Optimal Assortment Decisions for a Specialty

Retailer Facing a Mass Merchandizing Competition

Marcel Goi

c
mgoic@andrew.cmu.edu
Tepper School of Business
Carnegie Mellon University
July 31, 2006
Prelimary and Incomplete
Abstract
Traditional marketing and economic literature including search costs in pur-
chase behavior analyze the case of symmetric equilibrium where all retailers x the
same price. This type of equilibrium outcome does not provide useful insights for
the case where some intrinsic competitive advantage of some players allow them
to oer lower prices. In fact, mass merchandiser such as Wal-Mart are perceived
as oering lower prices. This paper propose asymmetric equilibrium model in
a duopoly to explain how specialty retailer could defend from this type of mass
merchandiser competition.
1 Introduction
Lets consider a specialty retailer who faces the competition of a mass merchandiser.
In general, the mass merchandiser assortment strategy consists in providing a reduced
number of the most popular items at reduced prices. On the other side, a specialty
retailer provides a wider variety of products in a much more focused set of categories
and possibly at higher prices. The lower prices charged by the mass merchandiser are
supported for the higher turnover that allow them to get cost advantages. In some
cases, consolidation of small company purchases have allowed to specialty retailers to
obtain prices from manufactures that were comparable with those obtained by mass
merchandisers. Even in that case, the existence of xed cost in the store could give to
the mass merchandiser a cost advantage. In the discussion the existence of a dierence
1
in price is not required. We only need the existence of a non null probability that one
of the players has lower/higher prices.
The most common explanation to the existence of both type of store is they are serving
dierent segments of consumers. While the mass merchandiser have focused on the price
sensitive consumer, the specialty have served consumers who look for products beyond
the most popular variants. In this paper deal with a complementary explanation where
the specialty retailer can compete against the lower prices of the mass merchandisers
oering a deeper assortment. We show that in market where consumer have signicant
search costs, a better exibility in the assortment planning, could compensate much of
the cost advantages of the mass merchandiser. Using a simple equilibrium approach, we
describe the eect of assortment decision for several market conditions.
2 Literature Review (Very Preliminar)
A key point in our approach to assortment decision model is the existence of search costs.
In a seminal paper, Stigler(1961) is included for rst time searching cost in consumer
decision processes. He assumed that dispersion of prices exists in the market and derives
conditions for a non-sequential optimal amount of search for the case of uniform price
distribution. In a non-sequential search model, it is assumed that consumer decide the
amount of search previous to the purchase. Although some non-sequential search could
be adequate to some high-involvement products that are sold in the retail industry, such
the case of personal computers or televisions, we will focus on the case where the nature
of the search is sequential. We believe this is a more adequate description for most of
the retail categories.
Sequential search models have a long history in economic literature. McCall (1965),
characterize the optimal criterium to continue searching and apply it to the job search
problem. Weitzman(1979), study the case of sequential search with costless recall, but
considering opportunity cost. MacMinn(1980) showed the existence of equilibria ex-
hibiting price dispersion for both cases sequential and non-sequential search processes
when production costs are uniformly distributed. As in our model, the source of price
dispersion is justied for some cost asymmetries.
Robert and Stahl (1993) analyze the equilibrium outcome when exist incentives to use
advertising to inform consumers
1
. The model consist in a xed number of identical rms
selling an homogeneous good deciding simultaneously the price and the amount of con-
sumers to be informed through advertising. A symmetric perfect bayesian equilibrium is
found showing price dispersion. The use advertising introduce consumer heterogeneity,
but the good is still homogeneous. In our approach we consider heterogeneity in the
relationship between goods and consumer valuation for them.
1
When all consumers in the economy are perfectly informed, the price equilibrium of a Bertrand
duopoly game, correspond to the marginal cost. When consumers face sequential costly search, the
outcome is monopoly price for all rms.
2
In all previous discussion, a single homogeneous good has been assumed and the only
motivation to search is looking for lower prices. However, consumers search for products
they like as well (match value). Although the former motivation had been widely studied
in search models, the latter was not until Anderson and Renault(1999). Using a random
utility approach, they found an optimal stopping rule for search behavior. Assuming
stopping rule demand function could be computed as a function of prices, and then a
symmetric equilibrium price is derived. The optimal number of rms and the eect of
diversity on tastes are studied for this equilibrium. Cachon et al (2006) also considers
matching and price motivations to engage in search behavior. Symmetric equilibrium
is described assuming that each rm oers a unique set of products implicitly assuming
costless recall. Both, sequential and parallel search behaviors are studied exhibiting the
same qualitative behavior with respect the eect of entry and search cost in equilibrium
assortment decisions. Certainly, Cachon et al approach is close to our research, but they
still look at symmetric equilibrium and assumes costless recall.
Several researches have used dierent approaches to shed light on the assortment plan-
ning process. An important stream of research deal with the operational facet of the
problem proposing alternative methods for shelf-space allocation(Corstjen and Doyle,
, 1981; Zufryden, 1986; Bultez and Naert, 1988; and Borin et al, 1994 among others).
Nevertheless, all this papers uses a reduced form approach to describe the demand side
and assumes perfect competition in prices. A second stream of research develop analytic
models to describe optimal assortment considering both the demand side (preferences)
and the supply side (inventory costs), but not considering search costs explicitly (van
Ryzin and Mahajan, 1999; Mahajan and van Ryzin, 2001). In a recent work, Cachon
analyze how assortments decisions change when consumer search cost are incorporated
(Cachon et al, 2005). They show that failing to incorporate consumer search into as-
sortment planning process may cause a retailer to underestimate the value a broad
assortment has in prevent consumer search. However, they assume a symmetric equi-
librium and focus on the performance of iterative algorithm to determine the optimal
assortment of dierentiated variants.
Coughlan and Shaaer(2003) study stylized assortment decisions in the presence of price
matching guarantees (PMG). They use a game consisting in three stages: (1) PMG/no
PMG, (2) Assortment decisions and (3) prices decisions. This game is solved for several
capacities conditions showing that the substitutability of product variants and capacity
constraints are key factors that jointly determine the characteristics of the equilibrium.
In this paper, assortment decisions are very simplied to the case where binary decision
are made with a maximum of 2 products, then optimality conditions are impose through
case comparisons.
Zettelmeyer(2000) use a detailed description of consumer decision process including multi
stage search as we use in this article, to describe the strategic use of consumer search
cost. This paper considers products for which increased knowledge about the prod-
uct category generally decrease consumers perceived dierentiation (e.g. pain killers).
Then, Zettelmeyer claims that rms may not want to make consumer search easy, even
if it is costless for them to do so. The author proof that, assuming utilities are uni-
3
formly distributed in [0,1] and costless recall, there exists parameters values such that
in the (sub-game perfect) equilibrium, one rm charge higher prices but lower search
costs. Unlike our approach, Zettelmeyer endogenize search costs decisions and does not
consider assortment decisions.
There is some empirical work that have explore some of the components of our approach.
Draganska and Jain (2005) examine the manufacturer perspective analyzing how prod-
uct line length aects their protability in the yoghurt market. Unlike our model they
assume that each consumer wants to buy a bundle of avors and conditional on that,
consumer select product line that is likely to oer the product they want. However,
their results are qualitatively similar to ours in that they found decreasing returns to
product-line length supporting the idea of an optimal length. In a recent work, Wat-
son (2005) studies empirically the eect of competition in assortment decisions in the
eyeglasses industry using an original data set. Assortment decision is the breath of the
assortment measured as the number of products oered. Results are qualitatively sim-
ilar to ours showing non linear reactions to changes in competition intensity. Facing
a moderate increase in competition rms could increase assortment breath, but facing
more competition, they will eventually start cutting product variety. However, Watsons
model is dierent to our in two aspects. First he take competition (number of rms in a
given zone) as endogenous, while we assume it as xed. Second he uses a reduced-form
relationship to describe equilibrium assortment while we derived from a much detailed
consumer decision process.
The contribution of the model developed in this article is threefold. First it introduce
an asymmetric game with give a more precise description for several scenarios in the
retail industry. Second, it introduce a cost search structure which depart from the most
traditional costless search recall assumption. We provide strong support of the usage
of this cost structure in a retail setting. Finally, we provide a comparison of our base
model with two simplied ones and describe in what extend they could be used as valid
alternatives. The rest of the paper is organized as follows: [paper structure]
3 Model
To describe the costumer decision process I will use a sequential decision framework
of two stages. In the rst stage, consumer has to decide the rst store to visit. This
decision is aected by two components: an intrinsic valuation of the store s (T
s
) and
the expected value of the trip conditional on choosing each store. In the second stage,
each consumer has to decide whether to purchase in the chosen store or switching to
the other one. This decision is inuenced by expected utility of purchasing in each store
and a search cost sc that consumer has to incur if he decides to move to the next store.
I assume that in the store consumer are risk neutral utility maximizer and therefore
the expected value of purchasing in each store correspond to the expected value of the
maximum of the utilities of the products variants oered in the assortment. The general
structure as is depicted in Figure 1.
4
Figure 1: Hierarchical decision process Framework.
Once retailers have decided their assortment consumers gather information about as-
sortment and prices to decided a store to buy. Having this information, consumers face
a three step decision process. First they decide the store where they want to start shop-
ping based on their expectations of the surplus they could get buying in each store and
an intrinsic attractive of the store to the consumer for this specic trip. The intrinsic
attractive is determined by factors such as proximity or the possibility of doing other
activities in the same trip (trip chaining).
Once in the store, the consumer have two alternatives: purchasing or move to the
competitor to buy there. This decision is made considering the expected value of the
utility of purchasing in each store and the cost associated to move to the competitor. A
somewhat strong assumption that we made is that consumer change the store no more
than once
2
.
In the model a random utility framework will be used.
3.1 Consumer Decision Process
To complete the model, we have to specify the recall cost. Three alternative assumptions
could be used as is depicted in Figure 2.
2
This assumption could be justied by a convex loss of utility in the purchase time. Thus consumers
are willing to move to next store once, but they are not willing to come back again to a store they
already visited. Clearly this assumption is not plausible for high involvement purchases
5
(a) (b) (c)
Figure 2: Alternative specications for recall costs. (a) Costless Recall: when
consumer decide to switch to the other store, there is no cost of coming back to
buy in the previous store. (b) No Recall: when consumer decide to switch to the
other store, there is no possibility of going back to buy in the previous store. (c)
Finite Recall: when consumer decide to switch to the other store, he could go back
to buy in the previous store, but paying an amount corresponding to the movement
between stores.
A common assumption in search literature is that recall to alternative previously searched
is costless. This assumption would mean that all cost come from looking in the store
and there is no costs of moving between stores. I think that this is not a plausible
assumption in the retail framework. Although a nite positive search cost could be the
best assumption, I will assume innite cost of recall. That is, once the consumer decide
switch to the other store, there is no possibility of coming back. For readers expecting
a sort of symmetry in the recall cost, this assumption could appear as counterintuitive:
why we should consider that they cannot go from store B to store A if we already allow
them to go from store A to store A?. However, there are two reasons that I could claim
to support it:
Nonlinear search costs: The decision of coming back is made in a dierent
psychological and physiological state. Assuming a symmetric cost of going from
the rst store to the second one, it would imply a non-weariness in the consumers,
but it is likely to assume they are less willing to do another trip after visiting two
stores.
Dierent incentives: When a consumer decides to continue searching is because
they got a bad draw from the random component of his utility in the rst store.
Then, the decision of coming back is unlikely even in the stylized situation of
costless recall. The approximation should be even better for the most realistic
case of positive, nite costly recall. The numeric example depicted in Figure 3
helps to develop an intuition.
6
Figure 3: Numerical example supporting the no recall assumption.
In the picture are simultaneously plot the exact expected gain of switching to the
next store, the approximated one and the density function of the best alternative
drawn from the rst store. Looking at points where the expected gain is positive,
we can realize that the approximation is very good. The approximation is not
close to the exact gain only when is very likely the consumer nally will decide do
not switch to the other store, where we do not need the approximation.
Also, note that the quality of the approximation increase with the depth of the assort-
ment. Then, for categories including everyday more variants in the assortment, should
be a quite good approximation. Clearly, the no recall approach is not adequate for high
involvement products such as searching for houses.
As pointed out by Weitzman (1979), the optimal solution in the general case can be
gotten using a standard stochastic dynamic programming techniques. However, given
that our stylized model only have two binary decisions, we can state it more explicitly.
3.1.1 Second Stage Decision
Let EG(y) the expected gain when consumer continue searching given that the utility
of purchasing in the rst store is y:
EG(y) =
_

ydF(

)
= IE(

) y (1)
Assuming that the random components of the utility of purchasing any product are
independent and Gumbel distributed, the distribution of

is also Gumbel with loca-

tion parameter
M
= ln(n
S
) when consumer visit mass merchandiser rst and
S
=
7
ln(n
M
exp()) otherwise. Then,
EG(y) =
_
y + ln(n
M
) + visiting S rst
y + ln(n
S
) + visiting M rst
(2)
Thus, the probability of switching store to continue searching, when consumer faces a
search cost c is given by IP(switch) = IP ((EG(y)) c). Finally, replacing EG(y) and
taking into account that y is also Gumbel distributed we can compute the probability
of switching from S to M (IP(SM)) and the probability of switching from M to S
(IP(MS)):
IP(SM) = IP ( y + ln n
M
+ c)
= F
y
( c + ln n
M
+ )
= exp
_
exp(( c + + ln(
n
M
n
S
))
_
(3)
IP(MS) = IP (y + ln n
S
+ c)
= F
y
(c + ln n
S
+ )
= exp
_
exp((c + + ln(
n
S
n
M
))
_
(4)
3.1.2 First Stage Decision
To decide which store visit rst, consumer have to consider the intrinsic value of pur-
chasing in each store (T
S
and T
M
) and the expected surplus of the nal output of the
shopping trip associated to each store. Let v
S
and v
M
the systematic utility of choosing
specialty retailer and mass merchandiser as rst store to visit respectively. Thus:
v
S
= T
S
+ IE {max
iSi=1
n
S
} (1 IP(SM)) + IE {max
iMi=1
n
M
c} IP(SM)
= T
S
+ (ln n
S
)(1 IP(SM)) + ( + ln n
M
c)IP(SM) (5)
v
M
= T
M
+ IE {max
iMi=1
n
M
} (1 IP(MS)) + IE {max
iSi=1
n
S
c} IP(MS)
= T
M
+ ( + ln n
M
)(1 IP(MS)) + (ln n
S
c)IP(MS) (6)
I will also assume there is a random utility component associated to each store decision.
Finally, assuming that this random component is Gumbel distributed with location
parameter = 0, I derive the rst stage probabilities.
IP(S) =
exp(v
S
)
exp(v
S
) + exp(v
M
)
(7)
IP(m) =
exp(v
M
)
exp(v
S
) + exp(v
M
)
(8)
8
3.2 Strategic Firm Behavior
Although several other games are interesting of being analyzed
3
, I will focus in the one
where mass merchandiser has a xed assortment depth having to decide price, while the
specialty retailer observing mass merchandisers prices has to decide the depth of its
own assortment.
Fixed assortment of the mass merchandiser: nationwide purchases give to mass
merchandiser a competitive advantage. However it require a common set of prod-
ucts across stores. Watson (2006) also provide some evidence of little variability
in chain stores in the eyeglasses market.
As pointed out by Montgomery (2000?), prices can be locally modied relatively
easy even for nationwide chains.
Mass merchandiser could sacrice protability in some categories to increase trac,
but specialty retailer have to be protable with its narrow set of categories.
I assume that both rm try to maximize their own prot. To derive prot function we
have to derive the demand functions for each store. To do so, note we can decompose
the demand for each store:
Primary demand (S1/M1): Consumers who decide to go directly to the store
S (M) and then decide to stay and purchase there.
Secondary demand (S2/M2): Consumers who decide to go to the store M(S)
rst and then decide to switch and purchase in the other store.
Then, primary(S1) and secondary(S2) demand for specialty retailer are given by:
IP(S1) = IP(S)(1 IP(SM)) (9)
IP(S2) = IP(M)IP(MS) (10)
Similarly, the primary(M1) and secondary(M2) demand for specialty retailer are given
by:
IP(M1) = IP(M)(1 IP(MS)) (11)
IP(M2) = IP(S)IP(SM) (12)
To complete the objective functions of both rms, let m the markup of specialty retailer,
v(n
S
) the cost of variety as a function of assortment depth
4
and the rate at which
3
In particular, it would be interesting to analyze the case where both rms decide price and assort-
ment depth.
4
Following standard literature in inventory and assortment planning, I will assume v

(n
S
) > 0 and
v

(n
S
) > 0 (van Ryzin and Mahajan, 1999).
9
mass merchandiser reduce its markup when the convenience premium increase. Then,
the objective functions of specialty retailer (
S
) and mass merchandiser (
M
) are given
by:

S
(n
S
|) = [IP(S1) + IP(S2)] m v(n
S
)

M
(|n
S
) = [IP(S1) + IP(S2)] (m ) v(n
M
)
Finally, assuming interior solution the market equilibrium can be derived imposing

S
(n
S
|)/n
S
=
M
(|n
S
)/ = 0.
4 Results
4.1 Numerical Example
No analytical properties of the market equilibrium have been derived yet. However,
some interesting behavior of the reaction functions

(n
S
) and n

S
() have been observed
in a series of numerical examples
5
. Let consider the case where c = 0.5, n
M
= 10,
m = 2, = 0.5 and T
S
= T
M
= 0 as a representative example
6
. Figure 4 shows the
reaction curves for this example where the market equilibrium is given by (
eq
, n
eq
S
) ==
(1.901, 38.461).
Figure 4: Market equilibrium for a representative numeric example.
5
Matlab code available upon request.
6
The conducted analysis is quite exploratory. There is nothing special with the chosen example, but
it shows several of the characteristics observed in a arbitrary sample of 20 instances.
10
Some general qualitative observations about market equilibria found in the exploratory
analysis:

(n
S
) and n

S
() had a concave form for all observed instances. It would be useful
to proof that this is always the case or at least show that few additional conditions
in the parameter space are required to get the result.
When mass merchandiser decide prices level such that markup are close to being
null, the optimal assortment depth for the specialty retailer fall down quickly to
zero. However, it seems the solution where the mass merchandiser has no null
prot is never an equilibrium.
Given that mass merchandiser has the assortment depth xed, the specialty retailer
can take advantage and adjust that decision oering more variety even in the case
where mass merchandiser has no convenience advantage ( = 0).
5 Alternative Models
5.1 Joint Logit Approximation
Although the previous model is could be more appropriate to describe the decision
process and therefore to derive the purchase probabilities, a simple approximation result
assuming that the shared attributes are observed and therefore a joint logit model can
be applied. Formally, let s {S, M} the initial store alternatives and r {pS, pM} the
nal store alternatives. Then, the nal utility of initially visit store alternative s and
making a nal store decision r (u
sr
) is given by:
u
sr
= v
s
+ v
r
+ v
sr
+
sr
(13)
where v
s
is the systematic component of utility common to all purchase decision where
rst store visited is s, v
r
is the systematic component of utility common to all purchases
where nal store decision is r and v
sr
is the systematic component of utility of the
purchases paths where store s is initially visited and the nal purchase is made at store
r. In this particular case:
v
s
: intrinsic attractive of start a shopping trip at stores
=
_
T
S
if s = S
T
M
if s = M
(14)
v
r
: expected surplus of making nal purchase decisionr
=
_
ln [(n
S
)] if r = pS
ln [(n
M
) exp()] if r = pM
(15)
v
sr
: search cost associated to time and resources used to move to the next stores
=
_
0 if (s, r) {(S, pS), (M, pM)}
c otherwise
(16)
11
where v
r
is derived from the assumption that in the store the random component of the
utility is Gumbel distributed with scale parameter = 1 and location parameter = 0.
Finally, assuming
sr
is also distributed Gumbel(0,1) we can derive an expression for
every alternative:
IP(s, r) =
exp(v
s
+ v
s
+ v
sr
)

exp(v
s
+ v
r
+ v
s

r
)
(17)
In our problem, we are particularly interested in the marginal probability of the nal
store decision that can be easily computed
7
:
IP(r) =

s
IP(s, r)
=
exp(v
r
)

s
exp(v
s
+ v
sr
)

exp(v
r
)

s
exp(v
s
+ v
sr
)
=
exp(v
r
+ v
r
)

exp(v
r
+ v
r
)
(18)
Where v
r
= ln

s
exp(v
s
+ v
sr
) is the inclusive value associated to the alternative r.
Replacing terms we get the probability of nal purchases in every store:
IP(pS) =
exp
_
ln
_
(n
S
)e

+ ln
_
e
T
S
+ e
T
M
c
_
exp (ln [(n
S
)e

] + ln [e
T
S
+ e
T
M
c
]) + exp (ln [n
M
e

] + ln [e
T
S
SC
+ e
T
M
])
(19)
5.2 Uniform Distribution
In the previous models, the random component of the utility as always been assumed as
following a Gumbel distribution because it has a closed form for the distribution function
for the maximum. However, search literature also report uniform distribution for the
random component as an alternative assumption. In this case, beside the distribution
of the maximum we could compute a truncated distribution of the maximum, i.e, the
distribution of the maximum given that is greater than a certain value. This property
would be particularly useful to compute an exact probability in the rst stage without
impose any additional condition.
6 Conclusions And Future Research
Having analyzed the market equilibrium we could state managerial implications for the
mass merchandiser but specially for the specialty retailer. But, I think that this stylized
model could provide some basic insight to develop more realistic models:
7
The marginal probability associated to the initial store decision could also be easily computed and
could be interesting to further analysis
12
Complete game where player decide both price and depth of the assortment.
Games where the assortment are not independent by nature.
Games where players decide depth and breadth of the assortment.
Learning: A common rule used by the specialty retailer is do not include low end
products in the assortment because they are already included in the set oered
by the mass merchandiser. Doing so, they make more dicult the consumer price
comparisons. However, deleting these products of the assortment make less attrac-
tive shopping in the store to the consumers
8
. In this article I develop a stylized
model to describe the essential features of the assortment decision of the specialty
retailer and explore conditions under which it is optimal to compete in the low
end part of the market. For example, assuming a linear learning rule, the purchase
probability in the joint logit model is given by:
IP(pS) =
exp
_
ln
_
(n
S
M
+ n
S
S
)e
n
S
M
nm
_
+ ln
_
e
T
S
+ e
T
M
SC

_
exp
_
ln
_
(n
S
M
+ n
S
S
)e
n
S
M
nm
_
+ ln [e
T
S
+ e
T
M
SC
]
_
+ exp (ln [n
M
e

] + ln [e
T
S
SC
+ e
T
M
])
(20)
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13
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