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International Journal of Industrial Organization Organization
ELSEVIER 14 (1996) 227-242
Abstract
1. Introduction
nearly $100 billion worth of coupons (potential savings) were sent out to
consumers in the United States through Sunday newspaper inserts (see
Koselka, 1990). Manufacturers in the United States distributed 310 billion
coupons in 1992, representing a 6% increase over the year before (see
H u m e , 1993). Rebates are virtually equivalent to coupons except that they
impose some additional redemption cost on the customer, namely the cost
of mailing and waiting for the cash refund. For our purposes coupons and
rebates play the same role and we will treat them interchangeably in our
analysis.
We investigate the role of coupons in a market that is segmented due to
location or brand loyalty. By offering a rebate, a manufacturer can attract
some consumers who are otherwise more inclined to buy a competing brand.
In the location interpretation of our model, consumers face a transportation
cost. Supermarkets, department stores, and shopping-malls can use coupon-
ing of specific residential areas to compete more effectively in their rivals'
h o m e markets. In the alternative interpretation, consumers differ in their
degree of brand loyalty. By price discriminating between his own customers
and the clientele of competing manufacturers, the seller can increase his
own market share. Of course, this requires marketers to use tightly focused
coupon distribution programs as they are offered by special marketing
companies. Targeted coupons have been used successfully by Trump's
Castle to lure gamblers from competing casinos, by Stop & Shop stores to
win customers from other grocery stores, and by L'Oreal Visuelle to attract
users of Cover Girl and Revlon makeup (see Zeldis, 1987).
With couponing the manufacturer has at least partial control of the type
of household reached. Thus, he is able to offer a reduced price to a specific
segment of the market. Coupons can serve as a price discrimination device.
Only those consumers who have received a coupon are able to benefit from
the rebate. Since this enables the manufacturer to separate market seg-
ments, coupons are more than just a low price offered to all consumers. It is
worth mentioning that the use of coupons as a discriminating device does
not depend on the market structure. Coupons would also be used in a
m o n o p o l y version of our model. An alternative explanation of coupons has
b e e n proposed by C r e m e r (1984) and Caminal and Matutes (1990). In these
models, coupons create a lock-in effect because the consumer is offered a
rebate on future purchases of the product. The seller can stabilize his
market share by creating an artificial cost of switching suppliers, This is in
direct contrast with our model, where coupons tend to make switching more
attractive. Yet another explanation (Gerstner and Hess, 1991) is that the
seller can motivate retailer participation in the sales promotion by offering
rebates to the consumers.
T h e literature on the price discrimination aspects of coupons is rather
scarce. Narasimhan (1984) studies the consumers' decision to use a coupon.
H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 229
2. An example
good for all prices between zero and v > 0. When a consumer purchases the
good from the seller in the distant location, he has to pay a transportation
cost, s < v.
Shilony (1977) studies the equilibrium of this market when the sellers
compete by setting prices in a standard Bertrand fashion. If v <~ 2s, both
sellers will post the price p * = v in equilibrium. Undercutting the com-
petitor's price is not profitable since this would yield a profit of at most
2 ( v - s)~< v. The price-setting game between the duopolists fails to have a
pure strategy equilibrium if v > 2s. Indeed, any combination of prices
(PA, PB) would allow one of the two sellers to gain either by undercutting
the other seller or by increasing his price by some small amount. Shilony
(1977) shows that there is a unique symmetric mixed strategy solution where
each seller gains an expected profit higher than s.
We now introduce oligopolistic price discrimination. Even though the
seller is unable to identify the origin of the customers at his store, he can
separate them through coupons. Each seller is able to offer the good at
different prices in the two regions by mailing coupons to the other region.
Coupons entail a legally binding promise by the seller to offer a rebate upon
presentation. In our example we abstract from mailing costs and assume that
seller i can costlessly send coupons to all consumers in region j. The coupon
entitles the bearer to buy the good from seller i at the price Pi -- ri, while
buyers without a coupon have to pay Pi.
In this simple example, competition between the duopolists, A and B,
results in the following equilibrium outcome:
P -PB * =p* =s, r A* = r * : r* =s.
B (1)
As is usual in this kind of model, the equilibrium is based on the tie-
breaking rule that consumers buy from the closer firm if prices are equal.
This can be justified by taking the limit as heterogeneous consumer tastes
b e c o m e homogeneous (see Anderson and de Palma, 1988). Each consumer
is indifferent between buying the good from seller A or seller B. If he buys
at the neighbouring store, has to pay the price p* = s; otherwise, has to pay
p* - r * = 0 but incurs the transportation cost s. In equilibrium, it must be
the case that each consumer buys at the local store. If not, the local seller
would have an incentive to lower his price slightly below s. Clearly, the
outcome described by (1) constitutes an equilibrium: by charging a price
above s a seller would lose all his customers. Charging a price below s can
never be optimal, since each seller enjoys a local monopoly position for all
prices up to s. Actually, the equilibrium is unique (after elimination of
dominated strategies with Pi - ri < 0)" if some seller i were to charge a price
Pi > s, then the opponent could induce all consumers in region i to switch by
offering pj - rj slightly below Pi - s. Accordingly, a price Pi > s cannot be
part of equilibrium behaviour. The same argument shows that both sellers
H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 231
must offer the rebate r* = s. Obviously, given p* this is the highest rebate a
seller is willing to offer. If seller i sets r~ < s, then seller j would optimally
charge his local customers the price pj > s, which was already shown to be
inconsistent with equilibrium.
The example demonstrates that price discrimination increases competi-
tion. The consumers have to pay lower prices and the finns' profits are
reduced. Indeed, each seller earns a profit of s, which is lower than the
profit he gets in the absence of discriminatory pricing. In what follows we
will verify this observation in a more general model. In fact, the above
example has some unappealing features because the consumers' purchasing
decisions have to be based on a tie-breaking rule. Even though the
equilibrium requires both sellers to use coupons, this marketing instrument
is actually ineffective since no consumer is induced to switch. If the sellers
had to pay a mailing cost, the above equilibrium would therefore collapse.
The subsequent model will overcome these difficulties by introducing some
consumer heterogeneity.
3. The model
4. Equilibrium
attracted by firm A's price offer ifpA + S ~<PB" Otherwise, with a coupon r A,
he will purchase from firm A if PA - rA + s ~<PB.
Given the consumers' demand decisions, firm A's profit, IiA(XA,XB),
depends on both firms' sales strategies and is given by
where
D(z)=--z/~, for 0~<z~<~,
D(z)=-O, for z~<0, (4)
D ( z ) = 1, for z ~>~.
By symmetry, firm B's profit equals HB(XA, XB)= HA(XB, XA). To study
equilibrium advertising in this market, we consider the Nash equilibrium in
the sellers' game. Thus, a pair (x*, x~) of marketing strategies constitutes an
equilibrium if IIA(X~, X*) >t IIA(XA, X~) for all XA, and liB(x*, x~) ~ l i s ( x * ,
XB) for all x B.
Our first result characterizes the symmetric pure strategy equilibrium and
provides a sufficient condition for its existence. To state the result, we define
p(h) --= - k " ( h ) / k ' ( A ) . In utility theory, p(- ) is well known as the coefficient
of absolute risk-aversion. Negative values of p(A) indicate the degree of
convexity of k(h) at h.
/ (P*~)
Fig. 1. Equilibrium (p*, h*).
With the help of Fig. 1 we can easily establish some comparative statics
properties of the equilibrium outcome (p*, r*, A*). For instance, an increase
in the marginal cost k ' ( . ) leads to a higher equilibrium price p* and a lower
level of advertising A* because the K - K schedule is shifted upwards. How
does the equilibrium react to a change in the consumers' transportation
cost? Increasing the parameter ~ is equivalent to increasing each consumer's
switching cost by the same factor. In Fig. 1 this leads to an upward shift of
the P - P schedule. Consequently, both p* and A* are increased.
Not all consumers who are couponed will make use of the rebate.
Redeeming the coupon is worthwhile only when s ~< r* = p * - r * . Accord-
ingly, the redemption rate is ( p * - r * ) / ~ = 1 / ( 2 + A * ) . That is, more than
one-half of the coupons are not returned to the manufacturer. Using the
above comparative statics results, it follows that the equilibrium redemption
rate is increasing in the marginal cost of couponing. A cost increase reduces
the n u m b e r of households that are couponed, but the fraction of households
that redeem the coupon is increased. An increase in the consumers'
transportation cost has the opposite effect: more households are couponed,
but a lower fraction return the coupons. Note, however, that the total
n u m b e r of coupons actually redeemed is given by A*/(2 + A*), which is
increasing in 3,*. This number is, therefore, negatively related to the
marginal cost of couponing and positively related to the level of consumer
switching costs.
Of course, the result that the coupon offers a 50% price rebate is specific
to the setting of our model. In particular, the uniform distribution of
switching costs is important in this context. We can show that the sellers
would optimally offer a lower rebate if the distribution of s puts more weight
on low switching costs. The intuition is that attracting high cost consumers
through a rebate is not profitable when these consumers represent only a
small fraction of the total population.
Proposition 1 only provides an implicit characterization of the equilibrium
H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 235
values p*, r*, and A*. To obtain an explicit solution of the equilibrium, we
have to look at a parametric example of the cost function k(- ). The simplest
example is k(A)= cA 3. This function satisfies restriction (2) if-s/c < 27. The
equilibrium described by Proposition 1 is then given by
Note that within the family of cost functions k()t)= cA ", Proposition 1
guarantees the existence of a symmetric pure equilibrium as long as a / > 3.
The equilibrium characterization by Proposition 1 is derived from the
first-order conditions that the profit-maximizing marketing strategies xA and
x B necessarily have to satisfy. Unfortunately, the first-order conditions are
not sufficient for profit maximization. By (3), the firms' profit functions are
concave in Pi, ri and Ai, but not jointly concave in (p~, r~, A~). Because of this
non-concavity, we have to be careful that no seller can increase his profit by,
for instance, simultaneously lowering his price and his advertising intensity.
The restriction p(A) ~ - 2 guarantees that such deviations from (p*, r*, A*)
are not profitable. For any given A~, the first-order conditions determine
p*()ti) and r*(Ai) so that seller i's profit can be written as
///(p*(A~), r*(Ai), A~, xj). Since p(A) ~< - 2 ensures that the cost function
k(. ) is sufficiently convex,//~,.(p* (Ai), r* (Ai),)t i, xi) is concave in )ti. Accord-
ingly, the first-order conditions are sufficient for a global optimum if
p(a) <~ - 2.
For specific cost functions, we can prove the existence of a pure strategy
equilibrium even when the condition p ( A ) ~< - 2 is not satisfied for all
A ~ [0, 1]. The following result extends Proposition 1 to the case k(A) = cA ~,
a > 1, by imposing a restriction on ~/c. Also, we consider the cost function
k ( A ) = - c I n ( l - A ) , which Butters (1977) has derived from a simple
underlying advertising technology.
5. Welfare
is 5, the higher is the coupon distribution intensity, A*, and the number of
coupons actually redeemed, ~ * / ( 2 + A * ) . This means that the resources
spent on couponing and the consumers' aggregate travel costs increase with
7.
6. Conclusions
high. Also, the value of the coupon relative to the price of the product
would presumably depend on the distribution of consumer valuations.
Removing the symmetric structure of the model would be another
interesting extension. In our model, the sellers were identical and so they
used the same marketing strategy. This would no longer be the case when
different production technologies are considered. An extension along these
lines could provide insights into the relation between a firm's efficiency and
its marketing policy. Similarly, we could study the role of a firm's size when
the number of consumers differs across market segments. We might expect
that smaller firms have a higher incentive to distribute coupons because they
can gain more by attracting consumers from other market segments.
Appendix
L e m m a 3. Let p(A) -- - k " ( ) t ) / k ' ( A ) ~ - 2 f o r all A @ [0, A2]. Then k'(A2) >
(1 + }k2 -- } k l ) 2 k ' ( A 1 ) f o r all 0 ~< h~ < h 2 ~< 1.
for /~1 = /~2" Therefore, L e m m a 3 holds if 0G(A~, A2)/OA1 < 0 for all 0 ~</~1 <
h2~<l. Differentiation shows that OG(A1,A2)/OAI<O is equivalent to
p(A~) < - 2/(1 + A 2 - A1). Since - 2 < - 2/(1 + h 2 - As), L e m m a 3 holds if
p(A) ~< - 2 for all h ~ [0, h2]. Q . E . D .
OH (8 + 2A*)'~'(A*) 2 8 + 2A*
0--7 - ff'(a*)(2 + x*) + 2 ~ ' ( a * ) - n ( a * ) - 4 - a* + In(1 - a*);
(21)
OW (6 + h*)~'(h*) 2 6 + a*
0~- - f f ' ( a * ) ( 2 + ,X*) + 2 r t ' ( h * ) - 2 n ( a * ) - 4 - A* + 2 In(1 - a * ) .
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