pattern to the current and carry-over effects of dealing. It was as though the impact were some number close to zero with sampling variability accounting for the fluctuation in the observed direction of the effects. Though the differences between the responses of the two groups are not significant at the 0.90 level, there still is fairly good chance that they, like those for education, are real but small in magnitude. This same argument pertains to the results for the income segments which are discussed in the next paragraph. C. Income. One might expect that the lower a household's income the more sensitive it would be to changes in the offers made by manufacturers, especially changes in relative price. At first the results seemed to be inconsistent with this expectation in that the long-run elasticity with respect to price is greater for the low as opposed to the high-income market segment, thus confirming the hypothesis, while the opposite was true of the current price elasticities. However, it may well be that high-income families do more stocking up in response to price changes than do their low-income counterparts, thus making them appear to have a greater price sensitivity in the short run. In other words, both inventory practices and sensitivity to price may vary by income. The differences in response to dealing appear to have no consistent pattern, whereas the low-income elasticities for nonfeature advertising were consistently lower than those for the high-income segment. The responses of the two groups tend to converge when

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one looks at the effects of feature advertising. It may be that lowincome households have a higher threshold of response to retail advertising than do their high-income counterparts. D. Household Size and Age of Housewife. The observed differences with respect to segments formed on the basis of either household size or age of housewife were so slight as not to justify detailed interpretation. The two least important socioeconomic characteristics in terms of response differentiation are household size and housewife age. Both of these characteristics are associated with the concept of life cycle. Relatively speaking, education, income, and employment are more effective bases for segmentation. The first two of these characteristics, and to a lesser extent the third, are associated with the definition of social class. In other words, in terms of response differentiation, social class seems to be a more important basis for market segmentation than does life cycle for the product under study. 2. Purchasing Characteristics A. Total Consumption. What differences in response characteristics with respect to pricing, dealing, and advertising might one expect when contrasting light and heavy buyers? On average, light buyers buy less often than do heavy buyers. The per capita consumption rate for light-buying households is lower than that for the other category. It would seem reasonable to assume that light-buying households tend to be less interested and less well informed with respect to current price, dealing, and advertising conditions in the market, let alone to changes in these conditions over time. Probably a greater proportion of the purchases of light-buying households are accounted for by special needs such as entertainment. In fulfilling these needs, more attention is probably paid to the nature and immediacy of the occasion than to the offers made by alternative brands. These characteristics lead one to expect a lower proportion of the week-to-week variation in demand for Brand Μ to be accounted for in the case of light buyers as opposed to heavy buyers. The results are consistent with this expectation. The proportion of variance in Brand M's market share explained in the heavy-buyer segment is 0.59, while in the light-buyer segment it is 0.50. In addition, light buyers are probably less sensitive to the long-run changes in pricing policy. They are probably also less responsive to current price changes and tend to do less stocking up. The results are consistent with this assertion. The current effect of a 1 per cent cut in price on Brand M's market share is greater for heavy buyers than for light buyers. However, the carry-over effects are also greater

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for heavy buyers. Heavy buyers apparently stock up more than light buyers. In spite of this difference in stocking up, the long-run sensitivity of heavy buyers to changes in relative price is still greater than that of light buyers. The pattern of effects of dealing among heavy buyers is similar to that of pricing. The rationale is the same as that previously discussed. The long-run effect of feature advertising is greater for light than for heavy buyers, while the opposite is true for nonfeature advertising. It may be that it takes an advertisement the size of a feature advertisement to affect the awareness of a substantial proportion of light buyers. Small advertisements may tend to be selectively screened out by light buyers, leading to a considerably smaller net effect of market share. Going from a nonfeature to a feature advertisement accomplishes little by way of increased response among heavy buyers as opposed to light buyers due to what is probably the already high level of their knowledge and awareness. In spite of the fact that the observed differences in response between the heavy- and light-buyer segemts are consistent with expectations, they nonetheless are not significant at the 0.95 level. However, there is still a fair chance that there is a real, though modest, difference in response between the two groups. B. Brand Loyalty. Families that are habitually loyal to Brand Μ might be expected to be less sensitive to changes in the relative price of the brand than would families who rely on it for only a portion of their needs. This is particularly likely if, as is the case here, the favorite brand is not normally the lowest-priced brand in the market. If families become habitual purchasers for some other reason than price, it is less likely that they will change their behavior in the short run because of price fluctuations. The argument for deals is much less clear. Customers who are not strongly committed to any particular brand should be more likely to take advantage of special offerings than those who are highly loyal to brands other than Brand M. The nonloyal market segment defined in this study contains a greater proportion of "drifters" than does the loyal group, so we might expect the former to be more sensitive to deals. On the other hand, families loyal to Brand Μ may well become aware of its dealing activity more rapidly than nonloyal ones; this kind of behavior is consistent with findings from research on selective perception and promotion. People tend to remember the things in which they are most interested and loyal families are presumably anxious to obtain their favorite brand at a discount. Thus, there is some reason to expect that loyal customers may be more, rather than less, sensitive to deals.

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What are the objectives of dealing activity, as far as Brand Μ is concerned? Aside from the possibility of stimulating retailer interest and obtaining the corollary benefits of better shelf facings and local promotion, the primary reason for dealing is to attract customers who are not already loyal to the brand in the hopes of modifying their future purchasing behavior. Families who are loyal to the dealing brand get a free ride. Therefore, management hopes that nonloyal consumers are more sensitive to deal magnitudes than are loyal ones. Loyal families might also be expected to be less sensitive to the effects of retail advertising, whether it be feature or nonfeature, for Brand Μ on the one hand or total retail advertising for all other competing brands on the other. While the differences observed between the price, deal, and advertising regression coefficients for the loyal and nonloyal family groups in this study are far from significant at the 5 per cent level, some tentative hypotheses are suggested by the data. First, the current price elasticity of loyal customers is less than that of the nonloyal group. The same tends to be true in the long run. The nonloyal families tend to have a stronger reaction to changes in price, but they are also more receptive to the competitive price adjustments that tend to follow these changes. The loyal families also tend to be less responsive to dealing than the nonloyal segment. There seems to be some tendency for their carry-over effects to become negative after the second week; this is consistent with the idea that deals tend to steal demand from future periods. For the most part, the differences between loyal and nonloyal households with respect to their responses to retail advertising are relatively slight. This is particularly true for feature advertising for Brand Μ and retail advertising by competing brands. In the former case, nonloyal households are more sensitive than loyal households, while in the latter situations the opposite relation occurs. These differences, however, are so slight that they could easily be due to sampling variation. The negative sign associated with the long-run effect of nonfeature retail advertising for loyal Brand Μ customers is probably just the result of chance variation. There is no rationale that we are aware of in the context of this particular market that would support the possibility that there actually is a negative relationship between the level of nonfeature retail advertising activity for Brand Μ and its market share. Neither the socioeconomic characteristics nor the purchasing characteristics that have been discussed appear to be particularly effective bases for market segmentation. Though most of the results consisted of only

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modest differences between segments, nonetheless these "negative findings" do have a positive value. For some of us they add to the weight of evidence favoring what we already believed, while for others they may have had a somewhat greater surprise value. THE RETAIL SECTOR: Retailer behavior is one of the most neglected areas of research on marketing management problems. While the "marketing institutionalists" have made significant contributions to theory-building and empirical analysis with respect to the behavior of retail units, their emphasis has been on the influence of retail competition on price-setting and promotion rather than on the influence of manufacturers' offers. Yet from the O.R. point of view, the latter is the key set of relations and the former take the role of intervening variables. It is impossible to predict the effect of a change in manufacturers' promotional strategies upon sales and profits without considering the reaction of the retail middlemen. For food products in particular, the retailer controls a large proportion of the potential impact of promotion through price-setting, allocation of shelf space, newspaper advertising, and special deal offerings. The influence of manufacturers' decisions with respect to product and package design and mass-media advertising is conditioned by the activities of retailers. Our attempts to model retailers' behavior make use of the advertising data mentioned above in connection with the consumer model, together with information on the promotional allowances offered by the manufacturers of the major brands in the market. These allowance data are broken down by type of allowance (e.g., whether certain types of advertising or display performance must be demonstrated by the retailer in order to qualify for the money). They were available on a weekly basis for the period covered by the study. In addition, some data on shipments of the product from manufacturers to retailers were also available for analysis. The research was designed to answer the following questions: ( 1 ) What is the effect of manufacturers' promotional offers on the probability that retailers will advertise that manufacturers' brand in a given week? ( 2 ) To what extent are the prices mentioned in the retailers' advertisements related to the size of promotional allowance or other factors under the control of the manufacturers? Certain variables relating to the timing of advertisements by individual chain stores and competitive interactions between the advertising decisions by various stores had to be included in the model in order to get pure measurements of the factors cited above. The models are rather complicated and the results of several different methods of analysis had to be combined to obtain an integrated set of conclusions. The major conclusions will be sketched briefly in the following paragraphs. 1. The existence of a promotional allowance is strongly related to the probability that a retailer will advertise and, to a lesser extent, to the size of the advertisement. This result held up across all the brands

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considered separately in the analysis, and for both the chain and independent store categories. 2. The effect of the size of the promotional allowance is not linear, but, rather, appears to follow an inverted S-shaped curve. The relatively large effects obtained with fairly small allowances are followed by a long plateau; further effects can be obtained only at unusually high allowance levels. 3. The size of the allowance effect is strongly related to the market share of the brand in the particular store whose advertising is being considered. In this case it appears that, "Them that has, gets," since large market shares lead to increased sensitivity to promotional incentives. Retailers also advertise more in the absence of allowances if the brand's market share is large. 4. The type of allowance appears to have a substantial effect on the advertising performance of retailers, but the direction of the effect varies according to brand. In general, the type of allowance used most often by the brand gets the largest advertising response from retailers. 5. The level of competitors' allowances exerts a depressive effect on the level of retailer advertising for all brands, but the dominant one in the market. Competitive pressure actually appears to increase the level of advertising for the dominant brand. 6. There is a definite periodicity to the probability that stores will advertise particular brands. The probability is much lower immediately following an advertisement than it is later. This suggests that the probability density of the intervals between advertisements for a particular brand by a given store may be expressed in terms of a gamma distribution. 7. Given that a retailer has decided to advertise, the size of the promotional allowance exerts little influence on the price (if any) mentioned in the advertisement. There appears to be little tendency to pass on allowance savings to consumers in the form of advertised prices. (Some passing may occur in the form of unadvertised prices, however.) The relations uncovered in this study provide definite guidance for the formulation of a simulation model of the manufacturer-retailer-consumer system. In addition, they suggest new research approaches that might be applied to the original data and generalized for other markets. 8 R E S E A R C H IN PROGRESS

We have initiated a second major step forward in modeling the aforementioned market. The results reported in this paper are based on a single8

For a more detailed discussion of the results in this section, see W. Massy and R. E. Frank, "An Analysis of Retailer Advertising Behavior," Journal of Marketing Research, Vol. 3 (1967).

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equation model. Our current research activity is focused on developing a multiple-equation system, that is, a structural model of the consumer sector. As is well known, single-equation models fail to unravel many of the interrelationships of importance in an operating system. For example, in our case, our efforts to date fail to take fully into account the competitive interrelationships between brands, let alone those between the various package sizes of a given brand. In addition, our model does not incorporate the effects of various forms of in-store promotion such as displays and window banners. Qosely related to this issue is yet another problem. Our unit of measure is a week in a given metropolitan area. This measure aggregates what may well be quite a heterogeneous market structure existing within various stores. We have only a limited insight into this problem, as some work has been done on purchases made in one type of store (say, A & P ) . However, we are still faced with a substantial aggregation problem across stores. We are presently in the process of running a panel of stores in a given metropolitan area. For each store we are collecting data by week (for a year) for each brand-package-size combination of the product sold in the store. Our data for each combination will include a detailed description (once more, on a weekly basis) of the pricing, dealing, shelf display, special display (e.g., an isle display), window banners, retail advertising, and so on. Using this information, together with a multiple-equation model which we have developed, we hope to come much closer to embracing "reality" in a managerially useful fashion. We plan to estimate the model's parameters separately with each store. If we assume that there are 20 stores, 5 brands, and 5 package sizes, and, further, that there is an equation for every brandpackage-size combination in each store, a total of 500 equations would be required as a basis for the analysis. The actual scale of the project will be somewhat greater than the magnitude implied by these figures. This type of microanalysis, we believe, will provide us with a much clearer picture of the structure of the market with which we are dealing. If successfully completed, it will serve as a major building block in our artificial test market.

CHAPTER THIRTEEN PSYCHOLOGICAL PRICING IN THE FOOD INDUSTRY by Lawrence

Friedman

The food industry presents many interesting examples of the use of psychology in pricing. Manufacturers, wholesalers, and retailers have developed a number of patterns in their handling of numbers related to their business. The "magic numbers" seen in all phases of the business have a significant effect on the design of products and marketing strategy. The purpose of this paper is to describe the pricing patterns which seem to exist in the food industry and hopefully to suggest a few hypotheses which may explain the reasons for them. While it is easy at first glance to criticize some of these patterns as being irrational, tradition-bound, and costly, a deeper understanding of the reasons behind them will often show a great deal of wisdom on the part of the food industry. As in any sector of a free, competitive economy, the patterns will tend to stabilize in a given position. Deviations from these accepted patterns more often than not are punished by the ultimate judge, the market. The best preparation for reading this paper is a walk in a few grocery stores and perhaps a chain warehouse. While no two grocery stores or chain of stores behave exactly alike, there is a certain general consistency in their pricing patterns and in the patterns of their suppliers. In particular this paper will discuss the following: 1. Selling units per case—the rule of 12 2. Retail pricing—The rule of 9 and 5 3. Multiple items—Two for and three for 4. Wholesale case prices—9 and 5 again 5. Unit weights—The pound multiple 6. Discounts—The Rule of 5 SELLING U N I T S PER C A S E — T H E R U L E OF

12

The number of selling units packed in a case has an interesting pattern in the food industry. Table 13-1 shows the distribution of the number of selling units per case taken from a complete listing of 3115 food items carried by a major grocery chain. An examination of Table 13-1 shows the following features: 1. Almost all of the distribution is on even numbers. Less than 0.3 per cent of the items listed had an odd number of selling units in a case. 2. Multiples of 12 were the most popular, especially 12 and 24, which

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TABLE 1 3 - 1 . DISTRIBUTION OF SELLING UNITS PER CASE ON ALL FOOD ITEMS LISTED BY A MAJOR CHAIN Number of Selling Units Per Case

Number of Food Items in Listing

Percentage of Cases of Each Size

1 2 4 5 6 8 10 12 16 18 20 24 25 30 36 48 50 54 72 96 100 144

4 7 22 4 61 6 17 1161 2 37 90 1471 5 1 8 175 10 1 22 4 1 6

0.13 0.22 0.71 0.13 1.97 0.19 0.55 37.27 0.06 1.19 2.89 47.22 0.16 0.03 0.26 5.62 0.32 0.03 0.71 0.13 0.03 0.19

Total

3115

100.00

accounted for 74.49 per cent of all items listed. The determination by manufacturers of the number of units in a case is a result of many factors including: 1. The economics of packaging. 2. Expected turnover rates in retail stores. 3. Tradition 4. Methods of selling individual units. 5. The weight of a selling unit. While tradition plays an important part in determining units per case, essentially "the rule of 12" follows for a very logical reason—12 is a highly divisible number.

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In putting cans, bottles, boxes, etc., into a case, for efficient packing, the number of units must be even. (The case is symmetrical in shape.) Multiples of 12 are divisible by more numbers than any other—2, 3, 4, 6, and their multiples. This gives some flexibility to the design of a case, since there are several methods of arriving at a case of 12, 24, or 48 units. In setting up a display, an even number of units is desirable, and again multiples of 12 allow 2, 3, or 4 facings with a symmetrical number of units. In selling, the multiple unit is frequently used, especially for displays. Two, 3, and 4, which we shall discuss later, are the most popular multiples. Again this favors the multiple of 12. Twenty-four is the most popular case size followed by 12 and then 48. The higher the multiple, the larger the inventory for slow-moving items and if the item only sells 20 or so units a month, which is not uncommon, a 48unit case or even a 24-unit case would result in high inventories and possible quality deterioration in many food products in which aging is a factor. Thus the particular multiple of 12 used in sizing cases very often depends on the turnover rate in stores using the product. Tradition is important in the food industry, and once a particular casesize number becomes established in an industry, it is difficult to change even if the original reasons for the case size no longer apply. A buyer thinks in terms of cases, not units. His brand comparisons on turnover are remembered in cases per week or cases per month. A case-size number greatly different from the norm may confuse the buyer or his inventory control computer which has not had the special adjustments on cases put into it. This is not serious, perhaps, but may be just another small annoyance to a buyer who must memorize a great many numbers and furnishes a bit of evidence to him that the deviating manufacturer "just isn't with it." The weight of a single unit is important in the case-size decision, since in the many stages in the distribution channel cases may be moved by hand, and some of the movers may be women, especially at the retail level. This tends to put a maximum weight on case size. RETAIL PRICING—THE

R U L E OF 9 A N D 5

One of the most interesting of price phenomena in the food industry is the tendency for retailers to use prices with odd numbers and especially those ending in 9 or 5. The origin of this practice can only be conjectured, but retailers today believe that they get best results when their price ends in 9 (e.g., 29 cents, 39 cents, 49 cents, etc.). The second choice seems to be 5. Prices ending in 7 or 3 are sometimes seen but much less frequently than 9 or 5. Even numbers and prices ending in 1 are rarely seen. Although $1.00 is seen on occasion, three-digit prices are rare.

TABLE 1 3 - 2 . I N D E X O F P R I C E S F O U N D IN R E T A I L NEWSPAPER A D V E R T I S E M E N T S 10

20

30

40

50 I

60 70 80 I ι I M e t h o d of Charting Prices

90 I

100

The chart shows the relative frequency with which the different prices were featured in the newspaper advertising of retail food stores. Hie number of times that the most frequently used price (491) was noted has bee· made equal to 100, and the frequency of all other pricei has been related to that 100. For example, the number of times that 354 was noted is charted as 31, because this price appears with 31% of the frequency of the 49< price. Only prices with a frequency ratio of 3 or more are charted.

10

20

30

40

50

60

70

80

90

100

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Lawrence Friedman

Table 13-2 shows a distribution of prices taken from a large sample of newspaper advertisements. Table 13-3 shows a distribution of recommended retail prices by a leading independent wholesaler on 3326 items. These data are typical of the retail prices seen in the food industry, and the pattern has been going on this way for years. The only difference is that prices with higher first digits have become more popular over the years as the cost of living has risen: In general the observation of retail food prices show: 1. Prices ending in 9 are by far the most popular. 2. Prices ending in 5 are second in popularity. The 9's and 5's will often account for 80 per cent or more of the retail prices seen. 3. Prices ending in 3 and 7 are next in popularity with 3 slightly more popular than 7. TABLE 13-3. DISTRIBUTION OF 3326 RECOMMENDED RETAIL PRICES $1.00 AND LESS BY INDEPENDENT WHOLESALERS Retail Retail Retail Retail Price Frequency Price Frequency Price Frequency Price Freque (cents) (cents) (cents) (cents) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

19 3 2 6 27 4 9 —

61 10 48 15 62 58 51 70 32 122 37

21 22 23 24 25 27 28 29 30 31 32 33 34 35 37 38 39 40 41 42

76 60 84 34 155 85 5 215 2 93 4 135 2 139 104 1 261 8 87 3

43 45 47 49 50 51 52 53 54 55 57 59 61 63 64 65 67 69 70 71

130 104 20 162 1 7 1 61 1 44 25 128 3 25 3 39 6 102 2 1

72 73 74 75 77 79 81 82 83 85 86 87 89 93 95 96 97 98 99 $1.00

1 15 1 25 1 57 —

1 7 13 1 11 57 2 16 1 2 36 21 4

TOTAL 3326

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4. Prices ending in 1 are seen occasionally. The higher the first digit, the less likelihood of seeing a 1. 5. Even number prices over 20 cents, with the exception of $0.98 and $1.00, are seldom seen. 6. Three-digit prices are seldom seen. 7. The most popular unit prices are in the 25-to-49-cent range. Figure 13-1 breaks out the frequency distribution of prices ending in 9 and 5 from the data shown in Tables 13-2 and 13-3. The envelope of the frequency distribution of 9's and 5's is a good illustration of the range of popular prices. Figure 13-1 also shows the increasing popularity of 9 relative to 5 as the retail price level increases. Retail pricing clearly depends on: 1. The manufacturer's price. 2. The desired mark-up for the product category. 3. The actual price range. 4. The "magic" numbers nearest the "fair" price. Size and type of store and location in the country will often determine the retailer's conception of a fair mark-up and these will vary throughout the country, but the idea of "magic" retail-price numbers seems to be national.

RETAIL PRICE

ENVELCrtS OF RELATIVE PRICE FREQUENCY FOR PRICES EN DWG IN 9 AND 5 LUFT SC ALE-SOLID UN ES ADVERT1SED RETAIL PRICE INDEX (TABLE 2) RIGHT SCALE-DOTTED LINES RECOMMENDED RETAIL PRICES BY AN INDEPENDENT WHOLESALER (TABLE 3)

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It really makes little difference to the manufacturer whether the retailer is right or wrong in establishing these psychological prices, since the majority will set prices with "magic numbers," right or wrong. Therefore, most manufacturers design their package size and trade price with a likely "magic number" retail price in mind. Of course, if the retailer is dead wrong in his conception of psychological price, with the consumer reacting best to a price ending in 1 or 2, manufacturers and retailers trying for prices ending with these digits would ultimately get more sales. Since this "magic number" concept has existed a good many years, it is hard to believe that the food retailer is wrong in his understanding of price psychology. The basic idea behind the psychological price must be that the average retail-price elasticity is greater when moving away from a psychological price than when moving toward it. For example, the price elasticity in moving from 59 cents to 61 cents might be -1.5 for a product, whereas it may be only -1.0 in moving from 57 cents to 59 cents. There are several possible hypotheses which might explain the "magic number" phenomenon, although the true explanation, if there is one, would require a great deal of study and experimentation to be confirmed. One reasonable hypothesis is based on the fact that the nickel is the fundamental coin in making purchases under a dollar. The consumer's attitude may well be that basically all prices are multiples of 5 cents. Thus, when the consumer sees a 49-cent price, his reaction is that the true price is 50 cents and the retailer is giving me a penny "discount." When the price is 51 cents, the consumer imagines that "the true price is 50 cents and the retailer is trying to take an extra penny from me." Prices ending in 5, like 35 cents and 45 cents, may be thought of as "fair" prices. Prices ending in 7 are probably thought of more as an increase from a "fair" price of 5 than a decrease from a "fair" price of 10. A price ending in 3 may be partially viewed as an increase from zero and partially as a decrease from 5. This hypothesis does explain the apparent relative order of the popularity of the second digits 9, 5, 3, 7, 1. Note that the only apparent bargain in the list is 9, which may explain its great popularity. In actual fact, the consumer today may well be right. Because of the lure of the "magic numbers," it is probably a good bet that prices ending in 9 do in fact have an average mark-up lower than prices ending in 1. Even numbers are conjectured to have disappeared for the simple reason that they are divisible by 2. With an odd price, the consumer's temptation to buy half the offered quantity for half the price is reduced. This is probably less important today than it was many years ago when fresh produce was offered by the pound and not in a can. Half- and quarter-pound purchases would be discouraged by the odd-penny increase. Another interesting hypothesis is that looking at prices is a process of

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comparing numbers. A comparison of numbers can be done in several ways. 1. Compare the arithmetic value of the numbers. 2. Compare the first digits of the numbers. 3. Compare the second digits of the numbers. 4. Compare the sum of the digits of the numbers. Thus the perceived difference of the numbers will be some weighting of the above factors. This weighting would differ from individual to individual and depend on the time and circumstances during which the numbers were compared. Let Δ Pi = percentage difference in arithmetic value of two prices; Δ Ρ2 = percentage difference in first digits of two prices; Δ Ρ я = percentage difference in second digits of two prices; Δ Ρ4 = percentage difference in sum of two digits of two prices; Then, the "perceived" percentage difference of two prices will be лР, where ΔΡ = C.AP, + C 2 \ P 2 + С 3 ДР 3 + С 4 лР 4 The values of C b C 2 , C 3 , and C 4 depend on the relative importance of the 4 factors. To illustrate the hypothesis, let us examine 2-cent price differentials at various prices between 19 cents and 31 cents. For illustrative purposes we have taken C, = 0.90, C 2 = 0.08, C 3 = 0.01, and C 4 = 0.01.

TABLE 13-4. METHODS OF COMPARING TWO PRICE NUMBERS Prices Compared

Arithmetic Number

First Digit

Second Digit

Sum of Digits

19f 2U 214-234 23Ф-254 254-274 214-294 294-314

+ 10.5% + 9.5% + 8.7% + 8.0% + 7.4% + 6.9%

+100% 0 0 0 0 + 67%

-89% +200% +67% +40% +29% -89%

-70% +67% +40% +29% +22% -64%

Weighted Total 'Perceived Difference' + 15.9% + 11.2% + 8.9% + 7.9% + 7.2% +10.0%

While this hypothesis may help explain the popularity of the 9's, it does not explain why the 5's are second choice. Perhaps the 9's are so psychologically correct that the 5's represent a best intermediate step between the 9's, where a change from a 9 to another 9 is too large a step percentagewise. In considering retail prices it must always be remembered that the manufacturer has a single price. There is a wide distribution of retail prices due to store size, store policies toward a given category or brand, and section of the country.

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An example of the type of distribution seen is shown in Table 13-5. Two surveys, taken one year apart, show the distribution of retail prices 5 months before and 7 months after a change in manufacturer price. The initial price was 39.2 cents per unit. The average retail price before the increase was 48.4 cents per unit and the average retail price after the increase was 52.6 cents per unit. The average mark-up rose from 19.0 per cent to 19.4 per cent. Before the price change the modal price was 49 cents. Special price promotions in a number of stores resulted in some pricing at 47 cents and even 45 cents. The price change was aimed at a modal price of 53 cents, which indeed resulted. Over a period of time, though, a gradual drift toward 55 cents was noted in a number of stores. TABLE 13-5. DISTRIBUTION OF RETAIL PRICES

Retail Price 43 4 444 45 4 464 474 48 4 49 4 504 514 52 4 53 4 5M 55 4 564 514 58 4 59 4

Before Price Change Percentage of Sample at Each Retail Price

After Price Change Percentage of Sample at Each Retail Price

1% 18%

2%

20% 1% 43%

9%

7% 1% 9%

13% 9% 1% 30% 2% 25% 5% 4%

Average Retail Price

48.44 / unit

52.6^ / unit

Purchase Price

39.2φ / unit

42.4^ / unit

Average Retail Mark-up

19.0%

19.4%

TABLE 3 - 6 . MULTIPLE-ITEM PRICE FREQUENCY 10

20

30

40

50

60

70

80

90

100

Method of Charting Multiple Item Pricing This chart shows food stores pricing practices as applied to the offering of more than one item. The number of times that the most frequently used price (2-294) was noted has been made equal to 100, and the frequency of all other prices has been related to that !00. For example, the number of times that 2-35 4 was noted is charted as 62 because this price appears with 62% of the frequency of the 2-294 price. In this chart only prices with a frequency ratio of S or more are shown.

70

80

90

100

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Friedman MULTIPLE

ITEMS—Two

FOR AND T H R E E

FOR

In the battle for the consumer's dollar, we find a great many multiple items being offered for a special price (e.g., 2 for 29 cents). This is invariably found in end displays and even on regular shelf positions and is yet another manifestation of psychological pricing by the retailer. It is an effective way of communicating the idea that a special price is being offered if the consumer will buy more than a normal quantity of units. Table 13-6 shows a distribution of multiple-item prices seen in newspaper advertisements. The largest frequency, 2 for 29 cents, was indexed at 100 and all other frequencies were computed in reference to it. An examination of this data, which is typical of the multiple-item prices found in food stores, reveals the following: 1. Up to a price of $1.00, multiples of 2, 3, and 4 are used extensively with 2 being the predominant multiple. 2. Only odd prices are seen up to $1.00. 3. Again the 9's and 5's dominate, with 7's and 3's also seen on occasion. 4. The multiples are such that they never divide evenly into the price. 5. $1.00 is a popular price for 3 or more items. Multiples of 2, 3 and 4 are believed popular because they are easy to divide by, especially 2. The consumer and the checkout clerk must easily compute the single unit price. This is most important for the consumer since he must recognize that buying a single unit is less economical by 1 cent a unit. Without this recognition, the multiple-item offer loses some appeal. Two, three, and four are all divisors of 12, the most popular case size. This is convenient for setting up displays. The pattern of 9's and 5's has been previously discussed. Again, these prices seem to be the "magic numbers" at the retail level. $ 1.00 seems to be an exceptionally popular price for multiples. Perhaps this is due to the difficulty the consumer has in dividing into three figure numbers. Prices above $1.00 are not popular in food stores and $1.00 is the "last of the good numbers." WHOLESALE

CASE P R I C E S — 9

AND 5

AGAIN

With most cases being multiples of 12 units, one might expect to find even-number case prices dominating. However, manufacturers apparently like to use psychological prices on their customers, too. A distribution of the last digit on prices offered by manufacturers to retail stores is found in Table 13-7. While the popularity of 9 and 5 in the last digit is not as distinct as in retail pricing, they are still the predominant psychological prices and probably for the same reasons.

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Prices: Issues in Theory, Practice, and Public Policy TABLE 13-7. FREQUENCY DISTRIBUTION OF LAST DIGIT IN WHOLESALE CASE PRICES The Last Digit of Wholesale Case Prices

Frequency of Last Digit in Wholesale Prices to Retailers

Percentage

0 1 2 3 4 5 6 7 8 9

677 263 521 498 461 953 278 609 475 868

12.1% 4.7% 9.3% 8.9% 8.3% 17.0% 4.9% 10.9% 8.5% 15.5%

Total

5,603

100.0%

Here 0 in the last digit is also popular, and 1 is the least popular digit of all. UNIT WEIGHTS—THE

POUND

MULTIPLE

The distribution of unit weights shows no "magic weights" in ounces, with the exception of the pound and half-pound, as might be expected. It is likely that multiples of the pound were seen much more frequently years ago. The shift from fresh produce to cans and packaged foods has made the "magic price numbers" more dominant. Weights tend to move toward the quantities which can be offered at the "magic price numbers" rather than prices being controlled by "magic number weights." Other consumer-oriented factors determining the unit weight today include the number of servings in the package, the volume of space taken up in the home food-storage area, and the ease of movement of the unit by the intended consumer. D I S C O U N T S — T H E R U L E OF 5

Everybody likes a bargain. Cents-off specials for the consumer with a cent-off label on a regular package have become very popular. These special off-price promotions draw attention to the package and also allow the manufacturer to make a price reduction on a product for a limited period of time, at his own choosing. They can be tied into special advertising campaigns, help smooth out low seasonal production periods, counteract competitive moves, and in general meet a number of marketing requirements.

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Friedman

Retailers and wholesalers are not immune to bargains. Price reductions per case by the manufacturer are popular means of inducing a wholesaler to try a new item with a hope of special display and/or price discount. Cents-off labels and trade discounts have the opposite psychological motivation of ordinary pricing. The object is to make the discount number appear large to the buyer, whereas in pricing the object is to make the price number appear small to the buyer. The distribution of cents-off labels offered at a given time by the independent wholesaler mentioned earlier is shown in Table 13-8. With 3326 items listed, there were 130 cents-off promotions being offered. The data shown here are rather typical of the cents-off labels seen in a store. The number of cents marked off on a label relative to the number of items listed may not be typical since they vary with time of year and marketing trends. Cents-off labels, like other marketing techniques, seem to have periods of relative popularity and relative unpopularity. The amount of the cents marked off on the label depends on ( 1 ) the regular price of the item (2) what the manufacturer can afford to give in TABLE 13-8. DISTRIBUTION OF CENTS-OFF LABELS BEING LISTED BY AN INDEPENDENT WHOLESALER Amount off Regular Price

Frequency

24 Η 4 54 Η 74 Η η w 12φ 15 φ 17 4 20 4 25 4 зо 4 504 75 4

3 12 15 27 4 13 3 1 20 5 12 1 7 1 4 1 1 130

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the way of a discount ( 3 ) what he feels will appeal to the consumer as a discount. The latter is what we are concerned with here, and in general, we find: ( 1 ) Multiples of 5 cents are the most popular. ( 2 ) Even-number discounts are relatively more popular than odd numbers. ( 3 ) One-cent discounts are never found, and even 2-cents-off-labels are becoming rare today. ( 4 ) Ninecents-off labels are the rarest of all. The psychology and price patterns appear to be almost the reverse of what we find occurring in regular pricing. The patterns are most evident when the cents marked off on a label are 10 cents or more. Below 10 cents off, the amount the manufacturer can give tends to be of more importance than consumer psychology. It would appear that retail and wholesale buyers are even more prone to psychological numbers when it comes to discounts. A distribution of 80 trade discounts offered to retailers by the same independent wholesaler is shown in Table 13-9. All trade discounts are offered by the case. The pattern in trade deals is much more obvious.

TABLE 13-9. DISTRIBUTION OF TRADE DISCOUNTS OFFERED TO RETAILERS BY AN INDEPENDENT WHOLESALER Trade Discount Per Case

Frequency

10* 15* 204 23 4 25 4 304 35 4 404 45 4 50tf 604 704 7 54 loo 4 1504 2004

3 12 2 1 7 5 14 1 1 18 1 1 4 4 4 2 80

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1. Only multiples of 5 cents are used. 2. Multiples of 25 cents when they can be given, are very popular. Of all the psychological pricing in the food industry, this pattern may be the least logical. Units per case are usually multiples of 12, primarily 12, 24, and 48, and yet the case discounts tend to be 15 cents, 25 cents and 50 cents rather than 12 cents, 24 cents, and 48 cents. Apparently the manufacturers have found that 5-cent multiples are most effective with the buyers. Much of the psychological pricing in the food industry which we have just discussed has now become traditional, and in many cases for very good reasons. Even those traditions which are difficult to explain perhaps have good foundations if explored in greater depth. In any event, we now ask the rather important question, "If there is no valid reason for a traditional pricing pattern today, should it be changed?" To answer that question fully we may have to delve into the fundamental nature of a transaction. All marketing theorists agree that the best transaction is one in which both buyer and seller are satisfied with the result. If there is any rationale at all to the use of "magic numbers" in pricing, it must be that the buyer "feels" better when he has bought at a good psychological price. If it makes him feel that he did better in buying 39 ounces for 39 cents rather than 40 ounces for 40 cents, then the entire seller-buyer interaction is enhanced, and everyone benefits. In other words, adding psychological value to a transaction is a positive contribution to the transaction in much the same way as a smile or pleasant word from the seller. This does not mean that traditional pricing practices should never be changed. Any time there is a new development in the industry which offers a valid reason for a new pricing practice, the first seller who can demonstrate its value is very likely to be rewarded by his customers.

CHAPTER FOURTEEN BUSINESS PRICING: THE IRRATIONAL USE OF IRRATIONAL RULES OF THUMB by A.

W.

Zelomek

Pundits are fond of saying that the man should fit the job and the title should fit the man. Since my paper involves the irrational, I think discretion would be the better part of valor, and so I shall choose to ignore the pundits. Thinking of the broad scope of business pricing and all the implicit ramifications, I am tempted to paraphrase the old dictum as "One man's rationality is another man's poison." In any evaluation of rationality as applied to business pricing, it is important to be cognizant of the background of the individual who is passing judgment. We say that pricing formulation is becoming more sophisticated because business is becoming more complex. This may be translated as pricing becomes more complicated as businessmen become more specialized. The term "businessmen"—applied to today's large corporation—means an assemblage of specialists in marketing, merchandising, sales, production, research, development, engineering, accounting, law, public relations, and personnel, plus a host of even more rigidly defined areas of specialization. Each such specialist may, and often does, view the price charged for the corporation's product or products with a different set of criteria. T o the small businessman of 50 years ago, pricing tended to be a black-and-white proposition: figure out the cost of production, add the desired profit, and charge the resultant price. For today's large corporation, pricing tends to be more in the gray area than in black and white. F o r example, and with the same factual situation: 1. The merchandising executive might be against a price decline. He may be seeking to maintain his product at higher retail levels, to avoid competing with numerous substitute products at lower levels. This situation exists for certain fibers in the floor-covering field today. 2. The sales executive might be in favor of a price decline. He may feel such a decline is necessary to deal with competition or to insure obtaining a longer-term, more profitable volume base. 3. The financial executive might be against a price decline. He may feel that the corporation is not in a financial position to justify any possible reduction in short-term profitability or cash flows which a price decline would engender. 4. The research and development executive might be in favor of a price

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Zelomek

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decline. He may feel that potential product innovations will be commercially feasible in a short period of time and would be better accepted in the market at a price level equal to present quotations. A lower price for the existing product would allow for a premium on the modified product. These admittedly are oversimplified extremes, but they are presented to illustrate 2 major points. First, it is increasingly difficult to pass judgment on rationality in business pricing without conducting substantial inquiry in each specific case. Second, business pricing has become increasingly complex because the management-decision process has had to rely more and more on the collective viewpoint of specialized business executives. I wish to stress this human element. In every practical area, quantitative business information and quantitative analysis are used. But the ultimate interpretation depends on the human element. As we shall see, so, too, depends the degree of rationality inherent in business pricing. The term "irrational" means, of course, not rational, not endowed with reason or understanding. I think it is fair to say that one seldom finds a situation where there exists an irrational price for a product already on the market and enjoying some degree of consumer acceptance. An existing product enjoying consumer acceptance would be fulfilling an expected role and its price could not logically be termed irrational. If a price is irrational for a specific product, the implication is that the price is either too high or too low. Yet even before this assumption can be made, the question must be answered: too high or too low in relation to what? Not in relation to costs, since the typical consumer generally has no idea of the cost factors entering into a particular product. Generally speaking, the comparison is made in relation to what the consumer is willing to pay or, to dust off an old cliche, in relation to what the traffic will bear. This paper, therefore, is not intended to examine whether or not business prices themselves are or are not rational in this sense. I would like, instead, to examine the various criteria which have a bearing on business prices and then examine the application of these criteria in the formulation of pricing strategies and structures. For, in the final analysis, it is not a specific tool or criterion which itself is irrational—rather, it is the application of a specific tool or criterion which may or may not be applied in an irrational manner. Finally, I am interested in examining the nature of the so-called rule of thumb, which in a business sense is defined as judgment based on practical experience rather than on scientific knowledge or analysis. A good way to start an argument among business people is to ask whether costs determine prices or whether prices determine costs; whether prices are calculated on a scientific basis or whether they simply evolve on the basis of an executive decision. Any such discussion rapidly underscores

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the fact that there is no quick and easy answer to the question of how business prices are determined. A complete semester or an entire book could be devoted to pricing within one specific industry and still be incomplete. If some of the illustrations used seem greatly oversimplified, this is the necessary consequence of attempting so broad a survey. Although there are numerous considerations influencing business prices, I would offer 5 major components or criteria which exercise the greatest influence. These would be (1) the product; (2) the industry structure; ( 3 ) the marketing objectives of the firm; (4) the character of the firm; ( 5 ) the role of costs. THE

PRODUCT

The individual product falls generally into one of two categories— controllable and noncontrollable. CONTROLLABLE: A controllable product is one of which production may be increased or decreased concomitant with the trend in orders received. An example of this would be steel. The price structures for a controllable product tend to be more stable than is the case in noncontrollable products. This reflects the ability of the manufacturer to regulate, to some degree, the production of this product, thereby effecting a better balance between supply and demand. NONCONTROLLABLE: A noncontrollable product, on the other hand, tends to be characterized by one of three major limitations: inherent product deficiencies, world-wide production and an international price structure for the raw materials, and a strong influence from imports. The raw material may be noncontrollable in that its output may be unpredictable and that it may be perishable. Certainly these are the major characteristics of the fruit-packing industry. A raw material which is widely produced restricts the control of producers utilizing that raw material. The erratic price history of copper is but one example. The effects of foreign competition vary from product to product, reflecting transportation advantages or disadvantages, tariffs, and so forth. Any textile mill producing filament nylon taffeta fabrics over the past year has had to alter its price structure, for the most part, in accordance with the volume of imported goods. Moreover, imports tend to exert an influence on the domestic price structure disproportionate to the volume of goods imported. New products may fall into either the controllable or noncontrollable category but, generally speaking, tend to join the ranks of the former. New products often offer opportunities in pricing which are not inherent in established products. The advent of each new noncellulosic fiber, such as nylon, polyester, acrylic, or Spandex, has offered the opportunity initially to establish pricing strategies reflecting the individual merits of the fiber,

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independent of the other fibers, despite the fact that similar end uses may be involved. Even for established products such as nylon, new product developments—second-generation developments—provide unique opportunities to utilize price strategies independent of the existing nylon product. In nylon these new product developments have taken the form, for example, of modified molecular cross-section and producer-textured yarns. Although these are nylon products, emanating from existing nylon producers, these advanced yams have been priced in complete independence of the existing product because of their own unique properties. T H E INDUSTRY

STRUCTURE

The pricing of individual products must take into account the structure of the particular industry and the degree to which individual firms dominate the industry or tend to act as price leaders. Depending on the product and area, the large firm tends to possess market power which renders ineffective any attempt by smaller producers to establish lower prices for the purpose of increasing their share of market. The result tends to be that the larger, more resourceful firm meets the lower price and that the market shares remain unchanged. Profitability, of course, is less for all concerned. In established-product industries, characterized by several relatively large producers, the unprofitability of price wars is generally recognized. The price leader leads in establishing new price levels; the others follow in matching the new price level. The competitive struggle moves into the area of nonprice competition, with the accent on service, quality, product-development, engineering, and similar considerations. Despite established-industry price leadership, the over-all price structure in a given industry may be subject to rapid erosion due to related developments in other areas. An example would be the production of polyester fiber in the textile industry. The development of permanent- or durablepress processes almost 2 years ago was accomplished by a firm which was not involved in noncellulosic fiber production. Among all available fibers, the inherent properties of polyester most lent themselves to garments utilizing this new process and a wave of capacity expansion and entry of new producers was touched off. Considering only polyester staple and tow, the industry capacity at the end of 1965 approximated 400 million pounds. Announced intentions will boost industry capacity to slightly more than 1.0 billion pounds by mid-1968, and the end is not in sight. During the pact several months, there was a moderate to substantial lag in polyesterfiber usage at the textile-mill level, due to expectations of impending lower prices. Recently, a price decline of about 15 per cent took place. Industry observers tend to feel that another price drop may well be seen in 1968, when most of the expected capacity will be on stream.

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Prices: Issues in Theory, Practice, and Public Policy MARKET

OBJECTIVES

The market objectives of an individual firm are an important influence on its pricing strategy. I have already touched on price-nonprice competition. On a nonprice basis, style considerations may be properly classified as nonprice competition. This is relevant in the automobile industry, for example. A comparison of the new models offered for the 1965 and 1966 model years discloses that there were 22 per cent fewer models offered in price classes below $2,500 in 1966 compared with 1965. The automobile manufacturers have often indicated that prices on comparable models have not been raised for several years and, indeed, the wholesale price index for motor vehicles was 100.3 in 1958 and 100.7 in 1965, based on the 1957-59 = 100 index. A comparison of the new model cars in 1966 as compared with 1965 shows that there was a 6 per cent increase in the total number of new car models offered in 1966, compared to 1965. In the $2,500 and under range, however, there were 22 per cent fewer models offered, whereas the remaining price ranges showed the following: between $2,500 and $3,000, 27 per cent more models were offered; between $3,000 and $3,500, 16 per cent more models were offered; and above $3,500, 17 per cent more models were offered. Thus, while comparable models were not increased in price, the automobile manufacturers have been successful in trading their customers up to higher prices by effective emphasis of the nonprice consideration of style and by proliferating offerings of higher-priced styles at the expense of lower-priced styles. Style considerations are also prevalent in the apparel industry. Few textile areas are as clear-cut as is women's hosiery production. One type of yarn, filament nylon, dominates, and over 95 per cent of total industry production is accounted for by circular-knit machinery. Active promotion of new styles, including pattern effects and stitch formations from sheers to wide mesh, have been successfully employed to obtain higher prices. THE

CHARACTER

OF

THE

FIRM

The character of the individual firm and its executives often can play a leading role in the adoption and administration of pricing strategies. For smaller firms, particularly family-owned firms, formal pricing strategies are often completely lacking. For large, multiple-product firms, especially those with diverse products, no single pricing policy is employed. Rather, numerous and diverse pricing strategies are used at the product-division level. Large firms which favor centralized management concepts tend to utilize pricing strategies greatly different from strategies utilized by those which favor decentralized management concepts and autonomy at lower management levels.

A. W. Zelomek

207 THE

INFLUENCE

OF

COSTS

The number of business people who cling to the concept that prices are or should be determined by costs of production is surprising. Under numerous conditions, as should be better known, the reverse is in fact true. The cost structure certainly exerts a marked influence in those products heavily dependent on, and primarily composed of, one particular raw material, as in the case of tin plate for can manufacturers. Pricing strategies for automobiles, on the other hand, tend to represent a determination of costs as a reflection of a predetermined selling price. The initial planning for a new model commences 2 to 3 years prior to the expected introduction date. But, in addition to the many general economic considerations to to be taken into account, such as the over-all economic outlook, employment levels, or disposable income, the pricing strategy for a new model car must operate within the limitations of the product line of the manufacturer, as well as the limitations of used-car prices. There are traditional price ranges, for example, for the Chevrolet car that are established, not only as a factor of what the customer is generally accustomed to paying but also as a factor of what the accepted price ranges are for other models in the product line such as Buick or Oldsmobile. In addition, too marked a price differential from the preceding model year will affect new-car sales through the effect on the used-car market. Too low a price may well aid new-car sales, but might tend to depress used-car values and adversely affect resale values for customers who had purchased earlier models. Too high a price may tend to siphon off potential customers who find more attractive values in the used-car market. Consequently, the pricing strategy for a new model car will generally begin with the premise of what price the car will command. Subsequent premises involve styling considerations the customer might be expected to demand in the automobile. Sales volume is forecast in relation to capacity. This process of working backwards from an initial price premise tends to regulate the degree of cost acceptable, in order to realize successful sales volume. In this case, it may be said that prices would determine costs, rather than the reverse. The process of prices determining costs tends, I believe, to hasten new product innovations. While subject to some debate, many observers think that automobile developments such as molded instrument panels, flocked window channels and glove compartments, innovations in upholstery and headliners, and experimentation with flocked carpeting, have been accelerated by the need to fit the cost structure into a predetermined pricing strategy. In very general terms, the cost structure of a particular product tends to exert comparatively little influence when the product is new, but the

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Prices: Issues in Theory, Practice, and Public Policy

cost structure tends to increase in importance as the product matures, ultimately exercising the greatest amount of influence when the product has passed through the growth and maturity stages and enters into a stage of decline. In the textile area, filament rayon experienced its growth and maturity stages up until the early 1950's. During the past 10 years, filament rayon has been in a declining stage. The major factor in the manifestation of this declining stage has been the growth of advanced noncellulosic yarns, which themselves are in either a stage of maturity, such as nylon, or a stage of growth, such as filament polyester. Concomitant with growth and maturity of textile products has been a steadily declining price trend. This results from competition and from the marketing objective of increasing market penetration through lower prices. With lower prices, nylon and filament polyester substitute for filament rayon in many of the latter's markets. In some instances, increased market penetration has been achieved without resort to modifications of pricing strategies because of the superior properties and merits of the newer fibers. To maintain markets, on the other hand, filament rayon prices have been forced to lower and lower levels. It is at this juncture that the cost structure assumes a markedly more important role. The differential between the cost and the selling price of the product represents, among other things, the return which the producer feels necessary to justify production of the product. This is residual in nature and the minimum necessary return depends in part on expectations of the product's longevity. When the declining stage is reached, a price level also invariably tends to be reached which precludes further price reductions, unless the producer is willing to substantially reduce his requirements in regard to expected return. If the competing fiber products are still in the maturity or growth stage, the flexibility in pricing, in view of expected return, tends to be much greater. This is fully illustrated by the position of filament rayon in the original equipment automobile tire market today. The preceding discussion of these five major influences on prices—the product, the industry structure, the marketing objectives, the type of individual firm, and the role of costs—is not meant to imply that there are no other significant influences governing pricing strategies. Certainly legislation enacted by federal and local governmental bodies can have a major bearing on the price policies for an individual firm in a specific industry. By and large, however, these 5 major generalizations tend to incorporate, in one form or another, most of the important influences which help to shape the pricing strategy employed by a majority of business firms. T H E R U L E OF

THUMB

I have often been amazed at the number of business people who defend the right of a ranking executive to render final judgment on the administration

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of pricing strategies, while at the same time assailing as irrational the modification of pricing strategies based on a rule of thumb. The latter apparently represents, to some, a crude method of applying a judgment valuation without benefit of supporting documents, data, statistics, and so forth. I am not suggesting that pricing strategies may be formulated through application of a convenient rule of thumb. I do suggest that the concept and accepted definition of the term "rule of thumb" should be closely examined. Aside from, and in addition to, the general definition of a crude measure, the term "rule of thumb," applied in a business environment, has come to be accepted to mean a judgment based on practical experience rather than on scientific knowledge. In this sense, practical experience is gained by continuous observation of repeated phenomena in the course of a business life. While hopefully not being too semantic, I would say that a rule of thumb is the expected forecast of the likely effects of a specific action and is based on past observations of cause and effect dealing with the same or quite similar subject matter. A rule of thumb may take the form of a rough equation, which tells the businessman that, based on past experience, every dollar added to his direct labor costs adds a specific amount to his nonlabor costs per yard of fabric or pound of metal. We know that scientific inquiry and knowledge tend to be empirical, thus implying that cause and effect must first take place, in order that the empirical data or knowledge can be gained. Yet we also see that, following every collective bargaining agreement, both management representatives and labor representatives issue statements regarding the expected cost of the new labor package. In most cases, the amount presented has been derived through the application of practical knowledge, through rough formulas, through—in other words—commonly accepted rules of thumb. Like business prices themselves, I do not consider a rule of thumb to be irrational. A rule of thumb, like a proverb, exists because it has passed the test of time. That which is irrational must, in the long run, fail this test. It is the application of a specific rule of thumb which may or may not be irrational. There is no one formula for establishing business prices, because the interaction of the various factors that affect prices is unceasing. Although there are numerous factors to be considered in adopting pricing strategies, several general criteria may be proposed as exerting the greatest influence. Pricing policy plays a significant role in determining the short-term and the long-term profitability of a firm, and effective pricing must take into consideration both of these aspects of profitability. A pricing policy which seeks expedient advantage through higher prices in a period of peak demand may adversely affect the longer-term marketing prospects. Customers would

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doubtless be encouraged to turn to other suppliers or to substitute products once peak demand had subsided. The pricing of a new product often presents unique opportunities in adopting time-phased pricing strategies, since there is no existing industry price structure. Such a new product may be priced at a high level or at a low level. When a producer has expended large amounts of capital in research and development over a period of years, he may well feel entitled to an exceptionally good short-term return and price accordingly. For example, Corfam, developed by DuPont, is used as a substitute for leather. The price established for Corfam was at a generally high level, approximating that of high-quality leather. This allowed for the desired return, for orderly expansion of production, and helped to create an image of a high-quality substitute rather than the image of a low-quality imitation. It is important to note, in the forgoing example, that the price established was high, but not too high to defeat the purpose. By pricing the product at a level approximating that of the best-quality leather, the shoe manufacturer had the option of using one or the other. Had prices been established at too great a differential above the best-quality leathers, such an option would not have been available. On the other hand, some new products may be priced at high levels without the consideration of the existing product, despite the fact that substitution of the new product for the existing product is desired. An example is furnished by DuPont's Cantrece nylon, a producer-textured yarn possessing properties not available in conventional nylon. In this case, the new product was priced 3 - 1 / 3 times higher than the existing product. Despite this differential, the new product has shown increased usage in women's hosiery. An example of a new product being priced at a low level would be color television. Here the pricing strategy in the middle and late fifties was to price the product at levels low enough to expand the market rapidly. The pricing strategy for color television could not rely on the experience gained when black-and-white television was introduced. In the latter case, television was an entirely new concept which met with an enthusiastic consumer response. When color television was introduced in the mid-fifties, it represented, to the consumer, only a technical improvement over its black-andwhite counterpart. Also, when the concept of television became a reality in the forties, television broadcasting gained rapidly. When color television appeared, only a minimal amount of color broadcasting was in effect. T H E S U B J E C T OF

IRRATIONALITY

It may be seen from the forgoing discussion that I have led up to 3 major points regarding the subject of irrationality in regard to business pricing: ( 1 ) that business prices per se need not be irrational; ( 2 ) that the various

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criteria which influence business prices need not themselves be irrational; (3) that the rule of thumb, as used in the accepted business sense, need not itself be irrational. An example of the irrational approach in setting pricing strategies is furnished by the actions carried out by major hard-line producers during the late 1940's. During the period 1948 to about 1951, in particular, manufacturers of refrigerators had completed the transition from a wartime to a peacetime basis. The bulk of production was sold on a nationally branded basis through traditional outlets, primarily major department and selected specialty stores. During this period, the manufacturers sought to reduce the retail price of the appliances in order to expand the market more rapidly. In and of itself, this represented a rational criterion in pricing strategy— a marketing objective of expanding a particular market, with corollary aims of increasing market penetration and share of market on the part of the respective producers. Up to this point, there was no form of irrationality involved. The manufacturers, however, attempted to have their cake and eat it too. They wished to expand the market by lowering prices but were loath to turn their backs on the higher profit inherent in the existing higher retail prices. They formulated a pricing strategy designed to satisfy both extremes, thereby ignoring the critical consideration that the problem was actually one of "either-or." This is one of the clues to the irrational application of pricing strategies—the unwillingness or inability correctly to define the nature of the problem before formulating the solution. In the case at hand, the manufacturers attempted to maintain the existing retail price structure though the existing channels of distribution. At the same time, they expanded the distribution channels through the addition of the new and growing discount store outlets, in some cases conceding lower factory prices and in other cases avoiding any attempt at policing their distribution system. They employed a strategy of which the consequence could only be a collision course between the two arms of their distribution system. In a comparatively short period of time, they lost the loyalty and goodwill of the department stores, who were unable to compete on price with the discounters, brand for brand or model for model. The department stores turned increasingly to private labels and/or store brands. Thus the operation was a success, but the patient died! The national brands gained volume through lower prices by way of discount outlets. In doing so, they lost their preferred position at department stores and unwittingly gave birth to unbranded and private-label merchandise competition. The pricing strategy of lowering prices to expand market penetration was valid and rational. The application of this strategy—the use of a double

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standard—was irrational. As another example, but in a different market, consider the following: Assume, if you will, an established market for an established product, characterized by several relatively large producers but effectively dominated by one producer, who tends to be the price leader. The desire on the part of one of the smaller existing firms to achieve a greater share of market is wholly rational but in this market context it will tend to be accomplished through nonprice competition. This is the rational choice. On the other hand, assume the same situation but add the fact that new producers are entering the market. Unless these new producers can offer a superior product, their ability to compete on a nonprice basis is severely limited. They are new to the industry and therefore lack a record of achievement. Unless the existing producers have done a poor marketing job, the new producers will not be in a position to offer more in the way of service, technical assistance, or the like. Since the new producer desires to achieve a share of market position, he may be forced to resort to lower prices, as a way to buy his way in. The lower prices invariably will be met by the existing producers, since their customers generally are involved. The end result tends to be lower prices and less profit for all concerned, including the new producers. The question then arises as to the rational course of action to follow in this situation. The new producer must ascertain the structure of the industry with respect to marketing—do existing producers tend to rely on a branded marketing concept or a generic marketing concept? The new producer must ascertain whether he desires to market on a branded or generic basis, assuming he has the freedom to go either way. If the general industry trend tends to be branded and he chooses to market on a generic basis, he will probably be in a position to do so without inviting strong and immediate price retaliation. If he chooses to market on a branded basis, he has to gain a share of market by following a price-plus route rather than a pricecutting route. The price-plus route refers to such marketing strategies as cooperative advertising, and special promotional efforts. He will have to, in other words, achieve market position through other marketing strategies rather than through pricing strategies. For those who feel the forgoing illustration is too abstract, I suggest that the textile-fiber-producing industry would fit the description without too much trouble. Production of Type 66 nylon, for example, was effectively dominated in this country by DuPont and Monsanto during the period 1953 to 1965. During this period of time, the product continued to show excellent growth. It became obvious, during the past 2 years, that new suppliers were going to enter this market. Recent entries have been Celanese and Beaunit, with Phillips presently constructing plant facilities. Competition

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from existing producers of Type 6 nylon, which possesses characteristics somewhat different from Type 66, has also increased during the past several years. The projected industry trend for filament nylon calls for about 1 ιΛ billion pounds of capacity by midyear of 1968, compared with approximately 1 billion pounds at the end of last year. The trend for production and shipments, while favorable, will not be of proportions sufficient to utilize this added capacity. As a consequence, industry observers expect filament-nylon producers to be operating at about 70 per cent of capacity by 1968, compared to 85 per cent of capacity for 1965. Much of the burden will fall on the new producers. Irrationality in the application of pricing criteria may also take the form of being too closely wedded to traditional concepts. Few areas are as priceconscious as are department stores, which cling to the $2.98 housedress year after year. Consumers have become more affluent, disposable income has risen to record heights, and the increase in the number of higher-income families ($10,000 and over) has been nothing short of amazing. Yet numerous retail outlets have allowed various items to become sacred cows in a manner which defies rational explanation. CONCLUSION

In general terms, the maximum price at which a product can be sold is a function of its value in use. Having estimated an appropriate selling price for a new product, the producer's decision to undertake its manufacture and sale depends on whether or not the estimated earnings and return on investment appear adequate to justify the investment and effort. Once the product is commercial, the producer must seek to expand the market, often through orderly price reductions, which allow for effective competition with lower-priced substitute products. Any price reduction is feasible only when the resulting increased sales volume leads to increased manufacturing efficiency, thereby yielding greater revenues and a minimum loss in return on investment. One of the many marketing tools which aid in bringing such goals to successful fruition is pricing strategy. And as pricing strategy is but one factor in the composition of the term known as "marketing," so it is, in turn, composed of many criteria, all interrelated and tending to be mutually dependent. I do not think that any one of these criteria is by itself irrational. The irrationality we deal with in business prices lies in the manner in which the criteria are applied. In the final analysis, pricing criteria are the tools of the executive—and tools are only as good as the person using them.

CHAPTER FIFTEEN THE UNDERLYING RATIONALITY OF BUSINESS PRICING DECISIONS by Alfred

R.

Oxenfeldt

INTRODUCTION

My topic implies that pricing decisions are "of a piece"—essentially similar and readily characterized by a simple label like "rational" or "irrational." That certainly is not the case. Individual executives and firms differ markedly in their understanding of the market process and of the role that price plays in their market performance. Indeed, pricing skills and behavior probably vary more than other business practices, because pricing occupies a unique position in the eyes of the law. As almost the only forbidden subject for open discussion by businessmen, pricing suffers the fate of most delicate subjects; understanding is relatively backward, strong emotion characterizes most opinions, and myths abound. Moreover, as a result of the ban on price discussions, little reliable information exists about how most businesses set prices. Those firms whose pricing practices have been reported are most likely to be atypical, and we must even wonder whether they have been described accurately. My topic could be approached from several standpoints. For example, one could evaluate business pricing practices according to their conformity to price theory. Divergences might be attributed either to "executive irrationality" or to the excessive simplicity of price theory. This approach would accept price theory as the yardstick of what is rational. If such an approach had been employed, its results could be readily foreseen. Economic theory assumes conditions in which rationality is virtually costless and quite within the power of persons possessing limited intelligence. When one assumes away the "stationary state," recognizes that firms usually offer many products which change frequently in method of manufacture and in product features, and that virtually nothing is known with certainty about the future, then the very definition of rationality becomes blurred. Having come this far, we would then feel obliged to erect a definition of rationality appropriate to a dynamic economy characterized by uncertainty, multiple products, frequent technological change, etc. Such an undertaking would be very taxing and hardly justified by the desire to label price-setters rational or the opposite. In any event, one can be certain that businessmen do not set prices in the way that traditional theory concerned with a stationary state describes them. However, that fact does not reflect one way

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or another on the rationality of their behavior. Instead of the forgoing approach, this paper treats pricing as a problem in decision-making and evaluates the price decisions in 3 common industry situations according to their conformity to normative decision-making procedures. In effect, we will ask ourselves whether businessmen in those 3 situations set prices in a manner that meets their needs as well as any that we could prescribe. If they do, we will call them rational—even if they make a substantial number of errors. We must beware of any standard that would call a bowler irrational because he fails to throw a strike every time. It is all too easy to second-guess the businessman and ignore the real difficulties he must overcome. The approach adopted here has as a corollary purpose the setting down of normative principles for businessmen. That is, we should seek heuristics and principles that will guide businessmen's pricing decisions so that they perform as well as circumstances permit. Accordingly, we will not simply evaluate present pricing decisions but will attempt to prescribe methods for approaching price problems. PRICE-SETTING

V I E W E D AS

DECISION-MAKING

A variety of procedures is prescribed for decision-making, but all have certain features in common; they call for specification of objectives, identification of feasible attractive alternatives, estimates of the outcomes of the selected alternative, and designation of the alternative that promises to achieve the decision-maker's objectives best. Accordingly, we shall assess any pricing method according to the validity or wisdom with which it deals with objectives, alternatives, estimates of outcomes, and the selection among alternatives. In so doing, we will hopefully isolate pitfalls to which businessmen are exposed and uncover guides for their actions. Before assessing the rationality of three types of price decisions, we shall explore what would be involved in rational pricing. PRICING OBJECTIVES: A firm sets prices in order to achieve its total objectives; it would not have pricing objectives in isolation. We need not cover the well-traveled ground which leads to the conclusions: businesses pursue multiple and conflicting goals; their goals are partly nonmonetary in the short run and the long run. Also, these goals probably vary over time and are not clearly understood by all decision-makers in each firm, while the goals of the individual decision-makers may conflict with those of the firm. How, then, might a firm's price decisions contribute toward the achievement of its goals? That is, what intervening goals or subordinate objectives might firms pursue by means of their price decisions that would enhance their long-run profitability, security, market shares, growth, etc.?

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Economists regard price solely as a device for attaining financial objectives. T h e price set for any product, in traditional economic reasoning, places a value on the benefits that customers perceive in the firm's offering, and it also takes account of variations in costs with changes in volume. As viewed by economists, price decisions should and d o reflect cost and demand conditions and balance them to the firm's greatest financial advantage. Certainly, price-setters must pursue financial goals. By means of a proper selection of price, the firm collects its rewards f o r skill in creating demand and for producing and marketing efficiently. A second intervening goal for price-setters is generally overlooked in traditional economic theory. Price can be used as a communication device. A skilled business executive will set price in a m a n n e r that will persuade potential c u s t o m e r s — a n d o t h e r s — a n d inform m a n y participants in the market process in a m a n n e r that might increase sales, raise price, or reduce costs. Although certainly not ends in themselves, the communication benefits achievable by price are often central to the profitability of a business. T o be rational, businessmen must recognize and exploit these potential benefits. Price can be used to communicate facts to potential customers about a firm's products, about its capabilities, and a b o u t the state of the market. Specifically, a firm that charges a relatively high price for its product "says" certain things to potential customers about that product. If nothing else, it says that the firm claims and would welcome a chance to prove that its p r o d u c t is superior to competitive products. Research results and introspection attest that customers forecast the benefits to be attained from a product as m u c h by price as by any other cues available to them. Interestingly, price even has this effect upon resellers—who probably are more like ultimate customers than many realize. Although evidence is not available on this point, customers may also judge the caliber of a business' management and research largely by the price of its products. The firm that charges high prices and offers what is regarded as high quality seems also to be considered by most customers to be the most skilled, innovative, and progressive, and to have a modern and reliable m a n agement. All of these "messages" would tend to increase sales and thus represent potential values to the firm. It would be irrational if, in setting price, the firm failed to pursue these values and to forgo some current profits to achieve some values in communications. As already suggested, price can communicate facts about the state of the market. F o r example, an increase in price of a b r a n d will suggest to many customers that the product is in short supply or that the particular b r a n d is meeting with great customer approval and possibly may become short in supply. A price change might also be used to inform rivals about management's view of the state of the market. A price increase, for example, might

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tell competitor managements that they should reassess the strength of demand and consider raising prices too. Conversely, a price reduction may represent a call to competitors to reevaluate conditions of cost and demand and lower price demands. Finally, price might be used to inform government about the state of the market—or to misinform it. For example, prices might be varied in a way that creates the impression of far greater competition than actually exists and thus forestalls government investigation or prosecution. Thus, an appraisal of the pricing practices of businessmen must take account of the extent to which firms pursue and achieve communications as well as financial goals. These goals represent intervening objectives that may be no less important to the success and growth of the firm than the achievement of short-range financial goals. Observe that the communications goals that might be attained will not be reflected in cost information or even in routine information about current demand. Hopefully, an executive who is operating in an industry can recognize potential communications benefits that his price decisions might engender. It is most unlikely, however, that an outsider can appraise the potential communications benefits without becoming thoroughly informed about the details of that firm's industry and situation. ALTERNATIVES: An executive responsible for pricing ordinarily possesses a substantial number of alternatives. (Price theory limits the executive to extremely simple choices: an upward or downward change in price—admittedly by different amounts.) The average businessman actually has a far wider range of choice. First, and possibly most important, he ordinarily will be able to 1 —and almost always will want to—combine price changes with changes in product features, design, advertising, personal selling, channels of distribution, services offered, etc. (We will call such combinations "merchandising programs.") Second, he has choices with respect to the timing of price changes, their frequency, the explanation he offers his customers for price changes, the number and nature of the particular products whose prices are changed and those that are kept the same. (Indeed, he will often be well advised to raise some prices, lower others, and keep many unchanged). In other words, a pricer enjoys a wide range of choice as to both the quantity and quality of his efforts to spur sales. He may employ novel and ingenious sales promotions, in which price generally plays a part; or, he may simply change the "weight" he puts behind his different sales promotion devices (that is, vary his marketing mix). Opportunities for imagination and creativity are great in using price as a promotional tool. A pricer who simply considers increasing or reducing price—keeping all else con' Accordingly, one test of rationality in pricing would be the extent to which responsibility for pricing and related organizational arrangements isolate price decisions rather than treat them as one of a combination of related decisions.

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stant—would be considered a dinosaur in most industries even though he might be well informed about the price elasticity of demand and a fanatic about equating marginal cost with marginal revenue. The ability to identify attractive merchandising programs thus must be considered an essential ingredient of pricing success. We must be certain, therefore, that we label as rational only those pricing approaches which rest upon a conscious and imaginative searching out of alternative merchandising programs; the rationality of a firm's pricing methods thus is related to the quality of the programs that are instituted. Of course, to appraise them one must be well informed about the possible alternatives under the circumstances—something not ordinarily possible for an outsider. T o identify alternative pricing actions, an executive requires far more than knowledge of the price elasticity of demand. Indeed, knowledge of price elasticity gives the pricer no "understanding" on which to develop alternative promotional programs. It simply represents a "black b o x " type of understanding. If an executive is to conceive of alternative programs, he must understand how potential customers perceive, interpret, and respond to the different combinations of stimuli he might employ. That is, pricers require a "behavioral understanding" of potential customers rather than knowledge of price elasticity if they are to devise attractive alternative merchandising programs. Up to this point, we have considered alternative merchandising programs alone. Price-setters also select among market strategies and price policies— if only by default. Their strategies and policies will strongly constrain and occasionally will dictate the specific prices that they set. Most firms possess special capabilities and limitations that make it wise for them to cultivate particular types of customers and to use special "customer appeals" to attract their patronage. The matching of a firm's capabilities and limitations against its market opportunities is among the most important factors making for marketing success. In such a matching process, the fundamental strategy that relates to price would ordinarily be set. In turn, from such a pricing strategy, a price-setter would ordinarily derive pricing policies. These would guide him and others to whom he delegates part of his pricing chores. Thus, we see thai price decisions as largely determined by a complex hierarchy of intervening goals. At the top of the pyramid we find a company's goals; these, in turn, are to be pursued by cultivating particular types of customers (target customer segments); in turn, these customers will be offered particular "customer benefits" in order to win their favor; to create such customer benefits, the firm must establish policies and select a strategy that will create consistency in its offerings; in any particular situation, the price-setter will find only a rather limited range of decisions consistent with this hierarchy of goals and intervening goals.

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We lack a reliable standard by which to rate the rationality of strategies, policies, and merchandising programs. Such standards clearly could not be derived from price theory. It makes no mention of these issues and does not suggest how best to deal with them. ESTIMATING O U T C O M E S O F D I F F E R E N T ALTERNATIVES: All decisionmakers must at some point estimate what would happen if they pursued each of the alternatives they isolated for careful consideration. More specifically, they must estimate the benefits to be achieved and the sacrifices that would be incurred to achieve them—as well as the time at which the benefits and sacrifices would take place. The validity of such estimates would depend upon 2 ingredients primarily: the information at the disposal of the decisionmaker and the concepts that underlie his collection, processing, and interpretation of information. Information. As suggested earlier, decision-makers confront uncertainty about many of the factors that they should consider in setting price. No matter how much they might be willing to spend to obtain information for pricing purposes, they could not forecast with certainty all outcomes that would be relevant to their decision. Accordingly, we would judge pricer's rationality partly by the size and nature of their expenditures to obtain information for pricing and by the methods they used to gather information. Similarly, we would appraise the techniques they employed to process and interpret the information available to them. Price-setters doubtless vary greatly in their ability to wring out valid conclusions from the information they possess; their rationality certainly varies with their ability to do so. When an economist thinks of information useful to a price-setter, his foremost desire ordinarily is for data on price elasticity. Would we conclude that a rational price-setter should make rigorous studies of price elasticity? What kind of data should he ordinarily collect? Several matters must be considered in answering this question: 1. Whose responses to price changes would be of potential interest to him? Would not many price-setters ordinarily be as much concerned with resellers' responses as with those of ultimate customers? After all, they generally sell to a middleman rather than to an ultimate buyer. 2. Would he study the effect on sales of a single price change? Should he consider an equal percentage change of all his prices, or of his best alternative—which would usually call for some increases and some reductions—both by different amounts? 3. With what speed would data on customer and reseller "responses" to price changes become obsolete? 4. For what kinds of alternative actions on his part should he collect response information? Should he study reactions solely to price changes, or should he include "programs," representing combinations of marketing efforts?

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5. Should he expect the elasticity of demand to be similar for similar products in his line of product offerings? 6. How accurately could he hope to measure the price elasticity of demand, even under favorable circumstances? What level of accuracy could he hope to achieve with forecasting responses to marketing programs? 7. Would he be justified in believing that the elasticity of demand for any item is essentially the same at different levels of price? As the forgoing questions should make clear, the information requirements of a price-setter are not easily defined. More important, they ordinarily have little to do with price elasticity of demand, as that term is technically defined. What the seller wants above all to guide his price and related decisions is information that would enable him to alter buyers' perceptions and dispositions—and thereby to change their behavior. Indeed, it appears that few price-setters today actually conduct experiments or gather data in other ways designed to measure price elasticity of demand; they are concerned with the responses of resellers as well as of ultimate customers, with price changes made in combination with other promotional efforts, and with many simultaneous price changes—of different size and in different directions. Price elasticity does not tell a price-setter these things or even suggest them. Concepts. Another fundamental requirement for rationality in pricing is the use of appropriate concepts. What concepts are relevant and appropriate for price-setters? Should we place at the head of the class those pricers who recognize the wisdom of equating marginal cost with marginal revenue under certain circumstances? Does mastery of marginalism constitute the basic test for rationality in pricing or are other concepts equally useful for a pricer? If so, to be considered rational, pricers must understand and apply them. We have already mentioned one important concept that pricers must understand and apply if they are to be adjudged rational, namely, that a firm can attain communications goals as well as financial goals by means of price decisions. We can list other concepts valuable for pricers, but space will not permit us to discuss them fully. 1. Marketing strategy: This consists of a firm's customer targets and the mix of customer benefits (marketing mix) most likely to attract such customers and yield a profit to the seller. 2. Marketing mix: This is the blend of marketing expenditures, including price changes, made by a seller in an effort to create the target customer benefits which are calculated to attract the patronage of his target customers. 3. Incrementalism: the central message of this concept is that business decisions and actions are best viewed as discrete changes from the present; the worth to the firm of any action is to be assessed by the change in

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costs and in receipts that would follow from the action. Incrementalism carries with it an understanding of "sunk" costs and irrevocable actions. 4. Demand interdependence within a product line: Recognition that different items sold by the same firm will influence the sales of other items offered by that firm. The interdependence may be that of a "substitute" —one of the items would be sold at the expense of some other item or items. Or the effect might be that of a "complement"—the more of one that is sold, the more of others that will be sold. Actually, the same product may be a substitute for some customers and a complement for others. One would not expect the demand for any one item in a firm's product line to be neutral with respect to all other items it offers. 5. Redundancy: This concept holds that certain of a firm's sales efforts may simply duplicate the work already done by other measures taken by the firm to spur sales—including a price reduction—and therefore have no effect. Sales measures that influence the same people at approximately the same time are usually highly redundant. They may add a little something to the total effect of all communications taken together, but essentially do again a job that has already been done. 6. Reinforcement: This concept states that certain sales efforts support and add substantially to the power of other sales efforts made by the firm. Ordinarily, reinforcement takes place by adding credibility to a sales message and by repeating it when it would otherwise "decay." Synergism —a polysyllable that I predict will become very popular—denotes this process. 7. Market segmentation: This notion suggests that potential customers should be divided according to their responsiveness to seller's promotional efforts—especially to the qualitative dimensions of those efforts (i.e., advertising messages and media as opposed to advertising outlays). 8. Incompatibility of market segments: Implicit in the concept of market segmentation is the fundamental notion that groups of buyers sometimes respond in opposite ways to the same sales appeal—including price. A price rise may attract some patronage while repelling other customers, for example. 9. Opportunity Costs: In computing the "reservation price" (the price below which the firm would profit more from not selling than from selling) a pricer must calculate opportunity costs rather than either accounting or replacement costs. SELECTING AMONG ALTERNATIVES: Each price-merchandising alternative would yield uncertain results. The decision-maker cannot know what state of nature will prevail and further lacks complete understanding of the forces operating in the marketplace and the effects of his actions on sales in the short run and long run. Consequently, each strategy must be associated in his mind with a variety of outcomes to which he would attach probabilities

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of occurrence. Thus we visualize a price-setter selecting from several sets of potential outcomes, each associated with a particular strategy. If any one strategy contains only outcomes as high or higher than the outcomes of other sets, his choice would be easy. In the overwhelming proportion of cases, that situation does not hold, and a selection among alternatives poses vexing choices. To a large extent, these choices will be governed by the pricesetter's appetite for risk. The elaborate discussions which gave rise to terms and phrases like "maximin" "minimax," "minimum regret," and the "Laplacian criterion" have not yielded a determinate solution to the problem of choice under uncertainty. Thus, as we look back over what has been said about price-setting viewed in the framework of decision theory, our criteria for assessing rationality involve appraisals of the following: (1) Recognition and exploitation of communications goals. (2) Imagination in conceiving of alternative strategies— including recognition of the numerous variables at the pricer-marketer's disposal. (3) Appropriate decisions about the amount and type of information to gather in support of a pricing decision. ( 4 ) An ability to interpret the information available and to process it into defensible conclusions. ( 5 ) Application of appropriate concepts in assessing the outcomes of alternative strategies. Observe that this list includes virtually none of the tests that economic theory would seem to require for an assessment of the rationality of a pricing approach. Theorists would be concerned primarily that the pricer apply the concept of incrementalism and know the price elasticity of demand. By the tests we would apply, a master of incrementalism could be a dunce as a pricer. Indeed, he would be one if he were to ignore the vast number of alternative strategies available, and failed to exploit the opportunity to exert ingenuity in the collection and interpretation of "quick and dirty" information. A N A S S E S S M E N T OF PREVAILING PRICING A P P R O A C H E S

Having thus discussed what we mean by rational pricing, we can consider several pricing approaches and decisions now in wide use and assess their rationality. We must recognize, however, that the pricing approaches we attribute to businessmen in the following pages are employed by only some and not all of them. As indicated earlier, we have much to learn about how businessmen actually conceptualize and behave with respect to pricing. Nevertheless, the 3 pricing approaches described here probably are among the most common of those to be found in industries where medium and large firms prevail. PRICING BY RETAIL FOOD CHAINS: Retail pricing plays a major role in the United States economy. Even though the manufacturer frequently is the "captain of his marketing channel," his pricing decisions often are largely dictated by the retail circumstances in which his products are sold. And,

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in most branches of retailing, price is governed by substantially different considerations from those that dominate the thinking of a manufacturerprice-setter. The difference mainly reflects the larger number of products sold together, and, even more important, bought together, at retail than in manufacturing. Demand interdependence is positively crucial to a retailer and generally only of modest importance to manufacturers. Let us consider pricing decisions as they are made by a large supermarket chain.2 The chief ingredients that compose the pricing method of a supermarket chain are strategy, policies, and specific decisions. First a chain's management adopts a conscious price-merchandising strategy. Ordinarily, it would adopt a broad general strategy that embraces such matters as location, size of store, target, store image, and customer targets. Price is only one ingredient in this strategy; price would be treated as "instrumental" and combined with the chain's other merchandising tools to produce the desired result. Next, the chain would adopt policies with respect to the following priceassociated matters: the number and frequency of its "price specials," the types of items to "special," the days of the week on which to run specials, whether to match competitor's specials and when to do so, the extent to which price should be featured in the chain's advertising. Beyond these, the chain would adopt policies with respect to whether store managers should be given pricing freedom to adjust to major moves by competitors and the circumstances under which such freedom would be extended. Perhaps the most important pricing policy decision a supermarket chain must make relates to the average level of its prices—compared to those of competitors. That is, will it try to be below the market average or above it? If different from the average, by how much? Perhaps more important, will it achieve its decided average prices by matching the market on all items? (Differing only to the extent that it seeks to be different from the average for the market). Or, should it achieve this target by major price bargains on a few selected items with compensating high prices on some other items? Following this, a supermarket's management must move from strategy and policy to specific decisions. It must decide precisely which items to "special," precisely how much above or below the average its prices should be, etc. In other words, specific and concrete decisions are one important ingredient of a supermarket's approach to pricing. These could differ very substantially even within the framework of the same strategy and policies for pricing. We know that supermarkets differ substantially in their strategies and This discussion is based partly on R. Cassady, Jr., Competition and Price Making in Food Retailing (New York: 1962) and P. E. Nelson and L. E. Preston, Price Merchandising in Food Retailing: A Case Study (Berkeley, Calif. Institute of Business and Economic Research, University of California, 1966).

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policies in all of the matters mentioned in the forgoing paragraphs. Nevertheless, they are quite similar in the following respects: 1. They add widely different margins to the invoice costs of individual items to arrive at price. These margins are quite stable over time, by and large, but "specials" create dramatic deviations from time to time. 2. Even within the same department, substantial differences in margins exist at any time. 3. Margins vary widely from department to department. 4. Margins usually are higher on private brands than on national brands of the same item. 5. Price cuts on items that are sold on special are usually substantial enough to be readily perceived; moreover, they usually are advertised. 6. Supermarkets run specials on a substantial number of items at any one time; frequently, specials are developed by the manufacturer rather than by the supermarket chain. 7. The items run on special vary substantially from season to season. 8. A supermarket chain will usually carry some items at a price well above the average prevailing in its market while offering some items at prices below the average—wholly apart from "specials." 9. Supermarket chains increasingly include some stores that are "discount operations"—featuring price appeals—while including also some nondiscount stores. As already suggested at several points, one cannot appraise the wisdom of a firm's pricing method without understanding its situation in great detail and without considering its alternatives. The forgoing list cannot substitute for a detailed description of a particular supermarket chain's pricing method, but it must suffice for our purpose. Can we characterize the forgoing implied pricing methods as rational? If not, what aspects of such pricing methods apparently depart from rationality as we have defined it? Persons familiar with the pricing activities of medium to large supermarket chains are usually impressed with their flexibility and imaginativeness. Their managements usually seem alert to perceptual aspects of pricing, thoroughly versed in demand interdependence, and, in general, aware of many ingenious alternatives. Moreover, it is a rare supermarket chain that settles into a stodgy pricing rut. All of these characteristics are earmarks of rationality as defined here. If there is some major weakness in these pricing methods, they will ordinarily be found in the amount and interpretation of data for pricing purposes. It appears that supermarkets do not keep a careful record of their price experience. Moreover, the few who do keep records seem to distort or even ignore the cross-elasticities of demand that are pertinent. A merchandise manager might recognize, for example, that by reducing his price for beef, he lowered his sales of pork and fowl; he is, however, likely to ignore its effects on sales

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of salmon, tuna, corned beef hash, eggs, etc., even when the effects might be substantial. But, before condemning him for his neglect, one should reckon the cost of collecting such data in a form that is sufficiently accurate to justify their use for decision purposes. Perhaps they are wise to do without such data; however, they must take account of these interrelationships—even if they do so by guessing. A MANUFACTURER'S PRICING OF A BROAD LINE OF PRODUCTS:

Consider

a producer of a line of plumbing and heating equipment—or of chemicals, pharmaceuticals, appliances, or foods for that matter. In such cases, the many individual items that the firm offers for sale are usually priced in a manner that seems quite crude and mistaken to sophisticated marginalists. First, pricers usually make a strong effort to avoid price changes even though their costs and sales vary moderately (albeit unpredictably) from year to year. Second, the prices of new or altered items are set on the basis of standard costs plus a fairly standard mark-up—with minor adjustments to maintain reasonable-appearing differentials. Third, when competitors do something notable, other firms follow. Fourth, every once in a while most firms depart from these policies to test new hypotheses or to adapt to some crisis or to a major change in personnel and policy. Many firms in such situations develop an intraline strategy. They include attention-getters and "traffic-builders," relying largely on the low price, and "reassuring items," which are high in price but convey the impression of superior quality, advanced engineering, mastery of new product concepts, and technology. Although very few of these items (as well as of "attentiongetters"), are actually sold, they are expected to enhance the sales of the "staples" in the line. Other firms handle their long product line routinely—with standard mark-ups—with the exception of a few items that are given special attention. These items may be supported by intensive demand studies and market experiments, their prices may be varied while others in the line remain unchanged, or their prices may be governed by simple heuristic principles. What can we say of such methods of pricing? Are they to be condemned because only a few items are given careful attention by the price-setter? How can we evaluate a price-line strategy oriented around the notions of "promotional items, prestige items, and staples"? Let us assume that such blatant disregard of marginalism would be proofpositive of irrationality. But what would we propose if we were asked how the firm should set price? Does anyone believe that knowledge of price theory would enable a price-setter to improve substantially on the procedures employed? In specific cases, we would surely find that some sellers had given too few or too many items careful attention or done so in a manner less rigorous than we would prescribe. But it would be their failings as data collectors and interpreters rather than their conceptual shortcomings that would be the

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main flaw—irrationality—in pricing method that we would find. THE

PRICING PROCEDURES OF A ONE-PRODUCT

MANUFACTURER:

Con-

sider now the pricing procedures of a manufacturer of fabric or steel or some basic raw material. Now we are dealing with a firm that resembles, however remotely, the hypothetical firms with which price theory is concerned. The firm has a single central price rather than a broad line; it sells to firms that reprocess the item; stability of price and psychological properties of price do not figure prominently in their considerations. Whatever image the various buyers have of the seller, it is not likely to matter much in the seller's considerations. Discussions by executives that relate to price in such firms ordinarily revolve almost entirely about competitors' behavior. A large proportion of the discussion would be concerned with rumors to the effect that one or more competitors are stealing business by secret price cuts. Approximately the same amount of discussion would consist of veiled suggestions that this firm should do the same thing. As perceived by many executives, their firm is more effective at "sharpshooting" than most of their competitors. That is, they possess the skill required to attract key customers from rivals by concentrating sales efforts on those accounts and by developing "deals" particularly attractive to them. However, sharpshooting activity has been kept close to zero by inhibitions and "taboos" based upon a form of social pressure. The doctrine is that a decent well-behaved firm simply does not behave that way. Management strives to achieve and preserve stability in the industry; outbreaks of competitive activity are regarded as an infectious disease—something that could be fatal if allowed to spread. In addition, individual competitors clearly are characterized by a lack of symmetry in their competitive relationships. Some of their competitors are much more successful than others in winning away their customers. Similarly, each one is more powerful in winning certain kinds of business away from particular competitors than from others. A study of price records would show that the willingness of firms to engage in sharpshooting and to make widespread secret price concessions is far from constant. When business is good, sharpshooting is reduced to almost zero. When business is bad, sharpshooting is the rule. Again we must ask, what would be a rational form of pricing of a single main product firm in a market characterized by very high cross-elasticity of demand? Surely it revolves around the kinds of issues that are entirely obvious to practicing business executives. In these matters, their knowledge and rationality is not likely to be less than that of economic theorists or even game theorists. SUMMARY AND CONCLUSIONS

Mainly this paper suggested a basis for evaluating prevailing pricing practices. It propounded a basis drawn from decision theory. The use of a stand-

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ard of evaluation from outside the bounds of formal economic theory results from the great simplicity of the traditional models of markets. (This fact makes them particularly useful for some purposes but not for mine.) Little effort has been made to build a set of normative models for use by businessmen; until that is done on a large scale and on a substantially different foundation, price-setters will derive much more help from decision theory than from price theory. In a rapidly changing world where uncertainty dominates, forecasts of market responses to multiple-product sellers' actions, price decisions understandably lack the appearance of precision and rigor. Certainly, they bear little resemblance to the picture of price-behavior presented in price theory. However, when one examines the pricing methods employed widely in business within their setting and takes account of the costliness and dubious accuracy of market information, they are not unimpressive. The simple cost-plus, a conventional margin method of pricing, no longer dominates all others. Demand considerations, including sophisticated notions about methods of creating favorable price misperceptions, are not neglected by any means. However, one finds an understandable—and I would say rational— effort to hold price changes to a modest number, for they impose sizable costs and often give rise to instability and speculation. In establishing a standard for evaluating pricing methods, one must attach major importance to the fact that price is only one of a combination of sales devices that almost always is most effective when used in combination. Also, pricing success is based largely upon the creation of wise strategies and policies and upon the identification of imaginative merchandising programs —in which price figures as only one element.

CHAPTER SIXTEEN PRICING PRACTICES AND ANTITRUST by Ε. T. Grether This discussion is concerned with the body of laws, regulations, and enforcement activities intended to maintain and enhance the rule of competition as our basic national economic policy with special emphasis on pricing practices. By now it is exceedingly difficult, perhaps impossible, to demarcate clear-cut, orthodox, recognizable antitrust laws from the full complex of consistent and contradictory public policies and regulations—federal, state, and local—affecting pricing. It will be impossible, of course, to survey the entire enormously complex universe. The discussion will open with a brief, taxonomic, interpretive view of recent actions of the Antitrust Division of the Department of Justice. Then, by way of contrast and contradiction, a few issues and areas of regulation based on special legislation will be interpreted. Finally, there will be some broad, general comments based on these brief glimpses in the setting of our presumed national economic policy of maintaining and enhancing competition. A

TAXONOMIC V I E W OF D E P A R T M E N T OF JUSTICE ANTITRUST

CASES

Recent actions of the Antitrust Division of the Department of Justice were classified in various ways in order to establish the extent and nature of the oversight over pricing and pricing practices. 1 In the Report of the Assistant Attorney General in charge of the Antitrust Division for the fiscal year July 1, 1964, through June 30, 1965, there is a tabular comparative analysis of cases filed covering the fiscal years 1959 through 1965. To this table we added the cases for the year 1958 and through June 30, 1966. If our classification is correct, 61 per cent of all the cases filed during this period involved price-fixing. We made a detailed, case-by-case review of the cases since fiscal 1961 through June 30, 1966. Fifty-three per cent of the cases were classified as relatively simple per se cases involving price agreements and in some instances territorial allocations and market division. In addition, about 11 per cent of the cases involved price-fixing in some form along with such other issues as acquisitions and monopolization, thus raising the total to 64 per cent. This percentage can be raised to 73 by including governmental treble-damage actions, which are becoming an increasingly important aspect of enforcement. 1

Appreciation is expressed to Ed T h o m s o n for his arduous labors; unfortunately, much of the result of his efforts will not s h o w in this particular paper.

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One hundred seventy-one cases during the 1961—1966 period were classified as involving price agreements and market division. One hundred of these cases involved horizontal arrangements with the largest number, 78, among manufacturers, 14 among wholesalers, and 8 among retailers. Thirty-four cases involved vertical market relationships, of which 11 were among manufacturers, 14 among manufacturers, wholesalers, and retailers (the market channel), 7 manufacturer-retailer relations, and 2 wholesalerretailer relations. Nine cases involved agricultural processors and distributors, 9 involved contractors, and 19 involved the service trades. All but one of the agricultural processor and distributor cases were in the field of dairy products; the lone exception was in meat packing. All but one of the dairy cases involved issues of price conspiracy, price-fixing, and bidrigging in sales to public schools or to an air force base. 2 The contractor cases typically involved charges of bid-rigging and joballocation. The service trade cases ranged from banks and insurance company groups to weigh masters, tailors expressmen, broadcasters, iceshow producers, refuse-removal firms, diaper services, and linen suppliers. In almost all of these cases, except for the banks and insurance companies, there were charges of price- and rate-fixing and bid-rigging, allocation of customers and territories, limiting the free choices of customers, and miscellaneous harassing and exclusionary practices. Price-fixing appeared in 34 additional cases in connection with other actions, excluding the governmental damage cases. The other actions included Sherman Act, section 2 (monopolization), and Clayton Act, section 3 (patent licensing, tying contracts, franchising, exclusionary practices), and section 7 (acquisitions) and section 2 violations of Robinson-Patman Act provisions. The element common to most of these cases was the monopolization charge. It is likely, of course, that prices and pricing were involved implicitly in the remaining Clayton Act, section 7 (merger), and Sherman Act, section 2, cases, even though there were no explicit charges of price-fixing. Although the majority of cases involving price-fixing and market- and customer-allocations were at the horizontal level during the period 1961— 1966, there was substantial oversight over vertical market relations. The largest single category of cases involved various types of agreements and arrangements fixing and policing resale prices in the market channels. Sometimes the entire structure of vertical relationships was involved, i.e., from manufacturer through to ultimate consumers. In some instances there were agreements among manufacturers which extended down through the marketing channel. In others, there was a simple arrangement among a given manufacturer and his dealers. One case involved a wholesale-retail agreement as to prices and policing. The various cases indicated consider"See below, pp. 242 and 243.

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able variations in the character of the understandings and the policing and breadth of involvement. Not infrequently, there were agreements as to territorial and customer-allocation. Occasionally there was some endeavor to restrict supplies to dealers who cut prices or in other ways violated the general understandings. There were occasional references also to the elimination of actual and potential competition and to the erection of barriers to entry. Thus, in recent periods, the Antitrust Division in the main has continued its traditional opposition to group arrangements establishing and policing resale prices, whether the impetus comes from manufacturers, wholesalers, or retailers, or all parties together. Similarly, but less frequently, are actions directed at restrictive distribution, territorial and customer-allocation, and controls over entry. Antitrust cases, like most examinations in university courses following the coverage of a great mass of material, can and do touch only a small portion of the universe. Insofar as there has been some concentration over the years since 1890, it has been in the broad categories of food and kindred products (including distribution), building materials and their distribution, and service industries, including transportation.11 In terms of the full classification and listings of products, the coverage seems light indeed. Undoubtedly, however, the multiplier impacts have been substantial. During the period of intensive review, 1961 to June 30, 1966, the same areas continued to rate high in antitrust interest as in the recent past; viz., alcoholic beverages, both production and distribution, building materials, optical lenses, and petroleum and petroleum products. There were substantial increases in antitrust activity in the following areas: bread-baking and distribution, dairy products, meats, pipes (cast iron, concrete, plastic, and brass), newspapers, news services, primary metal products (aluminum and steel products), chemicals, fertilizers, drugs (especially the distributive trades), electrical equipment, and motor vehicles. New areas of activity were opened up in the following fields: television, magazines, school supplies, some miscellaneous services, banking and aircraft. Many commodity and service areas, a list in fact too long to give here, in which there have been some scattered activity at one time since 1890, have escaped attention since 1961. This brief over-all review, of course, suggests the serious problems and importance of the selection and prosecution of cases in the light of limited resources, complaints received, congressional interest, and over-all ' S e e i. S. Bain, Industrial the period 1890-1957.

Organization

( 1 9 5 9 ) , p. 491.

Bain reviewed the cases for

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Grether

antitrust strategy. 4 We may conclude that so far as the Department of Justice is concerned, scrutiny of price-fixing, especially overt price agreements, continues to be the central area of emphasis. 5 The Sherman Act, section 2, cases on monopolization continue to represent a small percentage of the total actions (approximately 13 per cent over the period 1958-1966). In the merger area, however, there is a rising curve of both investigations instituted and cases filed. SOME CONTRASTS AND CONTRADICTIONS

In contrast with and in relation to the heavy emphasis of the Antitrust Division of the Department of Justice on the prohibition of price agreements and on freeing markets of price-fixing, the following areas or aspects of price regulation will be interpreted briefly: 1. The sales-below-cost statutes (or Unfair Practices Acts) of the states 2. Robinson-Patman Act 3. Resale-price maintenance or "fair trading" 4. Geographical and delivered pricing 5. Pricing and sales promotion 6. The public regulation of the milk industry THE UNFAIR PRACTICES OR SALES-BELOW-COST LAWS: Some 31 states still have effective general "Unfair Practices" statutes affecting the selling prices of particular products, especially in, but not limited to, the wholesale and retail trades. In addition, in some states there are special statutes directed at the pricing of milk, alcoholic beverages, tobacco products, bread, etc. Our concern in this section, however, is with the general statutes. Even though these laws have general applicability, their impacts are sharply upon the prices and price levels of particular products, especially in the grocery field. This is not the place to describe the variations among the states in the wording with respect to intent to injure or destroy competition, or effect or result of injuring a competitor, or the problems of defining and determining cost, or the variations in "the meeting of competition" defense, and so on. 8 4

We endeavored also to classify the cases in terms of areas of geographical coverage, national, regional, state, subregional, municipal and county, etc. T h e results of this endeavor will not be reported here in detail because of the difficult problems of area delimitation. It would appear that the largest single bloc of actions m a y be classified as "national," but there have been numerous regional, state, and highly localized actions. 5 Our percentage calculations were derived f r o m a simple enumeration of actions as filed and in process and involve some amount of double counting, since we did not, for this purpose, segregate the criminal f r o m the civil cases. β For a very brief over-all s u m m a r y of the state laws see V. H . Mund, Government and Business ( 1 9 6 5 ) , Chap. 22.

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The general effect of these heritages of the N.R.A. and Great Depression is to place artificial price floors under the local markets (as for food products) either contrary to or without relation to the prices that might have appeared under free, flexible, local competition. National firms, consequently, are faced with difficult pricing dilemmas. If they go along with these state and local pricing patterns they may be charged with participating in price agreements under federal actions. If they do not go along, and depart from the price patterns, they may be subject to action under the state law. Hence, they must be very careful in pricing to protect themselves against the charge of reducing prices locally below costs, or the arbitrarily established price floor, with alleged predatory intent. In any event, often aggressive, flexible pricing is checkmated in favor of defensive meeting of prices. And pricing in terms of local demand and competition and especially in terms of the total product mix comes under the influence of what I called back in the 1930's "the phenomenon of readjusting marking rates." 7 Thus, in my own state the Unfair Practices Act or sales-below-cost statute in 1961 was amended in such a manner as to make the Act much more effective. Under the amendment, proof of limitation of the quantity of an article sold, together with proof that the price is below the invoice or replacement cost, raises a presumption of intent to injure competition or destroy competition. During the weeks immediately prior to the effective application of the amendment, and ever since, pricing and competition, in the grocery field especially, began adjusting and readjusting, as they had also during the late 1930's. Marking rates in some situations began shifting from a small number of deeply cut specials and a large number of items under higher gross margins towards a general lowering of gross margins. Some stores shifted to a general discount or lower marking rate bases, i.e., towards a straight price stress. Others worked out various modifications including trading stamps and various types of special promotions. The variations in adjustment and emphasis are still continuing, with an apparent, increasing trend towards store-wide promotional devices unrelated to specific products. The point is that in California, as well as in some other states, the state market floor or salesbelow-cost laws do affect pricing and price competition to a significant degree. Much depends upon the character and relative aggressiveness of the state and local enforcement officials and the mix of enterprises, including especially the proportion of the volume of larger regional and national firms who are placed in double jeopardy by the state law and enforcement. A further effect is to focus pricing sharply upon individual products ;

See, e.g., Ε. T. Grether, Price especially Chaps. VIII and XI.

Control

Under

Fair

Trade

Legislation

(1939)

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umder conditions that require the arbitrary allocation of costs of doing business to the invoice or laid-down cost of the product. Undoubtedly thie pricing results are often quite different from what they would be if the enterprise were free to price in terms of the mix as a whole or even by broad groupings of products. In order to avoid or simplify such arbitrary arad nonsense allocations, some states have adopted the even more questionable procedure of naming specific cost floors, as presumed mark-ups as; 6 per cent (15 states), or 8 per cent (Minnesota, Idaho), 12 per cent (Arizona), 7 per cent (West Virginia), 5 per cent (Maryland), and 4 per cent (Pennsylvania). Actually, resellers in the final analysis are concerned with the gross and net margins above inescapable costs (as in-voice costs) on total operations, or by broad groupings of products, insofar as such groupings have significance in terms of cost-accounting and demand (sales) factors. THE ROBINSON—PATMAN ACT: The Robinson-Patman Act, like the sales-below-cost statutes, was rooted in the despair and conflicts of the Great Depression but oriented also from the locality price-discrimination or local price-cutting episodes early in this century as reflected in the Clayton Act of 1914. The basic motivation of the Robinson-Patman Act derived from the vigorous competition between the growing chain-store system and unorganized and organized independent retail dealers and their wholesale suppliers. A widely ranging series of studies of chain stores by the Federal Trade Commission, together with the recommendations in a Final Report published in December 1934, antedated the Robinson-Patman law, but, unfortunately, as is often true of great bodies of evidence and of recommendations presumably based in them, they had little direct influence upon the specific character of the Act as passed. Although the Act grew clearly out of the great conflicts of competing types of enterprises, its focus point was on price discrimination in the sale and purchase of commodities of "like grade and quality," rather than upon the full competitive clash of competing types of enterprises. This stress appeared even though the Federal Trade Commission Report had indicated that preferential buying advantages were by no means the sole or leading source of competitive advantages of the chains. Furthermore, enforcement of the Act requires attention to all levels of marketing relationships, or to the so-called market channels. That is, the Robinson-Patman Act deals with very complex relationships—primary, secondary and tertiary—as between competitors on the same level, and their competing customers at lower levels. Enforcement, therefore, concerns itself with the full, many-sided, complex relations between manufacturers and their wholesalers and retailers. Such vertical relationships involve not only sales prices to competing outlets but also so-called functional or trade discounts for services performed, and the provision of special

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Practice, and Public

Policy

services and facilities by sellers and the payment for services and facilities provided by buyers. As a result of political jockeying and compromise, particularly because of the fear of farm groups that the discount structures of agricultural purchasing cooperatives might be endangered, the Act omitted reference to functional discounts. But the provision of services and facilities or the payment for such facilities must be available on proportionately equal terms to competing customers. Thus, there was explicit recognition that manufacturer-dealer relations involve much more than the purchase and sale of particular commodities. Yet, the basic provision of the Act was a simple prohibition of price discrimination between purchasers "of commodities of like grade and quality" where the effect may be substantially to lessen competition or tend to create a monopoly or to injure, destroy, or prevent competition. Over the years, the Federal Trade Commission has successfully insisted upon a physical-properties-and-characteristics test of "like grade and quality" under section 2 ( a ) of the Act. This whole matter came into sharp focus again last year in the Supreme Court decision in the Borden* case in which the majority of the court accepted this traditional position of the Federal Trade Commission in reversal of the Appellate Court, in an opinion delivered by Mr. Justice White. Mr. Justice Stewart, joined by Mr. Justice Harlan, wrote a strong dissenting opinion. Unfortunately, I cannot here present and appraise the differing views and interpretations of the meaning of the act's legislative history. Basically, however, the matter becomes one again of Weltanschauung. The Commissioners and the majority of the court, for section 2 ( a ) purposes, prefer to drop out all of the meaning and significance of the economics of monopolistic competition and of product differentiation in favor of the presumably simpler conceptualization in terms of physical and chemical tests and identities. Thus, for threshold purposes under section 2 ( a ) , even sharp, well-recognized differences in consumer-buyer and market preferences involving substantial price differences are disregarded. To do so is to omit from consideration the essence of product differentiation and brand and sales promotion so characteristic of modern marketing, and the entire grand strategy of competitive marketing. Yet, measurable evidences of consumer market or economic preferences can often be established as readily as, or more so than, physical characteristics. The majority position is held so strongly because of the view—fallacious in my opinion— that the whole structure of enforcement against price discrimination would crumble, and hence, price discrimination would run rampant, if brand preferences were recognized in the definition of "like grade and ' F.T.C. v. Borden Company, 86 S. Ct. 1092 (1966).

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quality." The court, however, did not entirely deny the reality and importance of market preferences and differences. It cited with approval the opinion of the majority members of the Attorney General's National Committee to Study the Antitrust Laws "that tangible consumer preferences as between branded and unbranded commodities should receive due legal recognition in the more flexible 'injury' and 'cost justification' provisions of the statute."" It held, too, that a price differential under attack could be defended "as a good faith effort to meet the price of a competitor." Adequate discussion of all these issues would require many pages. Since my own views are available in some detail elsewhere, 10 I shall rely upon a few of the conclusions of the dissent in the Borden case by way of a sum-up: There is nothing intrinsic to the concepts of grade and quality that requires exclusion of the commercial attributes of a product from their definition (p. 1100) . . . The Commission's determination of 'like grade and quality' under section 2(a) in this case is seriously inconsistent with the position it has taken under section 2(b) in cases where a seller has presented the defense that he is in good faith meeting the equally low price of a competitor. The Commission decisions are clear that the 'meeting competition' defense is not available to a seller who reduces the prices of his premium product to the level of non-premium products sold by his competitors (p. 1104) . . . It is unlikely that economic differences between premium and private label brands can realistically be taken into account by the Commission under 'the injury to competitors' and 'cost justification' provisions of section 2(a). Even if relevant cost data can be agreed upon, the cost ratio between Borden's premium and private label products is hardly the most significant factor in Borden's pricing decision and market return on those products (p. 11 OS) . . . In Automatic Canteen Company of America . . . , this court cautioned against construction of the Robinson-Patman Act in a manner that might 'give rise to price uniformity and rigidity in open conflict with the purposes of other antitrust legislaton.' Today that warning goes unheeded (p. 1107). In sum, the Robinson-Patman Act, as worded, interpreted, and enforced, has become an instrument for the specific direct regulation of pricing and trade practices instead of a creative base for grappling with the broad clashes between types of enterprises in their vertical relations in American markets. Its basic thrust is toward uniformity instead of s

Report of the Attorney General's National Committee to Study the Antitrust Laws (Washington, D.C.: 1955), p. 159. 10 Ε. T. Grether, Marketing and Public Policy (1966), pp. 58-68: R. Cassady, Jr., and Ε. T. Grether, "The Proper Interpretation of 'Like Grade and Quality', within the meaning of section 2 ( a ) , of the Robinson-Patman Act," Southern California Law Review, Vol. 30 (April 1957), pp. 241-279. The latter paper was cited by both the majority and dissenting Justices in the Borden case.

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innovative flexibility, despite some favorable impact upon undue bargaining discounts. 11 RESALE-PRICE-MAINTENANCE OR "FAIR TRADING": In contrast to the Sales-Below-Cost and Robinson-Patman Acts, the state "fair trade" laws and the federal enabling legislation in this field explicitly recognize and in fact are based upon product differentiation, trademarking and brand promotion, and vertical market structures and relations. This departure from the previous and (as noted above) continuing Sherman Act interpretations and actions was through direct legislative intervention. Defenders of the traditional and current definition of "like grade and quality" under the Robinson-Patman Act by the Federal Trade Commission suggest that this interpretation must hold unless also changed by legislation. The long-term base of and requests for resale-price-maintenance are found in successful brand promotion by manufacturers and the consequent direct impact upon and intervention in the wholesale and retail trades (or marketing channels). But the various means of establishing resale prices of branded goods, one by one, fell under Sherman Act interpretations, including collective action, except for the mere suggestion of resale prices and refusal to deal "without more." Currently, consignment selling also may be on the way out as a means of resale price maintenance. 1 - Although the rapid momentum in the 1930's in the United States was Depressionbred and -borne (as was true of the Sales-Below-Cost or Little N.R.A. Acts), it is a mistake to call the Fair Trade Acts children of the Depression. The original, ostensible, frequently stated purpose of resale-price-maintenance was to protect the intangible property rights in the goodwill of trademarks and brands created by successful brand promotion, advertising, and selling by manufacturers. It is worth recording that the recent socalled quality stabilization approach reverts strongly to this emphasis as clearly expressed 30 years ago in Old Dearborn Distributing Co. v. Seagram Distillers Corp.™ But the actual drive behind resale-price-maintenance over the years came more largely from organized distributors, especially retailers in certain trades, as in drugs and pharmaceuticals. Successful product differentiation and brand promotion by manufacturers " T h e r e is a sizable helpful literature on the polemics of the Robinson-Patman Act including C. D . Edwards, The Price Discrimination Law ( 1 9 5 9 ) ; F. M. Rowe, Price Discrimination Under the Robinson-Patman Act ( 1 9 6 2 ) ; H. F. Taggart, Cost Justification ( 1 9 5 9 ) ; A. E. Sawyer, Business Aspects of Pricing Under the RobinsonPatman Act ( 1 9 6 3 ) . 12

Simpson v. Union Oil Co. of California, 377 U.S. 13 ( 1 9 6 4 ) , and comment by M. Handler in Michigan Law Review, Vol. 63 ( N o v . 1964), pp. 59-67. There is also the recent action against the General Electric Co.'s long-established consignment plan in the sale of light bulbs. 13 229 U.S. N o . 2, 183 ( 1 9 3 6 ) .

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creates one of the requisites of "pure" competition among their distributors, viz., product homogeneity, since all handle the identical branded product. This result is especially powerful when all dealers, large or small, must sell this identical brand because of its dominant market position. The requests for resale-price-maintenance have been most powerful and best organized in those trades in which this type of dominance exists. In trades in which dealers can and do carry different brands under forms of exclusive and selective distribution, or private branding, conditions and pressures are quite different. There may still be support for resale-price-maintenance but without the same urgency or organized pressure. As a matter of fact, there is and will continue to be a great deal of voluntary or semivoluntary resale-price-maintenance in the absence of Fair Trade contracts because of the high mutuality of interests when manufacturers find exclusive and selective methods of marketing suitable or preferable. It is likely that these forms of more voluntary resale-price-fixing are quantitatively more important in American markets than "fair trading" as such. Under these conditions, resale pricing must be looked at in terms of the full set of relationships between manufacturers and their distributors, including territorial rights, geographical pricing, cooperation in advertising and selling, and the provision or purchase of special facilities or services, as under sections 2(c) and 2(d) of the Robinson-Patman Act. And more recently the booming, troublous growth of so-called "franchising" in diverse forms has enlarged this great arena of market action. Actually, it is not too difficult to understand and interpret the play of such market forces as between the extremes of so-called general distribution and exclusive distribution. Unfortunately, for simple analysis and public policy many—perhaps most—situations are in the processes of uneasy adjustment between these extremes. Often manufacturers have great difficulty in making decisions in this area unless they are faced by a powerful, well-organized body of distributors. In recent years resale-price-maintenance in the form of "fair trading" has been on the decline as the consequence of unfavorable court and other actions among the states.11 It is easy for us as economists, on the one hand, to agree with the clear-cut judgment of the Attorney-General's National Committee to Study the Antitrust Laws that "fair trade" pricing is an "unwarranted compromise of the basic tenets of antitrust policy."1" But it is very difficult for us, on the other hand, to visualize the actual pressures and problems in American industry and trades and to enunciate reasonable approaches in public policy. The recent voluminous hearings " Glenn E. Weston, "Fair Trade Alias 'Quality Stabilization' Status, Problems and Prospects," 22 A.B.A. Antitrust Section (1963). 11 Report of the Attorney General's National Committee to Study the Antitrust Laws, p. 154.

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Prices: Issues in Theory,

Practice, and Public

Policy

on dual distribution and franchising merely reflect one of the current expressions of long-continuing sets of relationships, pressures, and clashes arising out of broad conflicts of interests, including the division of the market income. It is often overlooked that vertical market or channel relationships, like those between employers and organized labor, involve collective bargaining over the division of the market pie, as, for example, between automobile manufacturers and their dealers. The solutions to the broad conflicts cannot be found either through legislative favoritism, as occurred in the case of "fair trade," or simple per se proscriptions on the part of regulative agencies. GEOGRAPHICAL AND DELIVERED PRICING: A critical issue to t h e m a i n -

tenance of a strong procompetition policy is the extent to which competitive forces are effective over geographical areas. The high relative wealth and prosperity of the United States is often explained in terms of effective competition in our great, internal, free-trade area. Undoubtedly this model has been the most important single economic influence behind the European common-market conceptualization. The pricing of staple products especially from the agricultural industries derives from the play of the great impersonal forces of supply and demand. From a geographical standpoint, such prices are the sensitive valves adjusting the geographical surplus-and-deficit relations. But in the administered pricing of differentiated manufactured goods there is no simple presumption that price as enunciated at any point in the total system has this strategic role or significance. Rarely does the price as such stand out sharply and clearly. And in fact, the price may not be the same price from the point of view of the producer and seller and that of buyers for use or resale. From the point of view of the seller, the price or basic price represents a net contribution of some sort to gross and net profits after allowing for terms, datings, special services, freight absorption, and all inescapable costs. A publicly quoted price always is somewhat fictional until all allowances are made, and the allowances may involve accounting conventions about which there may be high disputes. From the point of view of the buyer and user the price is the laid-down cost of the product at the point of use or resale after making allowance for all discounts, allowances, etc. And even here there may be important accounting conventions that affect the determination. Thus, for example, the laid-down cost is quite different in the receiving room of a store from what it is on the counter ready for sale. Furthermore, the user or reseller, too, is concerned primarily with contribution to gross and net profit margins. Hence, a lower or higher quoted price on a specific product (as gasoline to a dealer) may be more than offset by changes in lease and lease-back arrangements, special allowances, special services, gifts of equipment, provision of capital below market rates, etc. Issues of price discrimination, both personal and

Ε. Τ. Grether

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geographical, cannot be resolved without full knowledge of all aspects of the transactions as negotiated. All of these variables, of course, reach their peak of complexity and of reality in the relationships between manufacturers and wholesale and retail distributors in the marketing of branded, differentiated products. Hence, the outcome often tends to be the quotation of public uniform prices to dealers and users in competition, thus avoiding a Robinson-Patman charge at the secondary level. But other elements of the total negotiated transactions need not and often are not uniform, although the provision or purchase of facilities or services are supposed to be on "proportionately equal terms" in terms of sections (c) and (d) of the Robinson-Patman Act. But in the sale of relatively homogeneous manufactured products of relatively low specific value available from relatively few sources (like cement and sugar), the publicly enunciated price has significance comparable to that of staple agricultural products. In these instances, the basing point method of delivered geographical price quotation springs almost spontaneously out of the conditions of the industry and requirements of marketing. The laid-down delivered cost to the buyer will be the most decisive factor affecting purchase. Thus, we again run into our old friend "meeting competition." Since a sale would be impossible at a higher level, it is obviously necessary to meet the laid-down price of actual competitors. If the sale can be made on this basis, it would seem marketing nonsense to offer a lower price, especially if it is assumed that competitors would react immediately. Whether "meeting" or "beating" occurs openly or sub rosa will depend upon the relative eagerness of competing sellers for the business, considering their rates of capacity utilization, backlogs of orders, and alternative opportunities and assumptions as to the reactions of competitors. The public-policy problem in the famous basing point cases was not the relative uniformity of quoted prices in any given situation but a general pattern for all competitors on a formula basis maintained over wide geographical areas and over a considerable time period. Beating prices on the part of national firms in local markets, however, raises the possibility of a charge of predatory pricing directed at a specific local competitor. Obviously, here is an exceedingly important matter because the effectiveness of geographical competition could be seriously weakened through fear of the charge and the treble-damage risks. Undoubtedly, this fear does affect pricing behavior. Business firms frequently stress the brinkmanship involved in a charge of a price agreement on the one hand if prices are uniform or of predatory pricing in the absence of uniformity. Undoubtedly, in some instances, this alleged fear becomes the basis for rationalizing meeting rather than beating prices. The drift of

240

Prices: Issues in Theory, Practice, and Public Policy

the Department of Justice cases in this field arising under the original section 2 of the Clayton Act on the whole supports the conclusion that localized price-cutting will be struck down only when it is of predatory intent and nature.1'1 The court reviews of Federal Trade Commission cases, including those under the Robinson-Patman Act, point toward the same general conclusion. 17 It is likely, however, that business pricing practices may not run entirely in the terms of case law and its interpretation. One always lacks the evidence of advice by counsel and of discussions in board rooms and by price-making officials. Actually, it is doubtful policy to interpret the behavior of large national firms only in terms of a single local market. The context and framework should involve the total pattern of competitive relationships in relation to the given submarket under scrutiny. 1 " PRICING AND SALES PROMOTION: A most interesting and difficult area— or rather whole series of areas—of regulation have to do with pricing and the myriad expressions of and devices for sales promotion. In terms of the problems and behavior of the enterprise, the various aspects of pricing and sales promotion are parts of an organic whole of business-getting at a profit especially in product innovation. The major differentiation is between expenditures focused on particular products or groupings of products or upon the enterprise as a whole or divisional break-downs within the enterprise. For internal managerial purposes, accounting conventions often decide how expenditures are allocated. Internally, there are often sharp differences of opinion as between price-makers, top management, and those in charge of selling, advertising, and promotional activities. Such internal differences become serious, often critical, in relation to the rules and precedents of law and regulation—federal, state, and local. One of the most difficult and interesting areas in terms of the problem of this paper derives from promotional means that confer substantial, direct, and indirect economic benefits. We have already noted the RobinsonPatman Act requirement that the provision or purchase of services and facilities be on a proportionately equal basis; our interest at this point, therefore, will be directed to consumer-buyers. Trading stamps and other forms of premium offers are currently the leading examples. A number of years ago I labeled such promotional devices a form of "external product differentiation" when applied to specific products and of "enterprise dif10

For review of the cases supporting this conclusion see W. Simon, "Pricing Practices Under the Antitrust Laws: A Survey of Recent Legal Developments," Rocky Mountain Mineral Law Institute, Vol. 2 ( 1 9 6 5 ) , pp. 226-231. 17 Ibid., pp. 231-245; see especially the discussion of Anheuser-Busch, Inc., v. Federal Trade Commission, on pp. 239-242. " See the interesting commentary of Robert C. Brooks, Jr. on the Anheuser-Busch case in New Research in Marketing (Berkeley, Calif.: Institute of Business and Economic Research, University of California, 1 9 6 6 ) , pp. 70-82.

Ε. Τ.

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241

ferentiation" when applied generally to all the offerings of an enterprise. The basic issue in terms of pricing and price regulation is whether the benefits conferrred can be met either by equivalent price reductions on specific products or by a general over-all reduction of marking rates—in other words, by intensified price competition. The difficulty, especially in the case of trading stamps, is that the benefits to consumer-buyers are conferred in terms of possible choices from a whole catalogue or display store of products. Hence, buying choices, especially on the part of housewives, are diverted from the price and quality of given products into a broader and likely much less precise type of calculation. When trading stamps and other premium offers are available on a restricted-franchise basis to dealers, they become means of enterprise differentiation. Thus, important issues concerning the use of exclusionary and restrictive policies also intrude into the pricing and promotional mix, further evidence of the organic, interdependent nature of the issues involved. By now there is an enormous mass of adjudicated evidence and precedents on trading stamps alone among the states and some interest and actions on the part of both the Department of Justice and Federal Trade Commission.2"' The recent report of the National Commission on Food Marketing states, "Trading Stamps have come to be the outstanding form of nonprice competition." 2 1 On the same page of the report, in a discussion of "Specials and Loss Leaders" it is observed that "price specials are best understood as a form of promotion—not affecting the overall price level of the store—along with stamps, advertising, and other attentiongetting devices." 2 2 The final conclusions and recommendations of the majority members of the Commission clearly highlights the paradox of the issue before us, because it is suggested that the Bureau of Labor Statistics "should study means by which it might improve the accuracy of its reports of changes in food prices," particularly because "prices of certain products, . . ., especially red and poultry meats, do not adequately reflect the influence of price 'specials' advertised by retailers." 23 It is worth repeating at this point that the various types of sales-below-cost statutes of the states usually are rationalized in terms of the alleged competitive evils of loss-leader selling. Then, by the same token, enforcement of these acts, together with resale-price-maintenance under the "fair trade" " Ε. T. Grether, "External Product and Enterprise Differentiation and Consumer Behavior," in R. H. Cole (ed.), Consumer Behavior and Motivation (Bureau of Economic and Business Research, the University of Illinois, 1955), pp. 82-103. x F.T.C. Docket No. 8671. In re The Sperry and Hutchinson Company; and the Department of Justice action against Blue Chip Stamps in California. 21 Food from Farmer to Consumer, Report of the National Commission on Food Marketing (June 1966), p. 77. "Ibid., p. 113. a Ibid., p. 112.

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Prices: Issues in Theory, Practice, and Public Policy

laws, requires some determination as to what is considered to be price competition or something else. So far as I know, nowhere are loss-leaders rationalized as promotional instruments without reference to the prices of the specific products used as leaders, 24 whereas there is considerable variation among the states as to whether trading stamps and the like are a form of price-cutting that may be met by simple, clear-cut price reductions,-"' or cash discounts, or promotional expenditures—or what? We have merely crossed the threshold of an important area full of uncertainties and paradoxes. This is especially true in the case of enterprises broadly diversified, including the so-called conglomerates. In these instances issues such as the use of reciprocity and the so-called deep pocket and of "conglomerate power" came to the fore with implications both for pricing and promotion but more particularly for the appraisal of the competitive functioning of enterprises as a whole. Such issues cannot be resolved by approaching them in terms of a series of discrete product markets, or separate practices; some combination of relevant market-product and over-all enterprise analysis is required. THE MILK I N D U S T R Y : Milk is probably the classic example of widespread, detailed, particular commodity regulation—federal, state, and local—outside of the public utility sectors. From some points of view milk may now be considered a public utility. Hence, it will serve as our example of the character of results of detailed, specific, product regulation. Actually, alcoholic beverages would be an even more complicated case study in terms of variations among the states. The recent actions by the Department of Justice have a monotonous similarity—price conspiracy, price-fixing, bid-rigging in the sales to public schools or an air force base. The one exception raises issues of pricecutting below cost to destroy competition, secret rebates, and monopolization under sections 1 and 2 of the Sherman Act and of secret and discriminatory discounts and below-cost selling to eliminate competition under the Robinson-Patman Act. It is interesting to look at some of the long-term results under state regulation in California under laws dating back to 1935 to 1937. Among the results recently interpreted- 7 are: 21

25

K

71

A n e x c e p t i o n m a y be l o w e r court cases in w h i c h the t e m p o r a r y use of loss-leaders at the time o f o p e n i n g a store w e r e c o n s i d e r e d to be p r o m o t i o n a l . T h e leading case originated in O k l a h o m a and o n appeal. T h e U n i t e d States S u p r e m e Court in general upheld the constitutionality of s a l e s - b e l o w - c o s t acts. See S a f e w a y Stores, Inc. v. O k l a h o m a Retail G r o c e r s A s s o c i a t i o n , 3 6 0 U . S . 3 3 4 ( 1 9 5 9 ) . U . S . v. H. P. H o o d and Sons, Inc. and the Great Atlantic and Pacific T e a C o m p a n y , Inc., M a r c h 15, 1963. " A n E v a l u a t i o n o f C a l i f o r n i a ' s Milk Price Stabilization P r o g r a m : A S u m m a r y Report o f Progress," processed, N o v . 1964, G i a n n i n i F o u n d a t i o n o f Agricultural E c o n o m i c s , under the leadership o f D . A . Clarke, Jr. and O. D . F o r k e r , 25 pages.

Ε.

Τ.

243

Grether

1. An increasing trend in surplus Grade A production. 2. Large price disparities among producers, i.e., lack of equity. 3. Deliveries of milk to military bases below state-set minimums with an increasing tendency towards leakage to non-military personnel. 4. Provision of strong incentives for processor-producer integration. 5. Creation of problems among alternative types of distribution arising out of the 4 different minimum prices established for the leading, recognized types of distribution. 6. Transfer to supermarket operators rather than to processors or consumers of the benefits of more economical marketing methods. Lowcost, large-volume operators are forced "to take abnormally high profit margins on fluid milk," ranging up to 4.91 cents per quart. It was concluded too, that the results under California's milk-stabilization program in terms of prices, margins, or profit rates are not out of line with the experience under similar milk-control measures existing in other states. 28 SOME

GENERAL

COMMENTS

One of the speakers during the first session of this conference, in a skillful presentation of a simplified mathematical model, remarked, "I am skipping millions of steps." The concern of the speaker was with the complexities of the actual world which could not be reflected in his model. My concern is just the reverse because I have chosen to deal with the actual world and with governmental policies affecting it. Of necessity my discussion had to be on a highly selective basis. I can well appreciate the rush of younger scholars towards simplified model building. A more complete view than the one presented here, but still far short of real-life actualities, would fit in the Federal Trade Commission with all of its special statutory duties and assignments, including the curbing of deceptive and misleading advertising, and its regulatory activities overlapping and conjoining those of the Antitrust Division of the Department of Justice. And there are the other independent regulatory agencies with some amount of overlapping and the serious problems of primary jurisdiction. There are, too, an increasing and bewildering array of special statutes often directed at particular industries. In addition, there are exemptions from the Sherman Act which usually are only partial and limited, and often without clear adjudication, even in the public utility and quasi-public utility sectors. And there are a host of subventions, subsidies, and varieties of differential treatment. 2 " * Ibid., p. 4. F o r an appraisal of the federal milk-marketing order system see Report to the Secretary of Agriculture by the Federal Milk Order Study Committee, Dec. 1962. M See, e.g., Staff of the Joint Economic Committee, Subsidy and Subsidy-like Programs of the U.S. Government (Washington, D.C.: 1965).

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Practice, and Public Policy

The facts of life in the United States are that we have intruded myriads of cases of special treatment, often by special legislation, into or in contradiction to our alleged national procompetition policy, especially on the part of the states, as indicated to a small degree in the second part of this paper. These have come along case by case, situation by situation, statute by statute, here a little, there a little, so that one must now examine carefully the full regulative setting of each situation with specialized expertise in order to be on solid ground. Even then, time and again one cannot be certain because of unadjudicated issues and contradictory approaches or overlapping jurisdictions. Actually, case by case, situation by situation, it is possible to rationalize almost any form of special treatment, and find reasons for limiting competition. There is always some alleged or even provable private, public, or social benefit that can be pleded. And there is always also the "me-too-ism" stated so succinctly by Congressman Chet Holifeld. Mr. Holifeld pleads for "modified, regulated competition" at the retail level (hence for "fair t r a d e " ) because at all other levels—production, transportation, manufacturing—either competition is "modified" or the input costs are fixed by outside authority. The numerous body of retailers, he states, also have fixed, rigid input costs but without the benefit of "modified competition" to protect them. Mr. Holifeld's approach is frankly and openly "protectionist," or, as he put it, "I am not asking complete protection, I am asking for a fair amount of protection." 3 ( 1 We have been working ourselves into a position in peacetime akin to that of wartime price controls with their unending series of hardship or other adjustments. Individual enterprises, of course, with the advice of legal and public relations counsel, learn how to adapt their short-run policies, strategies, and practices. Step by step on this basis, strong vested interests and positions become built up with their attendant rationalizations and need for continuing protective political support as evidenced currently by the furore created by the proposed moratorium on the 7 per cent investment credit. In the ongoing processes, however, inevitably there will be situations of unequal actual or alleged political favoritism. Consequently, our presumed procompetition policy becomes subverted and sabotaged and deflected into a widening orbit of particular actions and adjustments, to redress the shifting balances, as is amply demonstrated by the public regulation of milk, and the "meeting competition" defense under the State Unfair Practices Acts. In this setting, antitrust must plod its weary way, proceeding also on a case-by-case basis, without showing its full hand—if it has one. Furthermore, in the very nature of the processes of court review and of keeping in harmony with the precedents, there is an inevitable lag behind both the advance of knowledge and the rate of business and economic change. 30

See pp. 259-269 of the Quality

Stabilization

Hearings,

1963.

Ε. Τ.

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245

The antitrust actions are directed, for the most part, at least numerically, at price agreements and price-fixing affecting specific commodities and services, chiefly at the horizontal level, but to some lesser extent in the more complex vertical market relations. The approach and stress derives to a large extent from a pre-Chamberlinian Weltanschauung with a heavy relative stress on price as such in contrast with the other variables (means) of getting and holding business in competition. This is not to say that oversight over prices and pricing is not important and should and will continue to be so. It is to suggest, however, that antitrust actions do tend to overstress prices, pricing, and pricing practices. The reason, of course, is found in the presumed role of prices as stated in the classical interpretation of the functioning of market-type societies Recently, in the report of the National Commission on Food Marketing, it was repeated that "the classic function of price is to coordinate the activities of independent firms so that resources are used to satisfy the demands of consumers as expressed in the market place. 31 The very interesting, helpful paper by William Simon covering the same general area as this discussion, began as follows: "Prices play a central role in our modem competitive economy. While competition may be expressed in terms of price, variety of products, quality or service, price still remains the fundamental way in which firms compete with each other." 32 Undoubtedly, in earlier times prices were the strategic focus valves for the coordinating and regulating functions of the competitive market system. This was especially true in the hallowed classical models with their assumptions of homogeneity and large numbers of market participants. Even nowadays, in all private transactions, a "price" of some sort is enunciated, as is true also usually in internal transfers within enterprises. Bookkeeping and accounting in our form of society still requires the common denominator of "price" or a money sum. Imagine the extraordinary problems of communications in our investment and commodity transactions in the absence of the price denominator. Even in command societies such as the U.S.S.R., money prices play an important bookkeeping role and carry some of the burden of economic coordination and adjustment. Apparently the U.S.S.R. is now in the midst of an extraordinary reworking of its pricing procedures. The actual or presumed role and responsibilities of prices, of course, account not only for the large number and strategic importance of pricing cases in antitrust as well as for the rationalization of the per se rule against price-fixing. Yet, over the years until the Madison Oil case, 34 with its very strong writing by Mr. Justice Douglas, things were quite nip-and-tuck u Food from Farmer to Consumer, p. 98. " S i m o n , op. cil., p. 191. M U . S . v. Socony-Vacuum Oil Co., 310 U. S. 150 (1940).

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Prices: Issues in Theory, Practice, and Public Policy

in this arena. 14 And there continue to be waverings and even some strong skeptics with respect to the per se rule against price agreements. Most likely, however, for the foreseeable future, the electrical cases will have helped to maintain and reinvigorate the accepted per se doctrine and actions. Prices and pricing, especially actions against price-fixing, will continue to have central significance in antitrust enforcement. But the orthodox piecemeal antitrust approach in terms of discrete commodities and the definition of relevant markets, and the simple structural approach intended to enhance competition by an increase in numbers of participants, do not come to grips with many-faced, multidimensional, multilevel, highly diversified competitive functioning. Neither the Weltanschauung nor the economic models based upon assumptions of economic homogeneity and large numbers of competitors are appropriate to most critical problems of competitive regulation today. Instead, we must think in terms of many variations of small numbers (oligopoly) and of formal and informal intrafirm and interfirm organizational arrangements and interactions, and of both product and enterprise diversification and differentiation in an environment in which rapid technological changes and innovation require continuing dynamic moves and responses on the part of enterprises. Economic and managerial analyses, criteria, and public policies must be formulated in terms of a much more complex and sensitive competitive functioning than can be fitted into traditional categories and norms. It suggests, too, both for economic analysis, especially welfare economics, and for public policy, a much deeper understanding of the great areas of product differentiation, product-line diversification, and sales promotion in the context and perspective of total market relations, horizontally and vertically. In no other way can one come to grips with the broad strategies and tactics, conflicts and goals of American business in an environment of (1) rapid technological change and (2) the strong per se prohibitions of group arrangements with competitors. The most exciting and significant problems of public policy of the future lie in the emerging areas of the increasing diversification and conglomeration of enterprises. It should be possible, with the kinds of tools and computational aids available to us, to work out a framework of public policies which would allow acceptable competitive functioning without the straitjackets of detailed, commoditytype price-constraints and detailed oversight over specific business practices, so characteristic of much state regulation and of some federal legislation and regulation. The more likely development, however, is the creation of an increasing number of areas of special jurisprudence through legislative interventions. 31

C f . S i m o n , op. cit., p p . 1 9 1 - 1 9 6 ; A . P h i l l i p s , Market Performance ( 1 9 6 2 ) , C h a p . 10.

Structure,

Organization

and

INDEX Achievement, reduction of, in formation of organizations, 38, 39, 40, 41 Adelman on managerial discretion, 27 Administration, federal, position of, in guideposts, 52, S3 Adversity, firm behavior and, 30, 31 formation of new organizations in, 40 Advertising, change in, effect of, in market modeling, 174, 176, 177 Advisory Committee on Labor-Management Policy on control of wage-price behavior, 47 Airline machinists, 1966 settlement with, 1966 guideposts and, 58 Alternatives, in business pricing, 217, 218, 219 estimating outcomes of, 219, 220, 221 concepts in, 220, 221 information in, 219, 220 selection among, 221, 222 American Airlines, labor settlement in, guideposts in, 59 Analysis, cost, engineering, in marginalcost pricing, 125, 126, 127 statistical, in marginal-cost pricing, 124, 125, 126 Analysis, preposterior, definition of, in Bayesian decision theory, 145, 146 posterior, definition of, in Bayesian decision theory, 145 prior, definition of, in Bayesian decision theory, 145 Antitrust, cases of, classification of, in pricing, 228-231 contradictions to, 243, 244, 245, 246 geographical and delivered pricing and, 238, 239, 240 Robinson-Patman Act and, 233, 234, 235, 236 state fair-trade laws and, 236, 237, 238 state Unfair Practices acts and, 231, 232, 233 Approach, game theoretic, in explanation of oligopoly behavior, 4

Automobile industry, 1964 settlement in, analysis of, 54, 55 results of, 55, 56 Backloggjng in strategic smoothing, 31 Baumol, on role of management, 35 sales-maximization managerial theory of, 11, 15, 17, 18 Baumol and Quandt on decision-making, 3 Bayes, decision theory of, 143-146 Bayesian decision theory. See Decision, theory of, Bayesian Behavior, description of, illustrative model of, 5-9 managerial, extant theories on, pricing implications of, 11-19 characteristic attributes of, 12-16 oligopoly, explanation of, 4 rules for, in profit maximization, 2 theory of, dynamics and, in theory of firm, 2-4 wage-price, control of, Advisory Committee on Labor-Management Policy and, 47 Borden case in antitrust, discussion of, 234, 235 Brand, loyalty to, in market modeling, 182, 183 Brazil, inflation in, model of, in wage and price determination, 90, 91 Brookings model, in price and wage determination, 89 Capital, ratio of labor to, increase in, in slowed inflation, 105 Case, selling units in, in food retailing, 187-189 Chain stores, food, pricing by, 222, 223, 224, 225 Characteristics, purchasing, in market modeling, 181, 182, 183 socioeconomic, analysis of, in market modeling, 179, 180, 181 Chronology, decreasing costs and, in utility prices and costs, 138

248

Prices: issues in Theory, Practice, and Public

Compensation, test of, in utilities rate regulation, 116, 117 Competition, in effects of price cuts, in market modeling, 176 increase in, slowed inflation and, 104 Complexity, as obstacle to marginal-cost pricing, 127-130 Consumption, light and heavy, in market modeling, 181, 182 Conflict, causes of, 35 intergroup, in theories of firm, 34, 35 relevance of managerial theories of the firm in, 35, 36 Contracts, l a b o r - m a n a g e m e n t , 1962 and 1963, guideposts in, 52 C o s t ( s ) , decreasing, chronology and, in utility prices, 138 inflation of, 102 influence of, in business pricing, 207, 208 Council of Economic Advisors, 1961 inflation threat and, 45, 46 Curve, kinked demand, in explanation of oligopoly behavior, 4 Cyert and March, theory of firm of, 36 Cyert, March, and Simon, problemistic search process of, 39 Deals, argument for, in market modeling, 182, 183 price cuts and, in market modeling, 174, 176 Decisions, business pricing as, 215-222 making of, Baumol and Quandt on, 3 in pricing by food chains, 223, 224 theory of, Bayesian, 143-146 applications of, observations of, 165-167 components of, 144 terms used in, 145, 146 use of, in pricing decisions, 152, 153, 154, 155 Decrease, price, positions in, in business pricing, 202, 203 D e m a n d , excess, in inflation, 101 wage increases and, 78 inelastic, consumers with, protection of, 115-118 inelastic and elastic, pricing and resource allocation in, in utility rate regulation, 119-123 schedule of, estimation of, Bayesian theory in, 146-156 wages as, 71, 72 Discounts in retail food pricing, 198-201 Discretion, managerial, dynamic stochas-

Policy

tic model of, 20-30 models on, pricing implications of, 19 stockholder surveillance and, 12, 13, 15, 16 Dynamics, behavioral theory and, in theory of firm, 2-4 economic, definition of, 2 statics and, of utility prices and costs, 138, 139 Economics, planning on, Advisory C o m mittee on L a b o r - M a n a g e m e n t Policy, 48 Economy, 1963-64, guideposts and, 53 fiscal policy and, 67 m o n e t a r y policy and, 66, 67 Education, housewife, in market modeling, 179, 180 Efficiency, incentive for, in utility rate regulation, 110 operating, profit ceilings and, in utility rate regulation, 112-115 E m p l o y m e n t , full, guideposts and, 56 price stability and, 65 housewife, in m a r k e t modeling, 180 Environment, in d y n a m i c stochastic model of managerial discretion, 20, 21, 22 in theories of firm, 33-37 Estimates, pricing, uncertainty in, Bayesian decision theory and, 151. 152 Equilibrium, organizational, BarnardSimon, 39 Expansion, 1961, inflation threat and, 45 Experience, work, provision of, in mitigating effects of inflation, 106 Fair-trade laws, state, antitrust and, 2 3 6 . 237, 238 Federal T r a d e Commission, operation of. 243 Fiber, synthetic, irrationality in business pricing in, 212, 213 Firm(s), behavior of, illustrative model of, 5-9 character of, in business pricing, 206 conflicts between, in theories of firm, 34, 35 profit as objective of, 1 behavioral theory of, time in, 3 theory of, multiorganizational, 37-42 neoclassical theory of, by Samuelson, 1 theories of, synthesis in, 42-44 pricing implications of, 43, 44

Index comparison of, conditions in, 33, 34 environment in, 33-37 focal organization in, 33-37 intergroup conflict in, 34, 35 managerial, attributes of, 20 organizational focus in, 34, 35, 36, 37 pricing properties of, 17, 18, 19 utility function of, 20 Fiscal policy, consumer price level and, 73, 74 Five, in discounts in food retailing, 198201 in retail food pricing, 189-196 Focus, organizational, in theories of firm, 34, 35, 36, 37 Galbraith, on stabilization, 28 on strategic smoothing, 31 General Electric, labor settlement in, guideposts and, 59 Goals, achievement of, in multiorganizational theory of firm, 41, 42 Growth, maximization of, pricing implications of, 18, 19 Guideposts, Administration position in, 52, 53 alternatives to, 59, 60, 81 wage-price, background of, 49 labor's reaction on, 50 lessons of, 60, 61 1964, effectiveness of, 54, 55 nature of, 53, 54 1966, principle of, 57, 58 1966 economy and, 56, 57 as opportunity, 65-66 original, 63-65 purpose of, 51, 105, 106 rationale f o r , 48, 49 recommendations in, 61, 62, 79, 80 in slowed inflation, 105, 106 Heirarchy,

conflict within, theories of firm and, 34, 35 Household, size of, in market modeling, 181 Housewife, age of, in market modeling, 181 Ignorance,

as obstacle to marginal-cost pricing, 124-127 Income, determination of, theory of, in macroeconometrics, 82 firm, determination of, 141, 142 in market modeling, 180, 181

249 Industry, structure of, in business pricing, 205 textile fiber, characteristics of, 142, 143 Inflation, cost, 102 effects of, mitigation of, 106 excess demand in, 101 mitigation of, conclusion on, 106, 107 present, causes of, 103 price-wage targets and, 70, 71 slowed, increase in capital-labor ratio in, 105 increased competition in, 104 low unemployment and, 104 power concentrations in, 104, 105 threat of, 1961, description of, 45-47 unemployment and, 101, 102 wage drift and, 70 Investment base, in profit ceiling in utility rate regulation, 113, 114 Items, multiple, pricing in, in food retailing, 197 Japan, model of, in wage and price determination, 90 Kaysen on characteristics of managerial theories, 12 Knauth on proxy contests, 13, 15 Koopmans in characteristics of managerial theories, 12 Labor, mobility of, slowed inflation and, 104 1966 guideposts and, 57 ratio to capital of, increase in, in slowed inflation, 105 Labor force, in equation for determination of wage, 88 Labor market, crucial nature of, 77, 78 improvement of, in slowing inflation, 104 Learning, in description of firm behavior, illustrative model of, 5-9 Leibenstein on managerial discretion, 23 Location, wages and, 75-77 Loyalty, brand, in market modeling, 182, 183 Macroeconometrics, applications of, to wages and prices, 88-91 theory of income determination in, 82 Management, in assumption of response function, in market modeling, 170, 171

250

Prices: Issues in Theory,

Management—Continued conflict within, in theories of firm, 34, 35 discretion of, stockholder surveillance and, 12, 13, 15, 16 maintenance of, conditions for, 13 in managerial theories of the firm, 35 models of, syndrome analysis of, 19-30 theories of, characteristic attributes of, 12-16

pricing implications of, 11-19 Manufacturer, multi-product food, pricing by, 225, 226 one-product food, pricing by, 226 Marginalism, in pricing by food manufacturer, 225, 226 Market, segments of, analysis of, in market modeling, 177-185 segments of, definition of, in market modeling, 178, 179 Marketing, present research in, 185, 186 Marris, growth-maximization managerial theory of, 12, 16, 17, 18, 19 on role of management, 35 Milk, pricing of, antitrust in, 242, 243 Mills, on pricing behavior, 17 Model, dominant-firm, in explanation of oligopoly behavior, 4 Modeling, market, data in, 171, 172 model in, 174 research strategy in, 168-171 methods of, 170 results in, 174-185 over-all share model in, 174, 176, 177 Monetary policy, consumer price level and, 73, 74 Nine (number) in retail food pricing, 189-196 Numbers, magic, in food pricing, 187 Objectives, market, in business pricing, 206 pricing, in business decisions, 215, 216, 217 Oligopoly, behavior in, explanation of, 4 Opinion, public, in promulgation of guideposts, 50, 51 Organization, focal, in theories of firm, 33-37, 41 formation of, changes in environment and, 39, 40, 41 multiple, changes in environment and, 38, 39

Practice,

and Public

Policy

conflicts among, results of, 38, 39 in firm, 37-42 Owners, in conventional theory of firm, 34, 35 Ownership, private, public regulation and, in marginal-cost pricing, 136, 137 Payments, balance of, effects of inflation on, mitigation of, 106 1961 inflation threat and, 46, 47 Phillips curve, psychological aspects of. 103, 104 real wage gains and, 103 Policy, in pricing by food chains, 223 public, as obstacle to marginal-cost pricing, 132-134 proposals for, in rate regulation, 108, 109 Population, resources and, in United States, 137 Power, concentration of, in slowed inflation, 104, 105 Price(s), change in, effect of, in market modeling, 174 determination of, new directions in, 91-97 implications on, of extant managerial theories, 11-19 irrational, definition of, 203 mark-up, equation of, 83, 84, 85 rate of, determination of, history of, 82, 83 reduction of, Bayesian theory in, 146156 stability in, full employment and, 65 volume and, in Bayesian decision theory, 148, 149 wages and, skeleton system in, 83-88 Price cuts, deals and, in market modeling, 174, 176 Price level, consumer, monetary and fiscal policy and, 73, 74 wages and, 72, 73 Pricing, antitrust cases in, classification of, 228-231 business, alternatives in, 217, 218, 219 estimating outcomes in, 219, 220, 221 concepts in, 220, 221 information in, 219, 220 selection among, 221, 222 approaches to, 214 character of firm in, 206 criteria in, 204 as decision-making, 215-222

Index industry structure in, 205 influence of costs in, 207, 208 irrationality in, conclusions in, 213 example of, 211, 212 market objectives in, 206 new products and, 210 objectives of, in decisions, 215, 216, 217 positions in, 202, 203 profitability and, 209, 210 purpose of study on, 203 decisions in, uncertainty of estimates in, Bayesian decision theory and, 151, 152 delivered, antitrust and, 238, 239, 240 destructive, by utilities, definition of, 111 prevention of, 118, 119 food, magic numbers in, 187 geographical, antitrust and, 238, 239, 240 implications for, in managerial models, 11-19 in synthesis of theories of firm, 43, 44 marginal-cost, American studies on, 135 exogenous factors and, 137, 138 obstacles to, complexity as, 127-130 financial objectives and, 130-132 ignorance as, 124-127 public policy as, 132-134 ownership and regulation in, 136, 137 rate-simplification and, 139, 140 by multi-product manufacturer, 225, 226 by one-product food manufacturer, 226 prevailing approaches to, in food retailing, 222-226 relative, resource allocation and, in utility rate regulation, 119123 retail food, discounts in, 198-201 retail, food, in multiple items, 197 nine and five in, 189-196 unit weights in, 198 by retail food chains, 222, 223, 224, 225 tactical, Bayesian decision theory in, 156-163 computer simulation in, 158-162 decision in, 162-163 problem structuring in, 157, 158

251 reception of study results in, 163 wholesale food, nine and five in, 197, 198 Product, categories of, in business pricing, 204, 205 controllable, definition of, 204 noncontrollable, definition of, 204 Productivity, average phenomena in, 67, 68 economy-wide, wage increases and, 68, 69 in equation for determination of wage, 87 normal, departures from, wage increases and 69, 70 Profits, ceiling on, in utility rate regulation, 110 operating efficiency and, in utility rate regulation, 112-115 results of, 110, 111 desire for, as obstacle to marginal-cost pricing, 130-132 in equation for determination of wage, 87 maintenance of, Bayesian decision theory in, 147, 148 maximization of, opportunity and, 21, 22 pricing implications of, 18 in theory of firm, 1, 2 behavioral rules for, 2 as objective of firm, 1 short-term, profit ceilings and, in utility rate regulation, 114, 115 wage-price level and, 75 Profitability, business pricing and, 209, 210 Proxy contest, likelihood of, conditions for, 13, Д5 Rates, regulation of, public policy in, 108, 109 simplification of, in marginal-cost pricing, 139, 140 Rate base, utility, calculation of, compensatory operation and, 117, 118 in calculation of profit ceilings, 112, 113 increase in, 110, 111 Rees on managerial discretion, 22, 23 Refrigerators, irrationality in pricing and, 211, 212 Regulation, public, private ownership and, in marginal-cost pricing, 136, 137

252

Prices: Issues in Theory, Practice, and Public Policy

Research, strategy in, in m a r k e t modeling, 168-171 methods of, 170 Resource, allocation of, relative pricing and, in utility rate regulation, 119-123 Resources, population and, in United States, 137 Response function, assumption of, in market modeling, 170 Restraint, admonitions for, history of, 49 Retailers, behavior of, in market modeling, 184, 185 Robinson-Patman Act, antitrust and, 233, 234, 235, 236 R o b i n s o n - P a t m a n Act, Borden case in, 234, 235 reasons for, 233 Rule of thumb, in business pricing, 208210 definition of, 209 R u n , long, definition of, 3 short, definition of, 3 Sales, maximization of, pricing implications of, 17, 18 Sales promotion, pricing and, in antitrust, 240, 241, 242 Samuelson, neoclassical theory of firm by, 1 Satisficing in multiorganizational theory of the firm, 41 Search, problemistic, Cyert—March— Simon, in f o r m a t i o n of news organization, 39 Service, compensatory, utility, definition of, 116 requirements in, information as, 117 tests of, 115-118 Share model, over-all, in market modeling, 174, 176, 177 Sharpshooting in pricing by one-product food m a n u f a c t u r e r , 226 Sluggishness, pricing implications of, 28 Smoothing, strategic, pricing implications of, 28, 29, 30 Statics, dynamics and, of utility prices and costs, 138, 139 Steel, confrontation in, inflation threat in, 48 Stockholder, surveillance of, in managerial theories of firm, 12, 13, 15, 16 Strategy, in pricing by food chains, 223 Suppliers, price rise by, in utility rate

regulation, 111 Survival, threat to, in synthesis of theory of firm, 42, 43 Syndromes, in firm behavior, adversity and, 30, 31 analysis of, in pricing implications of managerial models, 19-30 rationale for, in managerial discretion theory of firm, 23-30 shift in, pricing implications in, 28, 29 Synthesis, in theory of firm, 42-44 m o d e for, 32 pricing implications of, 43, 44 Taxation, consumer price level and, 73, 74 wages and, 72 Textile fiber industry, characteristics of, 142, 143 Time, in description of firm behavior, illustrative model of, 5-9 in price decisions, Bayesian decision theory and, 149, 150 Tobin on guideposts by Council of Econ o m i c Advisors, 50 Trading stamps in sales promotion, antitrust and, 240, 241 Twelve, in selling units per case, 187-189 U n e m p l o y m e n t , composition of, in econometric forecasting, 92-97 in determination of wage, 92-97 inflation and, 101, 102 4 per cent, 103 low, less inflation and, 104 U n e m p l o y m e n t compensation, in mitigation of effects of inflation, 106 U n f a i r Practices Acts, state, antitrust and, 231, 232, 233 United Kingdom, model of, in wage and price determination, 89, 90 Utility, firm, maximization of, opportunity and, 21, 22 Utilities, public, rates and costs of, dynamics and statics of, 138, 139 rate regulation of, compensatory service in, 115-118 desiderata of, 109-112 inelastic demand in, 115-118 marginal-cost pricing in, American studies in, 136 complexity and, 127-130 financial objectives and, 130132

253

Index ignorance and, 124-127 public policy and, 132-134 prevention o f destructive pricing in, 118, 119 profit ceilings and operating efficiency in, 112-115 public policy in, 108, 109 relative pricing and resource allocation in, 119-123 requirements for, 111, 112 Variables, in market modeling, definition of, 172, 173 Volume, price and, in Bayesian decision theory, 148, 149 Wage drift, inflation and, 7 0 Wages, allocational aspects of, 7 5 - 7 7 average phenomena in, 67, 6 8 consumer price level and, 72, 73 as demand, 7 1 , 72 determination of, equation for, 86, 87 labor force in, 8 8 profit and productivity in, 87 history o f , 82, 83 new directions in, 91-97

unemployment in, 92-97 distributional aspect of, 7 4 increase in, departures from productivity norm and, 69, 70 economy-wide productivity and, 68, 69 excess demand and, 78 psychology of, 103, 104 policy on, abandonment of, consequences of, 81 need for, 67 in price mark-up equation, 83, 84, 85 prices and, skeleton system in, 8 3 - 8 8 recommendations on, 79, 8 0 profits and, 75 taxation and, 7 2 Weights, unit, in retail food pricing, 198 Western Electric installers, 1966 settlement with, guideposts and, 5 9 Wharton School, model of, in price and wage determination, 9 1 - 9 7 alternatives to, 9 7 - 1 0 0 Williamson, О. E., on role of management, 35 managerial discretion theory of, 12, 16, 19

11,