Demand Management

Drze, Drolet, Rossi, Sood

MGMT 411A Spring 2011

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

Demand curves

A demand curve or demand function relates the quantity of a good sold

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

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

Q
sales units

Both own and the competitors marketing actions will typically affect
demand

Consumer behavior and demand

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

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

3000

2500

2000

Price

1500

1000

500

10

20

30

40

50

60

70

80

90

100

110

Order willingness to pay in descending order and plot against the rank (highest
price rst, ) 10 students indicated a willingness to pay of $1,000 or higher
5

What a demand curve represents

A demand curve shows the distribution of consumers willingness to pay How does this relate to what they said in micro?
The basic microeconomics model emphasizes a model in which consumers
choose a quantity demanded that is continuous (e.g. .5 units!!!) and they adjust demand downward as price increases. This is a representative consumer model. Not applicable to most products in the marketplace. The more general model emphasizes differences heterogeneity in consumers willingness to pay as a source of downward sloping demand

Modeling demand

Goal:

Infer the relationship between unit sales and prices, promotions, and other
variables from the data using regression analysis

To use a statistical tool such as regression analysis we need a

mathematical formulation of demand

This formulation should be exible and have a good chance of tting the demand
relationship present in common data sets

The linear demand model

Formula:
Q = a bP

8 7

Q is unit sales, P is the price a and b are parameters

1.4

6 5 4 3 2

Example:
Q = 40 5 P
1.4

1.4

1 0 0 5 10 15 20 25 30 35 40

Effect of a given price change

is the same for high and low price points

Is this a desirable property?

The multiplicative demand model

Formula:
Q=AP

8 7

A and are parameters

1.4

6 5 4 3 2

Q = 100 P 2

1.4

Example:

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

1 0

10

15

20

25

30

35

40

Consistent with niche and mainstream segments of consumers

9

Multiplicative demand model = log-linear demand model

We can use logarithms to transform the multiplicative demand model:

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

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

We will therefore also refer to the multiplicative demand model as the Purpose of this transformation
The parameters and now enter the model linearly model has the form of a linear regression
10

log-linear demand model both represent the same demand relationship

Effect of parameters
6

Parameter A : intercept increase in A increases the demand level given price

5 4 3 2

A = 100 A = 150

10

20

30

40

Q
2.5

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

=2

log(P)

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

=4

log(Q) 11

Price elasticities

The (own) price elasticity of demand is dened as the percentage change

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

%Q price elasticity = = %P

Q1 Q0 Q0 P1 P0 P0

Useful measure of price sensitivity or price response of demand because it does

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

Interpretation

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

Note: The price elasticity can be calculated for any demand curve, not
just the multiplicative demand model
12

What does the price elasticity measure?

Substitutability

Availability of substitutes Actual or perceived quality differences Awareness of substitutes Cost of nding (or switching to) substitutes
Private label orange juice Tropicana/Minute Maid orange juice Orange juice All juices All drinks
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Examples of price elasticity hierarchies:

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

Categorization of price elasticities

Inelastic demand: Elastic demand: After a price cut:

1 < price elasticity < 0 price elasticity < 1

Revenue increases for elastic demand

Revenue = P Q

Revenue decreases for inelastic demand

Revenue = P Q

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Results of EDLP vs. Hi-Lo Pricing Study (Hoch, Dreze, Purk)

15

Price elasticity in the multiplicative demand model

In the multiplicative demand model,

Q = A P
the parameter has simple and straightforward interpretation it is the absolute value of the price elasticity of demand

The property that one parameter directly measures the price elasticity is
very special and not true for other demand models

16

 Use the log-linear representation of the demand model Change price from P0 to P1 sales will change from Q0 to Q1
log(Q1 ) = log(P1 ) log(Q0 ) = log(P0 )
take difference between equations

log(Q) = log(P )

log(Q1 ) log(Q0 ) = [ log(P1 )] [ log(P0 )] log(Q1 ) log(Q0 ) = [log(Q1 ) log(Q0 )] log(Q) = log(P ) = log(Q) %Q log(P ) %P
use logarithm property L*
17

= price elasticity

Demand for groups of products

The multiplicative demand model discussed so far is too simple it does We now generalize the multiplicative demand model
Allow for the effect of competing product prices Predict demand for multiple products or groups of products
Qi = Ai P1 i1 P2 i2 PKiK

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

Demand for product i in a market with K products:

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

18

 In a market with two products (K = 2 ):

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

Now take the log of each equation (and dene

= log(Ai ) ):

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

The coefcients in these equations are price elasticities, just as in the

simple multiplicative demand model discussed before:
ik %Qi = %Pk

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Own and cross price elasticities

The coefcient on the price of product i in the demand equation for

product i is the own price elasticity of i
%Qi ii = %Pi %Qi %Pk (< 0)

All other coefcients are cross price elasticities

ik = (> 0)
effect of price of product k on demand for i

Why are cross price elasticities typically positive? Do you expect that cross-price elasticities are typically symmetric, =
e.g.
12 21 ?

20

What do cross price elasticities measure?

Extent of substitutability Competing product with high cross price elasticity

Cannibalization of own product sales

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

Product in our own product line with high price elasticity

21

Estimating the log-linear (multiplicative) demand model

To account for variation in demand that cannot be explained by the

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

product prices we need to add an error term to each demand equation:

In the case of two products we have two regression equation, one for each
product log(Qi ) is the dependent variable, yi log(P1 ) and log(P2 ) are the independent variables, x1 and x2

General approach
elasticities)

Obtain data on sales units and prices Estimate the regression equations to obtain the specic parameters (price
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Example: Demand for Philadelphia Cream Cheese, 8 oz, at Jewel

1 .2
9

.4

log(P) .6

.8

9.5

10 log(Q)

10.5

11

11.5

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Survey of price elasticity studies

Tellis: The Price Elasticity of Selective Demand: A Meta-Analysis of

Economic Models of Sales, Journal of Marketing Research.

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


Detergents

Durable goods

Food



Toiletries


Drugs




-1.76 -2.77
-2.03
-1.65 -1.38 -1.12

Elasticities

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Summary: Demand Curve Analysis

A demand model mathematically relates the quantity of a good sold to

the marketing mix and other variables inuencing consumer behavior

The multiplicative demand model

Substitutability Competition Cannibalization

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

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

25

Base-Pricing Analysis
1. Scanner data 2. Base pricing analysis 3. Examples

IRI base pricing analysis Base pricing analysis: Step by step

26

Scanner data

Timeline

First scan test at Kroger in Cincinnati in

1972 IRIs InfoScan introduced in 1987

What do scanner data capture?

Sales at the UPC (universal product

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

IRI

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

Nielsen

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

28

Base pricing analysis

Base price = non-promoted price (everyday shelf price) Purpose of base pricing analysis
Understand competitive inuence of prices on sales Adjust / ne-tune base prices

29

Case study: Data-driven base pricing

A CPG (consumer packaged goods)

manufacturer approaches IRI

Company sells a national brand Product line: 16 oz, 24 oz, and 32 oz bottle
size (32 oz size has recently been added)

Key problems faced by the brand manager

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

Price the different sizes separately or engage

30

Base pricing approach

Scanner data

Demand analysis

Price effects / price elasticities

Cannibalization?

Private label competition

Price simulations

Cross price elasticities with

respect to other sizes in product line

Cross price elasticities with

respect to private label products

Predict prots from base

price price changes

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Results of base pricing analysis: Elasticities

How responsive is sales

volume to own price changes?

Own price elasticity

0

-0.5 -0.95 -1 -1.24 -1.43 -1.5

Note

16 oz
Note: IRI slides p. 11

24 oz

32 oz

Here, IRI does not report

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

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Cross price elasticity of:

1

16 oz

24 oz

32 oz

0.75 0.65 0.5 0.45 0.72

Inuence on demand for package size:

0.25 NA

0.32 0.23 NA 0.0 NA

Effect on:

16 oz

24 oz

32 oz

Is there evidence of cannibalization? Consequence?

33

Cross price elasticity of:

PL 24 oz
1

PL 32 oz

0.75

0.5

Inuence on demand for package size:

0.25 0.0 0.0 0.0 0.0 0.0 0.07

Effect on:

16 oz

24 oz

32 oz
Note: IRI slides p. 13

How severe is the competitive effect of the private label products?

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Base price simulations

Goal: Predict prot for each package size k in the product line
protk = Qk [Pk (1 retail margin) V Ck ]
P . . . retail shelf price

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

total prot = prot(16 oz) + prot(32 oz)

What we need to conduct base price simulations:

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

Prediction of unit sales conditional on own and private label prices

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Prots for different 16 oz and 24 oz price combinations

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

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

Prots in $1,000
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Note: Corresponds to IRI slides p. 24

Prots highest if both prices are increased by 10% Why not increase prices even further?
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- Price constraints acknowledges that statistical reliability of model decreases

when proposed prices are very different from prices in the data

IRI base pricing analysis: Take-aways

IRIs client had very limited access to sales and price data and only a
limited understanding of the key pricing issues

Competition (private label) Cannibalization Optimality of base prices

Insights to the client

Private label competition poses only a very limited threat to the brand There is cannibalization within the product line, but the main offender is not the
new 32 oz size but mainly the 24 oz size - Consider eliminating 24 oz size to save on costs (packaging, distribution, ) Base price points are sub-optimally low

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Base pricing analysis: Step by step

Goal:

Conduct a base pricing analysis for P&Gs Tide laundry

detergent brand

Examine cannibalization within the Tide product line Examine competitive threat from Wisk Make pricing recommendations Approach
Estimate log-linear demand model using scanner data

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 The data contains information from 86 stores in the Dominicks Finer

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

File detergent in the R package, PERregress (google CRAN)

store week acv promoflag q_tide128 p_tide128 q_tide64 p_tide64 q_wisk64 p_wisk64

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

40

Step 0: Data inspection

Calculate:

Market shares Summary statistics (mean, median, std. dev.) of prices

Is there sufcient variation in prices to estimate price elasticities?

41

Step 1: Demand estimation basic model

Dependent variable Solution

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

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

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Calculating Base price elasticities

Remember our goal: Estimate base price elasticities

Focus is on the effect of the everyday price, not on the effect of price
promotions Price promotions are typically associated with sales spikes - More details later

How can we control for the effect of price promotions?

category was promoted

Simplest solution: Eliminate observations when at least one product in the

43

 Price Elasticity is pretty high (-3.27!!!) No cannabilization!

44

Controlling for Store Differences

Stores differ in sales for reasons unrelated to price

Consumer demographics Consumer preferences Location

How do we properly control for such store-specic factors?

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

Dummy variables to control for differences across the cross sectional

units in a data set are called xed effects

Create store xed effects and add them to the regression model

45

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

- Do not report xed effects unless they serve a specic point

46

Pricing simulations

Goal: Predict the impact on total (product line) prots if we change the
current base prices of one or more of our products model parameters (elasticities) in the product line

We make these predictions using the estimates of the log-linear demand To predict total prots we need to predict the prot for each product k
protk = Qk [Pk (1 retail margin) V Ck ]

V Ck variable cost

To predict prots we need to predict demand for each product, Qk , after

the price change

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Predicting demand: Some notation

Tide 128 oz is product 1, Tide 64 oz is product 2, and Wisk 64 oz is

product 3

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

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

48

Predicting demand: Step A

Change the price of product 1 (Tide 128 oz) by 1 percentage points and
the price of product 2 (Tide 64 oz) by 2 percentage points. The price of product 3, Wisk 64 oz, is unchanged:
P1 = (1 + 1 ) P1 P2 = (1 + 2 ) P2 P3 = P3

Example: If 1 = 0.12 and 2 = 0.07 we increase the price of Tide 128 oz by

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

Evaluate the corresponding log price changes:

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

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

49

Predicting demand: Step B

Evaluate the change in demand corresponding to the price changes for

each product in the product line

Focus on the demand for product 1 (Tide 128 oz) Write down the log-linear demand equation after and before the price
change and take the difference:
log(Q ) = 1 + 11 log(P1 ) + 12 log(P2 ) + 13 log(P3 ) 1

log(Q1 ) = 1 + 11 log(P1 ) + 12 log(P2 ) + 13 log(P3 )

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

log(Q ) log(Q1 ) = 11 log(1 + 1 ) + 12 log(1 + 2 ) 1 Q1 log = 11 log(1 + 1 ) + 12 log(1 + 2 ) Q1 Q1 11 12 log = log (1 + 1 ) (1 + 2 ) Q1 Q 1 = (1 + 1 ) 11 (1 + 2 ) 12 Q1

50

take difference from previous slide

exp both sides

Predicting demand: General approach

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

log(Qi ) = i + i1 log(P1 ) + + iK log(PK ) + i

3. Consider the price changes
Pk = (1 + k ) Pk

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

51

Pricing simulations: Example

Cut the base price of Tide 128 oz by 7% and increase the price of Tide 64
oz by 4%

Predicted Tide 128 oz sales ratio after vs before the price changes:
Q = (1 0.07)2.414 (1 + 0.04)0.1591 = 1.20 Q

20% increase in Tide 128 oz volume

52

 Average Tide 128 oz unit sales are 55.25 at the week/store level
Implies a current annual base volume of 86 52 55.25 =
chain (Dominicks) level (86 stores in the chain)

247,078 units at the

Base volume after price changes: 1.20 247,078 = 296,494 Average Tide 128 oz price is $8.47 $7.88 after the 7% price cut Tide 128 oz prot after the price changes:
prot(Tide 128 oz) = 296, 494 [7.88 (1 0.25) 128 0.027]
unit sales price retail margin variable cost of 128 oz size

Note: Retail margin at Dominicks = 25% and the per-ounce cost of Tide is 2.7c
53

Summary: Base Pricing Analysis

Goals of a base pricing analysis

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

Data-driven approach to base pricing

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

Use base pricing analysis to predict product line prots

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