Why Markdown as a Pricing Modality? The Role of Threat of Entry

Abstract

Markdown as a pricing modality is ubiquitous in retail. In contrast, everyday-low-price (EDLP) is relatively rarer in practice, even though it offers several advantages (such as simplicity). Using a stylized model, we explore whether and why either of these pricing modalities can be an effective defense against a firm that enters the market with the alternative pricing modality to sell an identical product. Various studies have shown that consumers are strategic and heterogeneous in their reservation price. Similarly, consumers are also shown to be regret-prone and the anticipation of regret affects their purchase decisions. They may experience availability regret when unable to purchase a product due to a stockout, and high-price regret when missing an opportunity to buy the product at a lower price. When faced by a stockout at the markdown retailer, consumers may choose to spill over to the competitor. In such a market environment, we find that the possible entry of a competitor deters retailers from using EDLP, but not markdowns. We also identify a new reason (besides incentivizing consumers to buy during the non-discount period) for the markdown retailer to ration stock. In particular, our analysis show that rationing stocks at the markdown retailer is critical to maintain a sustainable equilibrium (as a defense against a possible entry of an EDLP retailer). We also show that consumer regret plays a key role in both retailers' decisions. For example, availability regret experienced by markdown consumers affects even the EDLP retailer's optimal pricing decision, while high-price regret experienced by EDLP consumers affects the markdown retailer's decisions. We show that high-price regret may intensify the rationing effect whereas availability regret may dampen it. Finally, we show that a failure to anticipate consumer regret results in up to 19% potential profit loss for the EDLP retailer whereas it results in up to 11% profit loss for the markdown retailer.