A Theory for Pricing Nonfeatured Products in Supermarkets

Abstract

If a management science team from another galaxy should enter a typical U.S. supermarket and measure sales response to price by varying shelf prices and observing sales, it would be surprised to find that the store seemed to be pricing each item much too low to maximize profit. Thus, for example, a typical store markup for a grocery product might be in the 15%-25% range. This would represent profit-maximizing behavior if the price elasticity were in the range 5-7. However, price elasticities obtained by instore experiment usually give numbers less than two and sometimes much less. For example, the measurements of Henderson, Brown, and Hind (1961) imply elasticities for fruits as low as 0.2. Thus, the store acts as if the customer is considerably more sensitive to prices than customer actions in the store seem to indicate. There is a reason for this. The store has a special apprehension. Even though a customer, once in the store, may buy the item at a higher price, will the customer come back? A pricing policy that maximizes profits taking into account the problem of store loyalty may call for much lower prices than implied by strictly in-store measurements. Supermarket chains go to great effort to project an overall impression of low prices and good values for the money. They run newspaper ads A two-stage theory of price setting postulates that customers once in the store purchase goods to maximize utility. This determines short-run price response. The store then maximizes short-run profit subject to a constraint on customer utility delivered. Utility level becomes a policy parameter that determines, in part, the long-run attractiveness of the store to the customers.