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Rational Shopping Behavior and the Option Value of Variable Pricing

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Author Info

  • Teck-Hua Ho

    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

  • Christopher S. Tang

    (The Anderson School, University of California at Los Angeles, Los Angeles, California 90095-1481)

  • David R. Bell

    (The Wharton School, University of Pennsylvania, Philadelphia, Pennsylvania 19104)

Abstract

When a product's price fluctuates at a store, how should rational, cost-minimizing shoppers shop for it? Specifically, how frequently should they visit the store, and how much of the product should they buy when they get there? Would this rational shopping behavior differ across Every Day Low Price (EDLP) and Promotional Pricing (HILO) stores? If shoppers are rational, which retail price format is more profitable, EDLP or HILO? To answer these questions, we develop a normative model that shows how rational customers should shop when the price of the product is random. We derive a closed-form expression for the optimal purchasing policy and show that the optimal quantity to purchase under a given price scenario is linearly decreasing in the difference between the price under that scenario and the average price. This purchase flexibility due to price variability has a direct impact on shopping frequency. Indeed, the benefit of this purchase flexibility can be captured via an "option value" that implicitly reduces the fixed cost associated with each shopping trip. Consequently, rational shoppers should shop more often and buy fewer units per trip when they face higher price variability. Our results suggest that if two stores charge the same average price for a product, rational shoppers incur a lower level of expenditure at the store with a higher price variability. Since stores with different price variabilities coexist in practice, we expect stores with higher price variability to charge a higher average price. Thus, given two stores, a higher relative mean price for a given item should be indicative of higher price variability, and vice versa. These model implications are tested using multicategory scanner panel data from 513 households and pricing data for three stores (two EDLP stores and one HILO store) and 33 product categories over a two-year period. We find strong empirical support for the model implications.

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File URL: http://dx.doi.org/10.1287/mnsc.44.12.S145
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 44 (1998)
Issue (Month): 12-Part-2 (December)
Pages: S145-S160

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Handle: RePEc:inm:ormnsc:v:44:y:1998:i:12-part-2:p:s145-s160

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Related research

Keywords: Rational Shopping; EDLP; HILO; Retail Pricing Format;

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Cited by:
  1. Piramuthu, Selwyn, 2005. "Knowledge-based framework for automated dynamic supply chain configuration," European Journal of Operational Research, Elsevier, vol. 165(1), pages 219-230, August.
  2. Jaenicke, Edward C. & Chikasada, Mitsuko, 2006. "Separate Decision-Making for Supermarket Leaders and Followers: The Case of Whether or Not to Offer Irradiated Ground Beef," Journal of Food Distribution Research, Food Distribution Research Society, vol. 37(03), November.
  3. Boztuğ, Yasemin & Bell, David R., 2004. "The Effect of Inventory on Purchase Incidence: Empirical Analysis of Opposing Forces of Storage and Consumption," Papers 2004,43, Humboldt-Universität Berlin, Center for Applied Statistics and Economics (CASE).
  4. Sanjog Misra, 2005. "Generalized Reverse Discrete Choice Models," Quantitative Marketing and Economics, Springer, vol. 3(2), pages 175-200, June.
  5. David Bell & Yasemin Boztuğ, 2007. "The positive and negative effects of inventory on category purchase: An empirical analysis," Marketing Letters, Springer, vol. 18(1), pages 1-14, June.
  6. Peter Boatwright & Sanjay Dhar & Peter Rossi, 2004. "The Role of Retail Competition, Demographics and Account Retail Strategy as Drivers of Promotional Sensitivity," Quantitative Marketing and Economics, Springer, vol. 2(2), pages 169-190, June.
  7. P. Seetharaman & Siddhartha Chib & Andrew Ainslie & Peter Boatwright & Tat Chan & Sachin Gupta & Nitin Mehta & Vithala Rao & Andrei Strijnev, 2005. "Models of Multi-Category Choice Behavior," Marketing Letters, Springer, vol. 16(3), pages 239-254, December.

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