Consumer Behavior and Firm Strategies in A Changing Retail Environment PDF

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Consumer Behavior and Firm Strategies in a Changing Retail

Environment
A DISSERTATION
SUBMITTED TO THE GRADUATE SCHOOL
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS
for the degree
DOCTOR OF PHILOSOPHY
Field of Marketing
By
Vishal P. Singh
EVANSTON, ILLINOIS
June 2003
UMI Number. 3087980
Copyright 2003 by
Singh, Vishal Pratap
All rights reserved.
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ii
A B ST R A C T
Consumer Behavior and Firm Strategies in a Changing Retail Environment
Vishal P. Singh
The supermarket industry has undergone dramatic changes in the past few
years. Alternative retail formats such as mass merchandisers, price clubs, and
supercenters have encroached upon supermarket sales to pose a serious threat.
A concurrent trend in the supermarket industry, in part driven by growing com
petition. is the movement towards developing customer databases. The impetus
behind these data collection efforts is a hope that data can be used to improve mar
keting decisions and thereby improve retailer position vis-a-vis new competitors.
However, a common refrain in industry reports is that most retailers are strug
gling to leverage this information. This thesis presents a series of three essays to
demonstrate how the information contained in retailers databases can be used to
guide marketing decisions, such as pricing and customer retention strategy, when
confronted with new competition.
iii
The thesis makes contributions to both marketing theory and practice. Past
research on supermarket competition has primarily focused on stores th at are iden
tical in terms of product offerings, cost structure, and pricing policies. Little
attention has been given to the growing competition from mass-discounters and
supercenters. This thesis contributes to this emerging area by addressing how
consumer behavior changes when a low-priced competitor enters the market, and
how traditional supermarkets can use the information in their database to better
compete with the new entrant. The research is also salient to the growing body of
literature focusing on database marketing. The first essay of the thesis shows how
a supermarket manager can use point-of-sales data to develop profitable pricing
policies. Similarly, the last chapter of the thesis demonstrates how a retailer can
exploit the information contained in its frequent shopper database to understand
and interact with their most valuable customers.
hr
C ontents
ABSTRACT iii
List of Tables vii
List of Figures x
Chapter 1. Introduction 1
Chapter 2. The Grocery Retailing Industry 7
2.1. Evolution of the Industry 7
2.2. Alternative Retail Formats 8
2.3. Response by Supermarkets 11
Chapter 3. Cross-Sectional Variation in Demand 13
3.1. Introduction 13
3.2. Model 21
3.3. Estimation 30
3.4. D ata 42
3.5. Results 48
3.6. Impact of Zone Pricing 53
3.7. Conclusions 61
Chapter 4. Supermarket Competition W ith MassDiscounters 63
4.2. Conceptual Development 71
4.3. Demand Model 82
4.4. D ata Description 86
4.5. Results 92
4.6. Conclusion 101
Chapter 5. Impact of Entry by Wal-Mart Supercenter 103
5.2. Impact of Wal-Mart Entry 109
5.3. Category Demand 117
Chapter 6. Conclusion 128
References 133
Appendix A. Tables and Figures for Chapter 3 142
Appendix B.
Tables and Figures for Chapter 4 155
Appendix C.
Tables and Figures for Chapter 5 168
vi
List o f Tables
A .l Descriptive Statistics 143
A.2 R-square values are medians across each of the products in the
category 143
A.3 Demographics measured as percent of population 143
A.4 Demographics and Competitive Variables by Zone 144
A.5 Demand for Laundry Detergent 145
A.6 Demand for Refrigerated Orange Juice 147
A.7 Marginal Effects of Store Characteristics on Category Size
(purchase prob.) 147
A.8 Latent Brand Factors 148
A.9 Minimum Distance Criterion 148
A. 10 Predicted Margins for Laundry Detergent 148
A. 11 Predicted Margins for Refrigerated Orange Juice 149
A. 12 Welfare Implications of Pricing Policies 149
A. 13 Store-Choice Regression based on share of market forstore
trips 154
vii
B.l Changes in Market Share for Non-Perishable Categories 156
B.2 Consolidation in the Supermarket Industry 156
B.3 Demographic, Competitive and Store Characteristics 157
B.4 Increase in Price Zones Over Time 157
B.5 Competitive Characteristics of the Highest and LowestPrice
Zones 158
B.6 Distance to Nearest Competitor 158
B.7 Descriptive Statistics 159
B.8 Impact of Mass Discounters on Category Sales 160
B.9 Estimation Results: Paper Towels 161
B.10 Estimation Results: Bath Tissue 162
B .ll Estimation Results: Orange Juice 163
B.12 Paper Towel Price Sensitivity: 3 periods 163
B.13 Margins for Paper Towels 164
B.14 Estimation Results: Paper Towel 165
B.15 Latent Attributes for Paper Towels: Before 166
B.16 Latent Attributes for Paper Towels: Entry 166
B .l7 Latent Attributes for Paper Towels: After 167
C .l Penetration of Frequent Shopper Card 169
vtii
C.2 Summary Statistics: Distance to Stores and Demographic
Variables 169
C.3 Regression Results for Changes in Sales, Transactions, and
Sales per Transaction Following Wal-Mart Entry 170
C.4 Model of Probability of Defection 171
C.5 Change in Shopping Behavior Following Entry 171
C.6 Model to Determine Impact of Walmart on Purchase
Behaviour 171
C.7 Comparison of Household Shopping Behavior 172
C.8 Summary Statistics: Milk 172
C.9 Summary Statistics: Bath Tissue 173
C.10 Summary Statistics: Laundry Detergent 174
C .ll Model Results: Milk 174
C.12 Covariance Correlation Matrix: Milk 175
C.13 Model Estimation Results: Bath Tissue 175
C.14 Covariance Correlation Matrix: Bath Tissue 176
C.15 Model Estimation Results: Laundry 177
C.16 Estimated Price Sensitivity, By Group 178
C.17 Household Comparison: Milk 178
ix
L ist o f Figures
A .l Perceptual Map for Laundry Detergent 146
A.2 Perceptual Map for Refrigerated Orange Juice 146
A.3 Consumer Welfare Gains and Losses with Zone-Pricing
(Laundry Detergent) 150
A.4 Consumer Welfare Gains and Losses with Store-Pricing
(Laundry Detergent) 151
A.5 Consumer Welfare Gains and Losses with Zone-Pricing
(Refrigerated Orange Juice) 152
A.6 Consumer Welfare Gains and Losses with Store-Pricing
(Refrigerated Orange Juice) 153
B .l Paper Towel Sales 160
B.2 Impact of Adding Pharmacy Department 164
B.3 Distribution of Price Sensitivity: Before 165
B.4 Distribution of Price Sensitivity: After 165
B.5 Transition of Store 71 to Lower Price Zone 166
C .l Impact of Wal-Mart Entry on Store Sales
xi
CHAPTER 1
Introduction
Supermarkets operate in an increasingly competitive environment. Rapid growth
of alternative retail formats, in the form of mass discounters, price clubs, and su
percenters. has transformed not only the competitive structure of the industry but
also the way in which consumers shop. While mass discounters like Wal-Mart and
K-Mart do not offer a full array of perishable and nonperishable products, they do
compete with supermarkets in specific high-volume categories such as paper prod
ucts. dry grocery, health and beauty care products, and other general merchandise
items. More recently, the line separating supermarkets from mass discounters has
blurred as supermarkets have added more and more general merchandise items to
their shelves while stores like Wal-Mart have transitioned towards the food sector
through their supercenter format. Adding to the pressure from these new formats
is the increased competition among the grocery retailers themselves, which leaves
the industry facing perhaps its most difficult competitive situation.
Another trend in the supermarket industry, in part driven by growing compe
tition, is the drive towards developing loyalty programs and customer databases.
Supermarket retailers have been at the forefront of adopting bar code sca n n in g and
collecting point-of-sale data. They were also one of the first to adopt customer loy
alty cards, which has led to the tremendous increase in information available to the
retailer. Providing more than just store-level sales and local area demographics,
frequent shopper databases allow retailers to track purchase histories for all their
customers. Just as the nature of the data collected has changed over time, its
use has evolved from addressing operational issues on the supply side, to category
management, and more recently to customer management.
However, despite this impetus towards building large data warehouses, a com
mon refrain in industry reports is that most retailers are struggling to leverage
this information (MacLeod 2000). The potential difficulty of converting data into
valuable marketing strategies is illustrated by the recent cancellation of loyalty
card programs by some of the retailers in Europe, who have begun to question
the value of the huge reams of electronic data collected using loyalty cards ( The
Wall Street Journal Europe, May 19, 2000). In the United States, on the other
hand, the number of stores offering frequent shopper programs has increased to
12,000, accounting for 66% of the all commodity volume (ACV). Further, a study
by ACNielsen found that 70% of American households participate in at least one
frequent shopper program (ACNielsen Frequent Shopper Program Study, 1999).
The wide penetration of these cards indicates that large volumes of data are being
collected. The need to leverage this information becomes even more important with
the growth of formidable competitors like Wal-Mart, which, with its supercenters,
has already become the fourth largest player in the grocery industry.
3
This thesis presents a series of three essays to demonstrate how information
contained in retailers' databases may be used to guide marketing decisions, such
as pricing and customer retention, when confronted with new competition. The
first essay demonstrates how retail chains can utilize their point-of-sales data in
setting up more profitable pricing policies. The data used in this study come from
Dominick's Finer Foods (DFF), which is the second largest supermarket chain
in the Chicago metropolitan area. DFF uses zonal pricing, where the stores are
grouped into clusters and prices vary over clusters. We estimate a system of
demand functions th at incorporates consumer heterogeneity due to both observed
and unobserved factors. A key feature of the estimation approach is the ability to
identify flexible substitution patterns while controlling for endogeneity of prices.
The demand estimates are combined with a model of category profit maximization
to simulate the prices and profitability under three scenarios: (1) current zonal
pricing. (2) uniform chain pricing, and (3) more profitable store-level pricing.
An interesting feature of the study is th at it also analyzes the impact of a
change in pricing from the consumer perspective. A move to store level can have
negative impacts in the long run by destroying the overall image and positioning
of the chain (Blattberg 1988). Further, the retailer also needs to be concerned
about the overall losses to consumers in stores where prices are expected to rise.
To mitigate these losses, we propose a constrained pricing procedure th at makes
use of the underlying economic structure of the model. The approach restricts the
new store prices to offer the population of consumers in each store at least the same
4
level of welfare as under a u n iform chain-wide pricing policy. We find that this
constraint still enables the store manager to capture a large portion of the gains
from unconstrained store pricing. The second practical consideration involves the
potential complexity of computing store-level prices for a chain like D o m in ic k ’s,
which has a large number of stores. We address this computational complexity
by suggesting an improved zone structure. Using our store-specific price levels, we
cluster the stores into five zones. We find that these zones offer substantially more
profit than the existing zone configuration.
The focus of the second essay is on analyzing competition between discount
stores such as Wal-Mart and Target and a traditional supermarket. This study
develops a conceptual model of how entry by discount stores impacts the sales of
competing products at the grocery store. A critical difference between mass dis
counters and grocery stores is that mass discounters do not offer the full grocery
line found in supermarkets. The conceptual framework models consumer hetero
geneity in terms of the utility they derive from buying all products in a single
shopping trip. Thus, consumers who prefer to buy all their groceries in a single
shopping trip would prefer to shop at supermarkets. Others may prefer to split
their baskets and take advantage of the lower prices of nonperishable goods at the
discounter while buying food items at the grocery store.
The empirical analysis uses the same data as in the first essay. However, the
focus in this study is on demand changes over time due to changes in the compet
itive environment facing the store. During the period of study, we observe entry
5
by two large discount chains—Wal-Mart and Target. Change in the competitive
environment for each of Dominick's stores is captured by using information on the
location and opening dates for all new entrants to the market. The objective of
the empirical analysis is to investigate the impact of entry by these discount stores
on demand for products sold at Dominick’s. In particular, we analyze how entry
impacts the total level of demand as well as consumer price sensitivity in both the
short and long run. The demand estimates are then combined with a model of
category profit maximization to measure the implications for category pricing and
profitability.
The last chapter of the thesis analyzes the impact of entry by a Wal-Mart su
percenter into a local market. Supercenters combine full grocery lines and general
merchandise under one roof and are seen by supermarket managers as the biggest
threat to the traditional grocery industry'. We utilize a unique frequent shopper
database that records purchases for over 20.000 households before and after Wal-
M art’s entry. Access to rich transaction-level data allows us to investigate not
only the impact of Wal-Mart ?s entry on overall store sales but also the changes in
store-visit frequency, overall basket size, and category demand for each individual.
We decompose the observed losses in store sales into components attributed to
customer attrition, loss of store traffic, and reduction in basket size. More impor
tantly, we combine the transaction data with household-specific demographic and
shopping variables to identify and characterize the consumers who contribute to
the observed demand changes at the store level.
6
The study also analyzes the impact of Wal-Mart’s entry at the product cate
gory level. Retailers increasingly employ category management tools where each
category is treated as a strategic business unit and pricing, merchandising, promo
tions. and product mix are determined at the category level. Thus, it is critical
to analyze the impact of competitor entry on a category-by-category basis and to
develop strategies to foster category-level retention. We estimate a hierarchical
Bayes random coefficient logit model for three product categories. An advantage
of the Bayesian approach is that it allows parameter inference at the individual
level, which allows customers to be characterized in terms of their sensitivity to
marketing mix or preference for specific attributes. This in turn can be used to
develop customized targeting tools.
The rest of the thesis is structured as follows. The next chapter provides a brief
overview of the supermarket retailing industry, focusing primarily on the growth
of new retail formats. Chapter 3 presents the first essay of the thesis. The essay
on competition between supermarkets and discount stores in presented in chapter
4. The third essay, which analyzes the impact of entry by Wal-Mart supercenter,
is presented in chapter 5. We conclude in chapter 6.
CHAPTER 2
T he G rocery R etailin g In dustry
2.1. E v o lu tio n o f th e I n d u s tr y
Grocery retailing traditionally consisted of small general stores, most of which
were independent, family-owned businesses. These stores generally operated on
the principle of high margins and low turnover1. The Atlantic and Pacific Tea
Company (A&P) introduced the concept of an organized multiple-store network,
marking the transition to a new phase in grocery retailing and the birth of the
chain store. W ith multiple stores. A&P generated the high volumes necessary
to obtain quantity discounts from manufacturers while reaping economies-of-scale
benefits on their self-produced private label items. By I960. A&P operated close
to 12.000 stores (for an excellent review on the factors leading to the rise and fall
of A&P. see Tedlow 1990).
The supermarket format emerged in the 1930s. While A&P first brought high
volume and low prices to the grocery industry, supermarkets took this concept to
new level. Supermarkets were much larger than the existing grocery stores and
were located primarily in low-rent areas. They also offered limited store services
and relied on nationally advertised brands as opposed to private labels. Over time,
‘See Ellickson (2001) for a historical overview o f the evolution of the grocery retailing industry.
s
supermarkets grew in importance, and by 1970 they had become the primary food
distributor, replacing the smaller grocery stores.
2.2. A lternative R etail Formats
Until recently, supermarkets viewed neighboring supermarkets as their primary
competitors. However, this perspective is changing. A supermarket’s biggest com
petitor these days is not only another supermarket, but also include supercenter,
warehouse club, dollar store, mass discounter, or drug store that also happens to be
selling food (Urbanski 2000). We next describe some alternative retail formats that
have emerged in recent years and their degree of competition with supermarkets2.
Mass Discounters: The big three mass discounters (Wal-Mart. K-Mart. and
Target) originated in the 1960s and now account for over 80% share in this retail
format. These stores have only a partial overlap with supermarkets in terms of the
products they sell. The two formats compete in products like general merchandise,
health and beauty aids, and other nonperishable grocery items. At the same time,
each format also sells a unique set of products (e.g., clothes, tires, etc. at mass
discounters; fresh produce and meat at supermarkets). Over time, this overlap has
increased as supermarkets have added more and more general merchandise items
to their shelves while mass discounters have transitioned towards the food sector.
A recent study conducted by Proctor and Gamble (P&G). which analyzed nine
nonperishabie categories, indicates that mass discounters have been able to steal
2This section is drawn from “Facts and Figures” , Food M arketing Institute web page and from
“T he U.S. Retail Food Industry: 2001 Store Form at U pdate” W illard Bishop Consulting.
9
significant volume from the supermarkets in the dry grocery business (see Table
B .l). There are a number of reasons for this. First and foremost, these formats
operate on a much larger scale, allowing them to bypass the wholesalers and buy
directly from the manufacturers. Economies of scale in distribution, coupled with
buying power with manufacturers, translate into lower everyday prices for con
sumers. Fox et al. (2000) compare the marketing mix across various retail formats
and find mass merchandisers to be least expensive, offering prices 9% below Hi-Lo
grocers. Further, in all of the nine categories reviewed in the P&G study, display
frequency was much higher and twice as long at mass merchants than in super
markets. Finally, mass merchants also create an image of value and convenience
by selling large-pack-size items.
Price Clubs: Price clubs are a membership retail-wholesale hybrid, with a
limited variety of products presented in a warehouse-type environment. The first
store of this format, Price Club Wholesalers, was opened in 1976, while Costco
and Wal-Mart’s Sam’s Club opened in 19833. According to Trade Dimension,
supermarket-equivalent sales of Sam’s Club and Costco in the year 2000 were $15.2
billion and $14.5 billion respectively. Sales of Kroger, the largest supermarket
chain in the country, were $45 billion, generated from about 2,400 stores. In
comparison to Kroger, Sam’s Club and Costco generated nearly one-third the
sales while operating only a fraction of the stores (Sam’s = 471, Costco = 253).
Thus, these stores operate on a much larger scale on a per store basis. While price
3Costco and Price C lub later merged in 1993.
10
clubs are becoming increasingly popular with individual households, their primary
clientele remains small businesses, restaurants, small grocery/convenience stores,
and other institutions.
Supercenter: In the 2000 annual survey by Progressive Grocer, over 75% of
supermarket managers cited supercenters as their biggest concern in the coming
year. Supercenters, which range between 110.000 and 220,000 square feet, combine
full grocery lines with general merchandise under one roof. Many of them also
include services such as a vision center, Tire and Lube Express, a hair salon,
and so forth, providing consumers with a true “one-stop shopping” experience.
Supercenters have shown dramatic growth in the past few years. For example,
the first Wal-Mart supercenter was opened in 1988, while in 1993 the company
operated only 10 such stores. By 2000, Wal-Mart had over 900 supercenters, and
the company plans to add 180 new such stores every year (a number of these stores
are conversions of existing discount stores to supercenters). Similarly, Target and
K-Mart have started opening their own versions of supercenters. The primary
reason why Wal-Mart and other mass discounters have added food to their stores
is to increase consumer store-visit frequency, hoping th at this increased frequency
will spill over to other general merchandise.
Neighborhood Markets: While the large size of supercenters permits the conve
nience of grocery and general merchandise under one roof, it also limits its ability
to penetrate urban areas. Wal-Mart has recognized this limitation and is testing
scaled-down versions of supercenters ranging in size from 40,000 to 50,000 square
11
feet. According to Wal-Mart, its neighborhood market format will charge the same
low price as its supercenters while providing the locational convenience of super
markets and convenience stores. While still in a test phase, this format is already
regarded by supermarket managers as the second biggest threat after supercenters
(Progressive Grocer Annual Survey, 2000).
Other Nutritional/Health Stores: While the mass discounters have made in
roads into the food sector via supercenters, they are not the only ones stealing
away shares from traditional supermarkets. Limited assortment organic or natural
food stores are also growing at a tremendous pace. The $5 billion organic market
is growing at a rate five times greater than the growth of the overall food indus
try. The sales growth of Whole Foods (21%) and Wild O ats (36%). together with
W al-Mart‘s plans to add organic SKUs. underscores the importance of this area.
2.3. R esponse by Superm arkets
Supermarkets have responded to these new sources of competition in a number
of ways. First, supermarket chains have increased their size through mergers and
consolidation. The past few years have seen some of the biggest mergers and
acquisitions in the industry (e.g., Kroger and Fred Myers, American and Albertson
stores, etc.). Size increases the bargaining power that supermarkets have with
manufacturers while also providing economies of scale in distribution. As seen in
Table B.2. this consolidation wave, coupled with the dram atic growth of alternative
12
retail formats, has led to a significant drop in the number of small and independent
grocery stores.
Besides consolidating, supermarkets have also increased their focus on services
and customer satisfaction. For example, supermarkets have added convenience ser
vices that are both food and non-food related. Deli counters, ready-to-eat foods,
salad bars, and cafes have been added to cater to the needs of a wider group of
consumers. Services such as banking, postal services, and video departments are
now commonplace in supermarkets. In terms of overall selection, the number of
SKUs and average store size have also increased. Further, more and more super
markets have introduced frequent shopper programs that deliver price discounts
as rewards to encourage shopper loyalty to a store. The strategy of introducing
loyalty programs, coupled with increasing services, has been to make a customers
shopping in supermarkets a more convenient and rewarding experience.
CHAPTER 3
C ross-Sectional V ariation in D em and
3.1. In tro d u c tio n
In recent years, the practice of “zone pricing” has become increasingly popular
for retailers. This form of third-degree price discrimination is a spatial pricing
policy whereby a firm selects various delivered prices and the geographic zones in
which they apply. In some instances, the definition of a zone may be sufficiently
narrow th at nearby outlets of a common retail chain may charge noticeably differ
ent prices. For instance, some large supermarket chains allow prices to vary across
clusters of stores within a given metro-market. Similarly, retail gasoline stations
in a given city often charge higher prices at outlets near freeways and fast food
chains charge different prices at airports.
Recently, policy researchers have begun investigating the legality of zone pric
ing practices in industries such as wholesale gasoline (LA Times 2000) and dairy
(Milwaukee Journal Sentinel 1999). In wholesale channels, zone pricing could
potentially inflate prices in certain markets at the expense of retailers. Alterna
tively, in the case of dairy, government-imposed zone pricing could depress prices
in certain markets at the expense of individual farmers. These are typical out
comes of the well-known monopoly third-degree price discrimination problem (e.g.
13
14
Schmalensee 1981 and Varian 1 9 8 5 ). In particular, u niform prices tend to lie
somewhere between the extremes of the discriminatory prices. For supermarket
price zones, similar “fairness” policy concerns as those above could arise if price
discrimination raises shelf prices in zones catering predominantly to lower-income
consumers with lower access to search for the •‘best” price.
In practice, supermarket pricing decisions tend to be made weekly on a category-
by-category basis by independent category managers. As a result, most supermar
ket pricing studies (e.g. Slade 1995 and Chintagunta 2002) consist of a short-run
partial equilibrium model of the category in question, rather than a broader model
of the store-wide pricing decisions. Consumer welfare losses within a category
may be small from the category manager’s perspective when going from a uniform
to a zone level pricing policy. From a store manager’s perspective, aggregating
the impact of zone-pricing across categories could generate non-trivial consumer
welfare losses that, in the long-run, could translate into losses in store traffic as
consumers switch to other stores. This possibility generates a strategic motivation
for identifying categories in which zone-pricing generates substantial additional
profits without extracting too much consumer surplus.
We investigate the implications of zone-pricing by using a rich scanner d ata set
for a large supermarket chain in the Chicago area. The data consist of weekly
store-level SKU prices, quantities, margins, traffic and promotional information
for 2 of the product categories available. The data also contain an index that
classifies clusters of stores into pricing zones according to the chain’s definition. To
15
complement the store data, we use competitive information from Spectra marketing
th at characterizes the demographic profile for each stores consumer base as well
as the proximity to local competitors. One of the unique features of the data
is the availability of weekly store margins, which we use to compute a measure
of the wholesale price. Combining wholesale prices with the zone designations
provides another interesting aspect of the data. Unlike previous empirical work on
price discrimination, we are better able to attribute cross-sectional price variation
to discrimination as opposed to alternative explanations, such as cost differences.
Thus, we are in a better position to measure the welfare implications from third-
degree price discrimination.
Using the data for 2 product categories available in the database, refrigerated
orange juice and liquid laundry detergent, we estimate structural demand systems.
Access to retail margins as described above allows us to validate the ability of our
demand system to recover the true underlying data-generating process by com
paring the margins observed in the data to those predicted using the estimated
demand system. This validation is similar to Nevo (2001) and Slade (2002) except
th at we observe a full time-series of margins rather than a single observation of the
approximate mean margin for each alternative. Using a static category manage
ment pricing model, we then simulate the prices and sales consistent with uniform
weekly chain-level pricing. Since the data contain the chain’s definition of the retail
zones, we are able to compute the price and welfare impacts of zone pricing rela
tive to chain level pricing. Moreover, we are able to assess which local consumer
16
segments benefit and which are hurt by this geographic price discrimination and
how these effects vary across product categories. We then repeat the exercise at
the store level by implementing a profit-increasing store-level pricing model and
simulate its impact on prices, profits and consumer welfare. Finally, given the
practical limitations of implementing a store level pricing policy, we propose an
alternative pricing scheme that alleviates this problem.
A key feature of our estimation approach is the ability to identify flexible
substitution patterns while controlling for the endogeneity of prices. We estimate
systems of demand equations, allowing the shape of demand to vary across stores.
As in Berry. Levinson and Pakes (BLP hereafter. 1995), we use an aggregate mixed
logit demand specification. The demand model allows for category expansion by
including a riio purchase” option in the specification. The parsimony of the BLP
approach comes, partially, from the use of measurable product characteristics.
This “characteristics approach” involves projecting consumer preferences onto a
set of product attributes and, thus, using these attributes to help explain aggregate
substitution patterns. As with many of the typical supermarket product categories,
our data do not include an exhaustive set of measurable product attributes. Our
solution is to estimate a richer correlation structure in the distribution of brand
valuations. To preserve some of the parsimony of the mixed-logit specification,
we use a factor-analytic approach. An interesting by-product of this approach is
the ability to produce a map of the brands based on intangible product attributes
(Elrod 1988 and Chintagunta 1994).
17
A recent body of empirical research has attem pted to identify and measure the
implications of price discrimination. Existing work has emphasized the identifica
tion of the practice of price discrimination versus cost-based differences (Borenstein
1991. Shepard 1991 and Cohen 2001). Others have looked at the underlying sources
of price discrimination and their magnitude (Verboven 1996 and Goldberg 1996).
Only recently has empirical work emerged documenting the welfare impact of price
discrimination. Leslie (2001) simulates the impact of several counterfactual price
discrimination schemes for tickets at a Broadway theatre. Cohen (2000) measures
the impact of second-degree price discrimination across brands in the paper towel
industry. A related literature on coupons has focused predominantly on the likeli
hood of consumer usage, rather than impact on equilibrium welfare (e.g. Chiang
1995, Gonul and Srinivasan 1996 and Erdem, Keane and Sun 1999). Nevo and
Wolfram (2000) investigate the impact of manufacturer’s coupons on retail prices
for breakfast cereals. Similarly, Besanko. Dube and G upta (2001a) demonstrate
empirically the potential for profit-enhancing targeted coupons in a competitive
environment.
Several studies have used the d ata set used in this paper although with different
objectives (e.g. Peltzman 2000 and Chevalier, Kayshap and Rossi 2000). Two
papers using these d ata are closely-related to our work. Hoch et al. (1995) find
th at a large proportion of the variation in category-level consumer price elasticities
across stores is explained by local consumer demographics and, to a much lesser
extent, to local competitive variables. In a follow-up study, Montgomery (1997)
18
looks at the profit-implications of zone and store pricing for the supermarket chain
in one specific product category.
Our work differs from these two papers in several ways. Our main objective is
to study the implications of zone pricing on consumer welfare (besides profits), the
results of which should interest policy workers, strategists and marketers. We then
use the underlying structure of the model to propose alternative pricing strategies
that address customer welfare due to store pricing and the computational com
plexity for the store manager. Our work also differs from a practical point of view.
Similar to Montgomery (1997), we find th at estimation of standard demand mod
els (double-log, linear etc.) underpredicts the price sensitivity of demand: implied
margins are much higher than the observed levels. The parsimony of the current
model enables us to solve this problem in two ways. First, we estimate flexible
substitution patterns with a relatively small number of parameters. As a result,
we do not observe "incorrect" signs in our cross-elasticities. 1 At the same time,
we are able to control for the potential endogeneity of prices. Previous w'ork with
various weekly supermarket data and discrete choice modeling consistently finds
that instrumenting for prices leads to noticeably higher magnitudes in the price
response param eter (Besanko, Gupta and Jain 1998, Villas-Boas and Winer 1999
and Chintagunta 2002) . 2 We find our model provides reasonable estimates of the
lNote th a t previous work has often estim ated negative cross-price elasticities of demand in cat
egories which one would expect to consist of substitute products. These incorrect signs will bias
simulated profit-maximizing prices upwards.
■^lontgomery and Rossi (1997) do not find noticeable effects from instrum ental variables. How
ever. their specification uses aggregate price indices for a category rather th an shelf prices.
19
zone-level margins. Finally, we validate the fit of our model using the observed
retail margins.
Consistent with the zone structure, we observe substantial price variation across
stores within a given week in the raw data. In fitting the demand curves, we find
both the price-sensitivity as well as the no-purchase probability vary tremendously
across stores. Interestingly, our estimates of zone-specific prices provide a reason
ably accurate representation of the true prices reported in the data. This finding
gives us confidence in our ability to capture the underlying data-generating pro
cess. As in Hoch et al. (1995), we find that demographic variables consistent with
willingness-to-pay are the most influential for market shares and elasticities. Thus,
we conclude that zone classification is based primarily on discriminating across
consumer types. However, we do find evidence th at measures of competition and
consumer search m atter, but to a lesser extent. To assess the welfare implications
of zone-pricing, we compute the prices and quantities that would prevail if the
retailer adopted a uniform chain-level pricing policy for products. As expected,
category profits are higher under the zone pricing relative to chain pricing. Con
sumer welfare effects vary across stores. We then compute the prices and quantities
that would prevail if the stores adopted a store-specific pricing policy. Now prices
rise substantially more than under the current zone pricing. Interestingly, while
consumer welfare effects vary across stores, we note th at the store-pricing seems to
target higher prices to less-affluent areas with larger ethnic populations and higher
search costs. In contrast, zone-pricing seems to target high prices to more affluent
20
areas. VVe also conclude th at shifting from uniform pricing to either zone or store-
level pricing may be better suited in some categories than others. For example, in
liquid laundry detergent, we find only modest gains from zo n in g - We also note the
importance of balancing store profits with consumer welfare. For example, in the
orange juice category, we do find sizeable losses in consumer welfare, especially if
the chain moves to store pricing.
Two practical considerations arise with such profit-enhancing pricing policies.
First, a store manager could be concerned about the overall losses to consumers
in stores where prices are expected to rise. To mitigate these losses, we propose a
constrained pricing procedure that makes use of the underlying economic structure
of the model. The approach restricts the new store prices to offer the population
of consumers in each store at least the same level of welfare as under a uniform
chainwide pricing policy. We find that this constraint still enables the store
manager to capture a large portion of the gains from unconstrained pricing in both
categories. The second practical consideration involves the potential complexity of
computing store-level prices for a chain which, like Dominicks, has a large number
of stores. We address this computational complexity by suggesting an improved
zone structure. Using our store-specific price levels, we cluster the stores into 5
zones. We find th at these zones offer substantially more profit than the existing
zone configuration.
The chapter is structured as follows. Section 2 presents the model. Section
3 discusses the main aspects of the estimation procedure. Section 4 provides an
21
overview of the d ata we use for estimation. Section 5 presents results, including
the demand parameters, the perceptual maps and finally the welfare implications
of zone-pricing. We conclude in section 6 .
3.2. M odel
To develop a viable pricing framework for a category manager, we begin by
specifying an economic model of individual choice behavior in a supermarket cate
gory. We then derive the expected aggregate demand facing the category manager.
Using the derived demand, we then model the category manager's pricing problem.
This structural approach presents several advantages. From a m o d elin g per
spective, we are able to compute a theory-based measure of consumer well-being
based on their willingness-to-pay. This measure permits us to compute consumers'
monetary valuations of various pricing policies by the retailer. At the same time,
the structured approach simplifies our treatment of the retailer’s pricing problem.
The derivation of aggregate demand from first principles yields a "well-behaved”
specification. Typically, popular approximations of aggregate demand, such as
the log-log model, generate non-concave regions in the profit function. The non
concavity makes it impossible to maximize profits without imposing additional (ad
hoc) constraints (Anderson and Vilcassim 2001) on the set of profit-maximizing
prices. Similarly, the parsimony of the model helps us identify “reasonable” aggre
gate substitution patterns. In contrast, studies using standard linear or log-linear
approximations of demand have typically provided unsatisfactory substitution pat
terns, such as negative cross-price elasticities for products that are substitutes. For
instance, Hoch et al. (1995) report category price elasticities th at are larger than
the individual brand elasticties. This outcome implies underlying complementarity
between some of the brands (negative cross-price elasticities). Finally, the struc
tural derivation helps us understand potential sources of bias in the estimation
problem. Several researchers have noted the tendency for regression models to
understate consumer price-sensitivity with comparable retail data, which leads to
over-confidence in the pricing recommendations. One solution to this problem has
been to impose constraints on the parameters during the estimation process (Brad-
low and Montgomery 1999). We believe that one source of estimation bias derives
from unobserved (to the econometrician) covariates th at influence consumer choice
and. thus, pricing. In developing the model, we indicate how such unobservables
could affect consumer choices and, potentially, bias estimation. Following the rec
ommendation of Berry* (1994), we solve this problem with an instrumental variables
procedure.
3.2.1. U tility and D em and
In this section, we describe the underlying consumer choice model generating the
observed aggregate purchases in each store-week. We use the mixed logit spec
ification (McFadden and Train 2000), which adds normally-distributed random
coefficients to the standard conditional logit choice model. For a more general
23
discussion of discrete choice models and their aggregation we refer the reader to
BLP (1995). One of the main advantages of this specification is parsimony. Con
sumer preferences are projected onto a set of exogenous product attributes, which
greatly reduces the dimension of the estimation problem. For industries with a
large number of alternatives, correlations in valuations of products is characterized
by heterogeneous tastes for the attributes. In many product markets, researchers
are easily able to collect a sufficient set of attributes to capture the underlying
market segments in the category. For example, this approach has been applied
to aggregate d ata for automobiles (BLP 1995, Petrin 1999 and Sudhir 2001a),
PCs (Bresnahan. Stern and Trajtenberg 1997), ready-to-eat cereals (Nevo 2001)
and movie theaters (Davis 2000). In packaged goods product markets such as
one would find in supermarkets, much of the correlation derives from intangible
sources such as brand perceptions. Since intangibles are not easily measured by
the econometrician, we model the joint distribution of brand valuations explicitly.
We use a parsimonious factor-analytic approach to recover the impact of intangible
attributes, as is typically used with individual data (Elrod 1988, Chintagunta 1994
and Elrod and Keane 1995) as well as with aggregate data (Chintagunta, Dube
and Singh 2002 ) . 3
3Additional m ethods exist for identifying flexible substitution patterns using similar data with
aggregate choices. For instance, Nevo (2001) samples consumer dem ographic profiles from the
empirical joint distribution provided by the census a t the MSA level. BLP (1998) construct
additional moments of th e data-generating process by combining additional micro d ata with
their aggregate data.
24
Formally, we assume that on a given shopping trip in week t (t = 1 , .. ., T), M t
consumers each select one of J brands in the category or opt for the no-purchase
alternative, whose mean utility is normalized to 0. We discuss the validity of this
single-unit purchase assumption in Appendix A. In a store-week t, each brand j has
attributes: (xj£,£Jt). The vector x includes a brand-specific fixed-effect as well as
an indicator for the incidence of a promotion and the size of the SKU (e.g. ounces).
The vector. £ encompasses the effects of unobserved (to the econometrician) in
store product attributes, such as advertising, shelf-space and coupon availability
th at vary across store-weeks (BLP 1995. BGJ 1998)4. These unobserved factors
generate deviations from the mean utility for a product across weeks and stores.
In the estimation section below, we explain how these deviations from the mean
might bias estimation. Finally, the variable pjt denotes brand j's shelf-price in
week t.
For a shopping trip during week t. the conditional utility consumer h derives
from purchasing product j is given by:
U hjt = &h] -f- - E jt& h P jt ~F £ jt d" ~ h jti
h = = 0 ,...,J .f = l . . . . , r .
4Since we estim ate a full set of product fixed-effects, we do not need to worry about unmeasured
physical product attributes, as in BLP 1995. We are nonetheless concerned with unobserved (to
th e econometrician) weekly in-store product-specific effects.
25
The coefficients 3h capture consumer h’s tastes for attributes, x, which includes
marketing mix variables. The parameter 0/, captures consumer h's marginal utility
for income. In the current context, income consists of the shopping budget for a trip
during week t . 5 The parameter a/y captures household h's idiosyncratic perception
of brand j . The term s^jt is an i.i.d. mean-zero stochastic term capturing consumer
h's idiosyncratic utility for alternative j during week t. We assume that Shjt has
a type / extreme value distribution. Previous work has also explored the use of
correlated errors, such as the multivariate normal, giving rise to the probit choice
model (McCullough and Rossi 1994). Below we discuss some of the limitations of
an i.i.d. additive error.
The formulation allows for an outside good, "no purchase", the utility of which
is given by
U-ktO ~ a h0 + QhYh. + ~htO-
In the current context, this alternative represents the shopping occasions where
consumer does not purchase in the category. For practical reasons, this outside
good is im portant for the retailer pricing exercise. In the absence of this alternative,
the total category size would be invariant to the prices of all brands increasing or
decreasing by the same amount. Hence, allowing for the outside good allows the
category sales to be influenced by the prices of the inside goods. For identification
purposes, is normalized to zero.
5In th e following analysis, we do not address formally how households allocate total income to
their weekly shopping budgets.
26
Since we do not observe the true distribution of consumer preferences, we as
sume tastes, brand perceptions and the marginal utility of income are drawn from
a multivariate normal distribution. For simplicity, we treat the taste parameters
as i.i.d:
3
+ \ v h, u h ~ N (0 .1)
eh e
3
where the vectors of means, . and the standard deviations, A, are parameters
0
to be estimated.
VVe do allow for a richer covariance structure for the vector of brand perceptions:
a h ~ iV (a, E ) .
In theory, we could estim ate the the full (J x J ) matrix E directly. In practice, as
the number of brands grows, E becomes increasingly difficult to identify. Instead,
we use the factor structure:
E = Lwu/'I', u/ ~ N (0 ,1 ) .
One interpretation for this structure is that L is a (J x K) m atrix of latent at
tributes for each of the J brands, and u; is a ( K x 1 ) vector of consumer tastes
for these attributes. The vector of mean brand perceptions, q, and the matrix
of latent attributes, L, consist of parameters to be estimated. In addition to its
27
parsimony, this approach allows us to estimate standard errors for the latent at
tributes. In the current context, we assume K — 2. For identification purposes,
we do the following (see Elrod 1988):
( 1 ) The outside or "no purchase '1 option is located at the origin of the map
(translational invariance).
(2) One of the brands is located along the horizontal axis (rotational invari
ance).
(3) We set the variances of jj above to 1 in the estimation (scale invariance).
As is now the convention in the literature, we simplify our notation by re
writing the consumers indirect utility in terms of mean tastes and deviations from
the mean:
u hj t = &jt "b Mhj t "b ~h]t
where 6jt = aj-rxJtJ —8pjt+£Jt is common to all consumers and fih]t = x]t\ v h+Lu}h
is consumer-specific6. The unconditional probability qJt that a consumer chooses a
particular product j in week t, after integrating out individual heterogeneity, has
the following form:
r exP Vit + Phjt) ,,

(3-i) <bt = /— = j -o{v)du.
J -oc 1 + 2J«=1 e x p ( ° i t + Mtot)
h = = Q............. =
6N ote that we remove the term BhYh from the equation as it will not be identified in the share
equations below. This term drops out of th e share equation as it is common to all th e alternatives
including no-purchase.
28
where o (•) is the pdf of a multivariate standard normal. From the store manager’s
perspective, (3.1) represents the share of consumers entering the store in week t
that purchase a unit of product j . With the total market size represnted as Mt,
the manager's expected demand for product j in store-week t is :
(3.2) QJt = qjtMt.
Our main motivation for using this random coefficients specification, as opposed
to a simpler conditional logit (or homogeneous logit), is the need for flexibility.
The homogeneous logit generates the IIA property (the independence of irrelevant
alternatives property) at the consumer level. The IIA property could manifest
itself into our aggregate analysis in several ways. First, it can be shown that the
assumption leads to aggregate cross-elasticities that are driven by market shares
(see BLP 1995 for a thorough discussion). For instance, products with similar
market shares are predicted to be close substitutes. In addition to the potentially
unrealistic predicted substitution patterns, the cross-elasticities also restrict the
implied retailer behavior in equilibrium. Multiproduct firms are restricted to
set a uniform margin for each of the products in their line (Besanko, Dube and
G upta 2001a). Since our analysis focuses on category management, this property
would imply that all of the products in a category have the same mark-up over
their wholesale prices. To alleviate the restrictive substitution patterns generated
by the IIA property, we allow for consumer-specific deviations from mean tastes.
29
As a result, the demand function in 3.2 above does not suffer from restrictive
substitution patterns.
We use random taste coefficients to generate correlations in utilities for the
various alternatives and, thus, relax the restrictive substitution patterns generated
by the IIA property. As discussed above, one could also use a correlated additive
error, such as the probit model, which avoids the IIA property directly. In general,
the probit strictly dominates the logit as it allows for freely-varying covariances.
The random coefficients probit also enables one to disentangle heterogeneity from
simple non-IIA behavior at the consumer level. We use the "mixed’' logit instead
of a multinomial probit due to the relative ease of estimating the former versus
the latter. McFadden and Train (2000) show that the mixture of normals with
the type I error, the mixed logit, is sufficiently flexible to approximate a broad set
of parametric indirect utility functions, including the probit (see Dalai and Klein
1988 for a related finding). In practice, the flexibility depends on the restrictions
placed on the correlations in the random coefficients, £ . W ith aggregate data, the
ability to integrate out the logit disturbance, as in (3.1), vastly increases the ease
of implementation versus a multinomial probit. Thus, we choose the mixed logit
due to its relative ease of use.
One of the complications of the mixed logit specification (3.1) is the lack of an
analytic form for the multidimensional integral. While it is true th at for a simple
model with fewer than three random parameters one could solve the expression
30
numerically (Hausman and Wise 1978), most categories consist of more than three
alternatives. Instead, we use direct Monte Carlo simulation, as in Nevo (2001).
3.3. E stim ation
We now outline the estimation procedure for the aggregate mixed logit. Unlike
BLP (1995), we do not require additional supply-side moments for identification
as we observe the exogenous wholesale prices and use these as instruments. This
approach also ensures that our demand-side estimates are not subject to specifi
cation error from incorrectly assuming static category management by retailers.
Since our estimation methodology is quite similar to th at used by BLP (1995), we
only provide an outline. We refer the more interested reader to BLP (1995) for a
more technical description and to Nevo (2001) for a more thorough discussion of
the implementation of the methodology.
A primary concern in empirical papers using similar discrete choice models is
the potential for estimation bias due to correlation between prices and the unob
served product attribute, £. Using weekly store-level data, our primary concern lies
in unmeasured store-specific covariates that influence demand and also shift prices
at a weekly frequency. Even after including a full set of alternative-specific inter
cepts, several papers have documented evidence of an estimation bias in models
th at do not control for this problem using weekly supermarket d ata (BGJ 1998,
Chintagunta 2001, Villas-Boas and Winer 1999). For instance, we do not observe
shelf-space; however, increasing shelf-space allocation typically incurs costs that
31
raise prices, such as allocation fees and opportunity costs. At the same time,
it is well known th at shelf-space influences consumer brand choices (Dreze, Hoch
and Purk 1994). Similarly, our data does not include detailed promotional activi
ties such as special display or availability of store coupons, which could influence
choice probability and are also likely to be correlated with prices. While charac
terizing the precise nature of measurement error in our data is beyond the scope of
the paper, we use standard instrumental variable techniques to avoid estimation
biases.
In order to facilitate the direct instrumentation of prices, we use the inversion
procedure proposed by Berry (1994). We begin by partitioning the observed prod
uct characteristics as X Jt = [xj£.pj£], where xj£ includes the brand fixed effects
and the promotion dummy. By assumption E (x£Jt|xJt) = 0 and E (p£Jt\pJt) ^ 0.
Following Berry (1994), we invert (3.1) to recover the vector St (0) of mean utilities
as a function of the parameter vector 0 , and we set up the estimation procedure
in terms of <f>£. Since the inverse of (3.1) does not have a simple analytical form, we
resort to numerical inversion using the contraction-mapping procedure suggested
in BLP (1995). The approach requires, for each store-week f, picking some ini
tial guess of the mean utility vector 6t and iterating (3.3) until the following J
expressions converge:
(3.3) 6?£+ 1 = <5?£ + Info*) - In [qjt ( X t, 6?; ©)] . j = 1 . . . . , J
32
where the superscript n refers to an iteration, and qjt is the observed market share
for brand j in period t.
The advantage of using 6]t for estimation is that the prediction error. <5j£ —J'
is simply the unobserved product characteristic. £Jt. The fact that £Jt enters (3.3)
linearly facilitates instrumentation. Moreover, with some intuition for the source of
the unobserved attribute, we are able to impose reasonable covariance restrictions
to set up our method of moments procedure.
We now set up a generalized method of moments (GMM) procedure to estimate
the system of mean utilities. Let £t be the (J x 1 ) matrix of unobserved attributes
for each of the products in store-week t. Similarly, we define our instruments, Z t,
an /-dimensional vector including the exogenous product characteristics as well
as other potential covariates that may be correlated with pJt, but not with £Jt.
Our key identifying condition is the conditional mean-independence assumption
E (£t S Z t \Zt) = 0 and E (£t£ |Z t) = ^ a finite (J x J) matrix. We are now able
to construct our moment conditions:
where at the true parameter values. ©0, E(ht(Qo)) = 0. For estimation, we com
pute the corresponding sample analogue of these moment conditions:
(3.4)
t=i
33
Our goal is to find values of 0 close enough to 0o to set the sample moments as
close as possible to zero. We estimate © by m in im iz in g the following quadratic
expression:
G (0) = (/iyT(© ))'W (/lJT( 0 )) .
The matrix W is a (J T x J T ) weight matrix. Hansen (1982) shows that the most
efficient choice of W is a consistent estimate of the inverse of the variance of the
moment conditions:
w = e {(m ©))(M©))'}
= E {&£ ® Z tZ[} .
We obtain such an estimate by first estimating with homoscedastic errors to com
pute W.
While we assume {ft}t is i.i.d. for estimation purposes, misspecifying its depen
dence structure will only affect the efficiency, not the consistency of our estimates.
We should also point out that in simulating the market shares (3.1), we effectively
simulate the moments used for estimation. (3.4). McFadden (1989) and Pakes and
Pollard (1989) both show that the method of simulated moments (MSM) still pro
duces consistent estimates. However, the efficiency of these estimates is reduced
due to simulation error. Only with sufficiently m a n y simulation draws can one
reach asymptotic efficiency with MSM. We use 30 draws and assume this number
34
is sufficient to eliminate any noticeable simulation noise. Alternatively, one could
implement variance-reducing simulation methods as in BLP (1995).
3.3.1. Local Interactions
Other than marketing mix variables, we have not yet discussed store-specific co-
variates that allow expected demand to vary across stores. In practice, we do not
expect each store in a chain to face the same distribution of consumers. Stores in
different neighborhoods typically face different demographic distributions of con
sumers. Moreover, the presence of local competitors could alter the sensitivity of
consumers to a store's marketing effort. We expect differences in both the distribu
tion of consumer types and the presence of local competitors to alter the derived
demand for goods facing each store. For instance, one might expect wealthier
neighborhoods to be less price-sensitive, on average, for some categories. Simi
larly. one might expect proximity of competitors to increase the price sensitivity
of derived aggregate demand in a store. We use a detailed set of variables that
proxy for both differences in the mean demographic profiles and levels of competi
tion facing each store. These proxies fall into three categories: willingness-to-pay,
consumer search and competition. A more precise description of these covariates
appears in the data section below.
For each of the s = 1, ...,83 stores, we summarize these store-specific charac
teristics in the vector Ds. These terms shift both the price sensitivities, 0, and the
35
probability of purchasing in the category by influencing each of the brand prefer
ences, q_,, equally for each of the store areas. We decompose the parameters across
the s = 1 ,.... 83 stores as follows:
(3.5) 6ha — @+ D ' 7 -+- A i/fc
a jhs = a ] + D 's6 + LjUJhjJ = 1 J
where 6 is the mean marginal utility of income across stores, weeks and households;
D ’s ~i is the mean marginal utility of income across consumers and weeks in store
s: and AV/, is the idiosyncratic component of marginal utility of income for some
consumer h. Similarly, a j is the mean brand preference for alternative j across
stores, weeks and households: D's6 is the mean across consumers and weeks in
store s: and Ljuihj is the idiosyncratic component for some consumer h. The
vectors 5 and 7 consist of parameters to be estimated. Note that the vector
6 is common across brands so that store characteristics will shift the category
size (brand qualities relative to no purchase). In principle, one could estimate a
separate 6 and a parameter for each of the 83 stores in our sample. However, this
approach is infeasible since it would require estimation of 166 parameters. The
proposed decomposition has additional potential benefits, such as the ability to
forecast demand in a new store based on its characteristics.
36
Nevo (2001) captures differences in consumer profiles across city-markets by
sampling individual households from the empirical joint distribution of demograph
ics collected by the Census. One of the disadvantages of our disaggregate data is
that comparable joint-demographic distributions are not available at the store-
level. Only marginal distributions are reported publicly by the census. In gen
eral. the zip-code and census block level data collected for the Current Population
Survey are too thin to provide credible representations of the true underlying de
mographic distribution. So we use mean demographics in each store area instead.
To the best of our knowledge, no study has modeled store competition explicitly
in determining aggregate demand for a retailer. In modeling demand for yogurt,
Berto Villas-Boas (2001) treats the same brands in different stores as substitutes.
However, she finds extremely small cross-price elasticities across stores, suggest
ing th at store competition has little impact within the yogurt category. Due to
d ata restrictions, most applications of store-level data treat retailers as local mo
nopolists (e.g. Slade 1995, BGJ 1998). Slade justifies her assumption on phone
interviews with store managers in a given market who claim that consumers do not
shop across stores on a product-by-product basis. We also conducted telephone
interviews with Chicago area store managers and our findings were consistent with
this claim. Stores do condition on their competitors’ actions in a limited way by
collecting a weekly sample of half a dozen SKUs from the local competitors’ entire
store offerings. However, this behavior seems more consistent with competition
37
on overall offerings rather than on a category-by-category basis7. For instance.
Chevalier. Kayshap and Rossi (2000) find that prices for items exhibiting holiday
or seasonal demand peaks tend to be priced in a manner consistent with loss-leader
competitive pricing (Lai and Matutes 1994). Therefore, we try to limit our focus
to product categories that are less likely to drive overall store traffic8. Since we do
not observe competitors' prices in our data, we cannot model competition explic
itly. Instead, we assume that any local market power is captured, on average, by
proximity to competitors. We discuss this assumption further in the data section
below.
3.3.2. M easuring C onsum er Welfare
One of our main objectives in using a structural demand system is the ability
to measure the change in consumer welfare associated with altering the pricing
policy. An attractive feature of the discrete choice model is the ability to compute
consumer welfare explicitly. A popular measure for welfare in such contexts is the
Hicksian, or compensating, variation, which captures the dollar amount by which
consumers would need to be compensated to maintain the same level of utility
after the change in pricing policy (e.g. TVajtenberg 1989. Nevo 2001 and Petrin
1999). VVe denote an individual h's utility net of the extreme value taste shock as
‘Stores do. however, collect a •‘full book” of about 600 to 1000 prices from local competitors on
an annual basis. This practice is not likely to generate inter-store com petition at the category
level and weekly frequency we consider in our analysis.
8In the section measuring the im pact of zone pricing, below, we provide empircal support for the
assum ption th a t th e categories we use do not drive store traffic significantly.
38
Vh (expected utility) and their marginal utility of income as Oh- Suppose a zone-
pricing policy is introduced that changes consumer valuations for each alternative
from Vrhdu,m to Vh™*. As derived in Small and Rosen (1981), assuming individual
marginal value of income is held constant, individual h's associated change in
welfare can be computed as:
log (E /= o exp (vh°ne)) ~ log (E /= o exP (vh unn) )

(3.6) CVh =
Th
The numerator of (3.6) captures the expected change in utility. Dividing through
by the marginal utility of income. 9h, makes this change money-metric. Integrating
across the distribution of consumer preferences, we can compute the expected
aggregate change in consumer welfare:
(3.7)
In the next section, we model the supermarket category manager’s pricing decision.
Using variable profits as the measure of the manager’s valuation, we are able to
compare the dollar value of gains of various pricing policies both to the supermarket
and to consumers. Similarly, we can compute the change in customer value in going
from zone to store level pricing.
39
3 .3 .3 . R etailer Pricing
We now describe our model of retail behavior. Our data comprise stores from
a single retail chain in a large metropolitan area. We have no reason to expect
store-level pricing decisions to elicit a competitive response from manufacturers.
Therefore, we treat wholesale prices as exogenous to the retailer. We discuss the
validity of this assumption in the data section below. In other contexts, marketers
have modeled the vertical channel to capture the strategic interaction between
retail and wholesale prices using a logit demand model (e.g. Besanko, G upta
and Jain 1998. Sudhir 2001b and Villas-Boas and Zhao 2001). Typically, these
studies do not have access to retail margins and, thus, use the channel structure
to help identify a time-varying wholesale price (see for example, Berto Villas Boas
2001). Kadiyali et. al. (2000) use information on retail margins. However, their
objective was to identify the nature of interactions between manufacturers and a
single retailer.
We assume that each week the retailer jointly sets the profit-maximizing prices,
Pj , of each of the J products in a category (see for example, Sudhir 2000b, Kadiyali
et. al. 2000). Based on our phone conversations with local chain managers, we
believe that weekly price decisions are made by category managers rather than by a
store-wide manager9. In contrast, most promotional decisions (newspaper features,
in-aisle displays etc.) are determined at the store-level. While promotions are
9T h e retailer’s definition of a category may differ from th at of academic research. T he lat
ter typically relies on the definitions used by Nielsen and IRI. the two traditional suppliers of
com parable scanner databases.
40
funded almost entirely by manufacturers, the timing and format are determined
by the retailer. Typically, the promotional calendar is determined in advance so
that category pricing decisions are made conditional on the promotion. Therefore,
we treat the promotion level as exogenous to category pricing10.
We also assume that the retailer's variable costs consist solely of wholesale
prices. w3. We treat all store and/or category-related overhead as fixed costs, Ft.
Thus, in week t . a retailer 11 solves the following optimization problem:
j
max II = y^ (p Jt - W j t ) Q j t - F t -
Ip j I j - i j = i
Note th at Qjt is the expected demand form (3.2)above. The first-order condition
for a typical brand i is:
( P j t - = o.
We re-write the system of first-order conditions for brands 1 . J in m atrix form
as:
(3.8) ft(p - w) + Q = 0,
10O ur phone conversations revealed th a t category managers may in fact request additional pro
m otional funds if they feel the performance of th e category or a specific brand therein is sluggish.
However, we were informed th at the incidence of such endogenous (to the category manager)
promotions are quite unusual.
11To simplify- notation, we drop the subscript for the retailer and the category. In our empirical
work, a retailer may be the store-manager, the zone manager or the chain m anager depending
on the context.
41
where
P it — w \ t
p—w =
P jt ~ w Jt
j* l
&p,rJi = K
22a k
=
apJt *-? ^ * JxJ
Qu
Q=
Q jt
J Jxl
This represents a system of J equations, one for each brand. The optimal set of
prices for the retailer are determined by solving:
(3.9) p = w —Q ‘q
where fl-1q is the retail mark-up. By checking the second order sufficient con
ditions. one can verify th at the solution to (3.9) represents an optimum for the
retailer. The actual value of Qjt depends on the level of aggregation considered.
For the store-level problem, this will take the form (3.2). where M t is weekly store
traffic. However, for a zone pricing problem. QJt would be obtained by integrating
across the store-level demand for each of the stores in the zone in week t. Simi
larly, chain-level pricing would involve integrating across all the store-level demand
curves.
42
As we mentioned in the demand section, the assumption of homogeneous tastes
leads to restrictive pricing behavior by retailers. When consumer tastes for at
tributes are homogeneous, the optimal retail prices satisfying (3.8) become:
P lt = w “ + « £ ’
where = \ — J2j=i is the share of the no-purchase alternative. Therefore,
when consumer heterogeneity is characterized solely by the extreme value taste
shock, the amounts by which a retailer sets its mark-ups over the wholesale prices
are the same for all the products carried. This property is not consistent with our
data in which margins vary across alternatives.
3.4. D ata
We use data from Dominick's Finer Foods (DFF), which is the second largest
supermarket chain in the Chicago metropolitan area. DFF operates close to 100
stores in the Chicago area. Our data consist of weekly sales, prices, promotions,
and profit margins at the individual UPC-level for 83 of these stores during the 52-
week period of 1992. In the current analysis, we look at the liquid laundry detergent
and refrigerated orange juice categories. We present the descriptive statistics for
the products included in the analysis for each of the respective categories in table
A.I. These data consist of means across store-weeks. The column labelled riinit
share" corresponds to the conditional shares, or share of unit sales, for each brand.
The actual market shares used for estimation are computed as total brand sales
43
divided by the total weekly store traffic. Effectively, our model implies that each
time consumers visit the store, they either purchase a unit of one of the alternatives
within the category of interest or they elect not to purchase. In the current context,
a unit corresponds to a UPC code (e.g. a 64 oz Tropicana Premium vs. a 96
oz). The promotion variable is an indicator for whether the given product had a
newspaper feature th at week. As mentioned previously, the promotion decision is
assumed to be exogenous to category management within a store or zone.
In table A.2, we summarize the sources of variation in our price and share
data. For each SKU in our data, we run separate regressions of prices and shares
on store and week fixed-effects. In the table, we report the median R-square across
products for each category. We find that cross-week variation accounts for roughly
72% of the variation in a product’s price, in the laundry detergent category, and
77% in refrigerated orange juice (78% and 76% respectively for shares). Similarly,
cross-store variation explains roughly 11% of the price variation, in laundry deter
gent. and 6 % in orange juice (2% and 5% respectively for shares). As explained
below, we are able to explain a substantial portion of the intertemporal price vari
ation using the wholesale prices. To help capture the cross-store variation, we use
characteristics of a store's trading area.
We supplement our store data with an extensive set of descriptive variables,
from Spectra (see Hoch et.al 1995), characterizing the underlying consumer base
and local competition associated with each store. ZIP code level demographic
d ata was obtained from the 1990 census. To capture heterogeneity across stores in
44
terms of the types of households they face, we include the following demographic
variables: INCOME (log median income), AGE60 (% of population over age 60),
ETHNIC (%of population that are Black or Hispanic) and HVAL (mean household
value). We also include SHOPINDX (ability to shop-% of population with car and
single family house) to capture the relative ability of local consumers to travel.
The two competitive variables used in the study are distance from the nearest
Jewel (the largest supermarket in the area), JEW EL, and minimum of the distance
from the nearest Cubfoods and Omni. EDLP, (the two main EDLP operations).
Our preliminary work also included variables on competitor volume but these had
limited explanatory power and were dropped in the subsequent stages of analysis.
Summary statistics for the demographic and competitive variables are provided
in table A.3. We find considerable variation in the demographic and competitive
characteristics across stores. For example. DFF stores cater to market areas with
Black and Hispanic representation ranging from 2 to 99% of the population. In
terms of consumer wealth, income levels range from $19,000 to over $75,000 (note
we report INCOME in logs). Similarly, average house values range from $64,000
to over $267,000. In terms of competition, some stores are located right next to
rival supermarkets. Others locate over 4 miles from the nearest Jewel and 18 miles
from the nearest EDLP store. We expect these differences to generate noticeable
differences in the levels and price-sensitivities of demand across stores. Note that
the demographics explain, on average, 6.7% of the price variation for detergent
and 3% for refrigerated juice. Thus, we are able to explain over half of the price
45
variation across stores using these demographic variables. Since the estimation of
store-specific parameters would generate an unmanageable number of parameters
for the given data sets, we are confident that the demographics do a reasonable
job explaining store-specific differences.
As discussed in the model section, we classify the demographics and competitive
variables into three categories: willingness-to-pay, consumer search and competi
tion. The demographic variables are used to capture consumer heterogeneity in
tastes across stores. The extent to which these factors influence shares at a store
are attributed to price discrimination. The Spectra measure SHOPINDX mea
sures the ability of a consumer to shop and, thus, to search for the "best’” price
in the local market. Finally, proximity to competitors provide a crude measure of
the extent of local competition. We classify the impact of consumer search and
competition on a store's brand shares as sources of price dispersion.
3.4.1. Zones
An important feature of our data is the ability to disentangle price discrimination
and differences in cost. In general, wholesale prices are virtually identical across
stores in a given week. On average, the standard deviation of wholesale prices
across stores in a given week is 0.008. Unlike previous work (e.g. Shepard 1991)
we can rule out explanations for price variation based on wholesale costs. 12
l2One explanation th a t we have not ruled out is differences in th e opportunity cost of shelf space
in areas with expensive real estate. In areas with high property values a n d /o r high property
46
Despite the roughly identical unit costs across the stores in our data, prices and
margins vary substantially within most weeks. Using the liquid laundry detergent
data, the average range in prices for a given product across stores in a given week
is 81 cents (prices are measured on $/oz. basis). By contrast, the average range
within a Dominicks-classified zone is about 16 cents. Given that the mean price in
the category is $5.58. the average weekly price range across stores overall is 14%
of the mean price, versus only 3% within a zone. For certain products, the price
differences are significantly higher. For example, in the refrigerated orange juice
category, the price of Minute Maid (64 oz.) is 38% higher in the highest price zone,
compared to the stores that fall in the lowest price zone.
As mentioned earlier, our data set contains an index th at groups stores into
pricing zones. In practice, the chain does not always appear to respect the specified
zones in its weekly pricing decision. Looking across products, we observe that many
items appear to use a coarser zone definition. For instance, prices of small share
items often have a uniform price across stores. Similarly, in some categories, prices
may only reflect three or four zones, rather than the full 16 th at we observe later
in the data. Other studies that have used this data (for example Hoch et al. 1995)
also suggest th at the actual number of zones might be fewer than those provided
in the data. We investigate this issue by looking at the prices of several products
across randomly selected weeks. Consistent with Hoch et al., we find only 3 levels
taxes, stores may have more rigid capacity constraints th at could affect pricing. In this regard,
zone pricing could reflect differences in these shelving costs.
47
of prices in the early years of the total available data (e.g. 1989-1990). However,
the number of zones increases over time. By the time of our sample, 1992, we
begin to observe substantially more prices for many large-share products in any
given week. For some of the large share items, we often observe between 9 and 16
different shelf prices across stores within a given week. 13
In table A.4 we report the average laundry detergent prices and demographics
by zone. These d ata demonstrate the ability of our store characteristics to explain
some of the observed price differences across zones. For instance, the highest prices
are in zone 7. where we observe the highest household values as well as fairly high
search costs. In contrast, zone 16 has the lowest prices and exhibits fairly high
incomes with very few elderly or ethnic households. Note also that zone 6 has the
closest EDLP store and, at the same time, has very low prices.
3.4.2. Instrum ents
Another interesting feature of our data is the availability of wholesale prices. As
discussed in the model section, we treat these d ata as exogenous. 14 We use the
wholesale price as an instrument for in-store shelf prices. Although not reported,
13T he explanation for this increase in the number of zones over time remains an empirical ques
tion. Two possibile explanations are th a t either the chain is facing a changin g com petitve envi
ronment (entry of mass-merchandisers and club stores) or th a t Dominicks management is varying
its pricing policy. See discussion in the next chapter for more details.
14Since prices appear to be determined a t the zone level, aggregate dem and for the chain requires
integrating across 16 different zone demand curves. Moreover, the chain only accounts for 25%
of the Chicago superm arket sales. Therefore, it is not likely th a t marginal changes in price at
one of the zones would have a noticeable im pact on aggregate dem and for the Chicago market.
As a result, we assume th at a zone pricing decisions do not impact the wholesale price.
48
a pooled regression of shelf prices on wholesale prices alone gives an R 2 of 0.71
(refrigerated juice) and 0.74 (laundry detergent). Running the regression by SKU.
we find th at the wholesale prices do a much better job of explaining the larger-share
brands of detergent (R2 of about 0.6 on average) than the smaller brands (R2 of
about 0.1 on average). For refrigerated juice, the costs alone explain about 25% of
the variation, on average, regardless of share. Introducing the additional exogenous
covariates used in the instrument m atrix for the GMM procedure tends to explain
an additional 10% of the variation in the prices. Given the reasonably strong
explanatory power of these instruments, we are able to identify the structural
demand parameters without using supply-side moments.
3.5. R esults
We now present the estimated demand systems for each of the two categories.
Demand parameters are reported in tables A.5 and A.6 . We report the corre
sponding latent brand factors in table A.8 . Rather than reporting the implied
brand correlation matrices. £ . we plot the brand ^locations” using the factors as a
coordinate system. We also report the elasticities of store characteristics on each
of the category sizes (probability of purchase) in table A.7.
Before describing the empirical results, we first explain what the parameters in
tables A.5 and A . 6 mean. We use table A.5 (laundry detergent) as an illustration.
The first five parameters correspond to the mean in trin s ic preferences, oJT for the
J brands included in the category. This is followed by the mean price effect, 6, and
49
the standard deviation of the distribution of price sensitivities across consumers, A.
This is followed by the effects of promotion and the interaction between price and
promotion. Following this is the effect of the dummy variable th a t distinguishes
between 64 and 128 ounce pack sizes of detergents. This variable takes the value 1
for the 64 ounce size. A holiday dummy variable is also included and its effect on
category demand is presented next. This is followed by a set of parameters, 6. that
correspond to the effects of store characteristics on the preferences of the brands
in the category. Recall from our earlier discussion that these effects are the same
for all the brands within the category. The coefficient 0.412 corresponding to the
income variable implies that a higher income household has a greater probability
of purchasing laundry detergents than a lower income household. The last set of
parameters are the interactions between the store characteristics and prices. 7 . In
other words, they represent the observed component of price heterogeneity across
stores.
In the laundry detergent category, table A.5, we find th a t Tide is the highest-
valued brand in the category. We also observe a preference for 64 oz versus 128
oz size packages. As expected, promotions increase the likelihood of purchase, as
does the incidence of a holiday week. Price sensitivity has the correct negative
sign and we do observe .sig n ific a n t heterogeneity'. Interestingly, we find the price
sensitivity rises for promoted items. Using the estimated factors, in table A.8 , we
plot the brand map for detergents in figure A.I. The map highlights the perceived
similarities and differences across brands in the market. The horizontal sods
50
seems to separate out brands manufactured by P&rG (Tide and Cheer) from those
manufactured by Unilever (Wisk. Surf and All). Further, the two P&G brands,
Tide and Cheer are perceived to be similar to one another whereas the Lever
brands appear a lot more differentiated in the minds of consumers. By positioning
All close to the P&rG brands. Lever may be using it as a ^ g h tin g ” brand in the
marketplace. We discuss the effects of store characteristics subsequently.
In the orange juice data, table A.6 , we find that TVopicana premium has the
highest mean preference effect, which is consistent with its dominant position in the
category. We also observe a preference for the smaller 64-oz size, versus the larger
96 oz. As before, promotions increase the likelihood of purchase, but at the same
time, they increase consumers’ sensitivity to price. In figure A.2, we present the
perceptual map for orange juice brands. Once again, we find the map of the brand
preferences to be quite revealing. There appear to be 3 distinct groups of brands
in the market. The first set. consisting of the TVopicana and Florida brands, is
perceived as being different from the other brands. We do however, observe slight
differences between the product not from concentrate (premium) and the product
from concentrate (SB). The second group consists of Minute Maid, a Coca-Cola
product, and the third group consists only of the store brand (Dominicks). This
finding is good news for the national brands as it does appear th at they have
effectively differentiated themselves from the store brand.
In table A. 7, we report the elasticities of the store characteristics on category
size (the probability of purchase). Since characteristics enter the demand systems
51
both as intercept-shifters and as price-slope-shifters, we feel the elasticity is more
revealing as a summary statistic. Median income seems to have a strong negative
effect on category size for laundry detergents. In contrast, higher income areas are
more likely to purchase refrigerated orange juice. Interestingly, the proportion of
retired households tend to increase the size of both categories. Ethnicity has an
almost negligible effect on both categories. The ability to shop increases the size of
the laundry category; but. it has a very small negative impact on the size of orange
juice. Both categories tend to be larger in areas with higher average household
values. Finally, neither of the competitive variables seem to have a strong effect
on category size. Even doubling the distance from a competitor (a 100% increase
in distance) will not generate more than about half a percent increase in the
probability of purchase.
3.5.1. G oodness-of-Fit
Our next objective is to try and assess the ability of our demand system to predict
the store-level margins. Using the observed wholesale prices, we compute the shelf
prices for chain-level, zone-level and store-level pricing by solving the system of
equations defined by (3.1) and (3.9). Since our main objective is to study the
implications of pricing, we need to verify that our demand estimates and our
category management model produce realistic measures when compared to the
observed margins.
52
The first step involves determining which model seems to come the closest
to approximating the observed margins in the data. One way to think of this
problem would be to solve a minimum distance procedure in which one minimizes
the distance between true and estimated margins, using the covariance of the
observed margins as a metric:
(3.10) min (margin-/*) $ (margin-/*)
where /* is the estimated margin and $ is the covariance m atrix of the observed
margins. In table A.9, we take the margins implied by the store-level, zone-level
and chain-level pricing policies and compute the corresponding criterion (3.10).
The zone-pricing model seems to provide the best fit according to the minimum
distance criterion.
We now compare the mean predicted margins for each brand under the three
pricing policies considered and compare these to the true margins observed in
the data. To illustrate, in tables A. 10 and A .ll, we report the m a r g in s as a
percentage of prices for the laundry detergent and refrigerated juice categories.
These tables capture how well we can reproduce the levels within stores. For the
laundry detergent data, the levels are reasonably close to the true values and the
correlations are fairly high, especially for the largest-share items (Tide and All).
For juice, our mean margins look, for the most part, fairly reasonable. The main
exception is the store brand for which we over-predict the margin and for which
53
price estimates are very poor. Our sense is that store-brand pricing may not fit well
with the category management model. In fact, store-brands may well be priced
below the category manager's level if they are set at a store-wide level to generate
store traffic (Chintagunta 2002).
3.6. Im pact o f Zone P ricing
Using the demand systems estimated in the previous section, we now set-out
to measure the implications of zone-pricing. Our analysis measures the impact on
consumer welfare and retail profitability. Measuring consumer welfare allows us
to assess the dollar value of losses or gains to consumers from the various pricing
policies. Similarly, retail profits provide a dollar value of the losses and gains to
the category manager.
3.6.1. W elfare im plications for retailers and consum ers
As discussed above, we use Hicksian compensating variation, as in equation 3.6,
to measure welfare changes. First, we evaluate the impact of zone-pricing by
comparing the zone prices and welfare with those computed at the chain level. In
conducting this analysis, we need to make certain assumptions. First, we assume
th at shifting from chain to zone pricing does not alter the nature of promotions
in the category. This assumption is analogous to Nevo (2000) and Petrin (2001)
who assume th at mergers and product-introductions respectively do not impact
(in the short-run) the mix of observed product attributes. Similarly, we assume
54
that zone-pricing does not impact the unobserved attribute, f. Finally, we also
assume that changes in pricing for the product categories in question will not alter
the levels of store traffic each week. To support this assumption, we present results
for a simple model of store-choice, in table A. 13. Assuming th at each household in
a stores market makes a single weekly store-choice decision, this model captures
the binary probability that a households visits the local DFF or not. We measure
the share of households that visit DFF as store traffic divided by the total number
of local households. We explain this choice using local market characteristics as
well as a price index for each of the 33 product categories available. Our results
may be biased due to the lack of competitors’ prices. However, the fact that both
laundry detergent and refrigerated juices are not significantly affecting the store
choice probability makes us more confident in our assumption above.
In table A. 12. we report the total annual chain-wide welfare implications of
various pricing policies for both of the categories studied. As expected, allowing
for more flexible pricing increases a category’s profitability, so th at zone-pricing
and store-pricing both generate gains to the store. In general, the incremental gain
from store-pricing far exceeds the gains from zone-pricing. At the same time, the
impact on consumers varies by category. Recall that one interpretation of these
consumer welfare numbers is the total dollar amount the chain would need to pay
consumers to make them as well off under some new pricing policy as they were
under uniform chain-wide prices. One must keep in mind th at the main reason
why Dominicks did not pursue a store-specific pricing policy was due to the lack of
55
technology at the time for implementation. Thus, the current analysis illustrates
ways in which structural econometric methods can be applied to a standard retail
database to execute more profitable pricing strategies.
We begin with the impact from a shift from uniform chain-pricing to the zone
pricing practice th at appears to be generating the observed data. Then, we will
discuss the impact of a hypothetical move towards store-level pricing. For laundry
detergent, we observe fairly small total effects from zone-pricing on the chain profits
(only 0.6% gain) or on consumers; although consumers do gain overall by §2,158.
Given the high-necessity oriented nature of laundry detergent, it seems intuitive
that such an item would not exhibit tremendous variation in willingness-to-pay
across store markets. In contrast, the orange juice category benefits reasonably
well, generating a $52,400 (1.6%) gain in profits. At the same time, total consumer
welfare falls $19,791. Figure A.5 plots the total compensating variation by store,
indicating that the negative impact on total annual consumer welfare is misleading.
In fact, in many stores, consumers benefit from the price change.
Now we demonstrate how our demand system can be used to implement a
more profitable store-specific pricing scheme. As above, we compare the prices
and welfare levels from the zone model with those of the store-level model. As
expected, the store-pricing leads to much larger profit gains than the zone pricing.
We observe an almost $542,000 (16.3%) gain in profits relative to chain pricing
for orange juice, and $109,700 (9.6%) for laundry detergent. At the same time,
we observe $158,100 in losses to consumers in juice, which is small relative to the
56
profit gains, but much larger than the losses from zone pricing. For detergent,
consumers do in fact gain overall by $16,215. As before, we can see th at the low
consumer welfare losses are misleading once we look at each store. In figure A.6 ,
we plot the compensating variation for orange juice by store.
The intuition for why consumers in some stores gain value while others lose
welfare, or value, from these more flexible pricing policies relates to the ability
of the store to re-align its product line pricing according to local demand. For
instance, in store 75, most laundry detergent prices are raised, on average, about
2-3% (e.g. 128 oz price rises by 26 cents). At the same time, the price of 64 oz
Tide (the category leader in the store with roughly 15% more share than the 2nd-
ranked alternative) is lowered by one percent. As a result, the conditional share
of 64 oz Tide rises almost 16%. while the conditional shares of most of the other
brands fall by 1-3%. Note th at store 75 in zone 7, one of the high-price zones
in which consumers have fairly high search costs and there are no nearby EDLP
stores. As a result, demand is fairly inelastic, which explains why the store would
want to raise its price level. In contrast, in store 128, 64 oz Tide has a much
smaller lead, dominating the 2nd-ranked alternative by only 4% in category share.
Interestingly, store 128 holds the prices of its top 3 products almost fixed, while
lowering the prices of the remaining brands in the category 1-2%. As a result,
shares become much more equalized in store 128, with the two largest-share goods
falling 2-3%. At the same time, the conditional share of 64 oz Wisk rises almost
9 percent, making it (by a narrow margin) the new category leader, on average.
57
Note th at store 128 is in zone 11, which caters to households with relatively low
incomes and house values. The area also caters to a higher proportion of ethnic
households with larger families. As a result, demand is much more elastic, which
explains why the store reduces most prices, allowing for a better-value brand to
gain more relative share.
An interesting question for customer relationship management involves which
types of consumers end up better versus worse off after the chain adopts a more
flexible pricing policy. In general, we find that both store and, to a much lesser
extent, zone pricing decrease welfare in lower income neighborhoods. Similarly,
welfare rises in areas with greater mean household values for all categories. We
also observe welfare falling in areas with larger ethnic populations. In general,
we do not find much relationship between age and welfare changes. Interestingly,
zone-pricing appears to lower welfare in areas where households have a higher
ability to shop. But. store-pricing raises welfare in stores catering to consumers
with greater ability to shop. This outcome is not surprising since the store-pricing
will clearly favor stores with more price-elastic demand. In terms of competition,
the welfare implications of proximity to a Jewel varies across categories and are
quite small. The impact of proximity to an EDLP store is even smaller. Overall,
it would appear that demographics are more influential for driving patterns in
welfare changes than proximity to competitors.
While our results showing greater profits from the store pricing are consistent
with those from Montgomery (1997), as noted before our analysis is different in
58
nature. Most importantly, we note the trade-offs of zone and store-pricing in
terms of the impact on consumer welfare. While it may be profitable to implement
geographic price discrimination within a city market, as consumer losses across
categories accumulate, one could eventually expect losses in traffic as shoppers
switch to other stores. We view store-switching as a longer-run implication based
on store-wide prices and therefore beyond the scope of our analysis. Naturally,
higher prices could also encourage new entry by a competing chain not currently in
the territory. Lower prices, on the other hand, could evoke competitive retaliation,
although they could also deter entry into the market. These issues are more long
term considerations that need to be balanced carefully with our short run findings
if they are to be used as inputs into chain strategy. Based on our current results, it
would appear th at managers would be better off allowing for price discrimination
in the laundry detergent category than refrigerated juice.
3.6.2. A ltern ative R ecom m ended Pricing P olicies
In the current section, we address some of the limitations of the pricing policies
analyzed in the previous section. In particular, we address potential managerial
concerns with losses in consumer value, on the demand-side, and complexity of
price-determination on the retailer-side. To address each of these issues, we propose
alternative pricing policies.
As demonstrated in the previous section, one of the main advantages of us
ing a structural econometric approach is the ability to measure explicit economic
59
metrics. In the current context, two such metrics are the category manager’s valua
tion of a pricing policy, variable profits, as well as consumers’ valuations, Hicksian
compensating variation. In this section, we leverage both these metrics to pro
pose an overall welfare-enhancing pricing strategy for the retailer. Store managers
may be concerned that extracting too much value from consumers could gener
ate store-switching in the long-run. Previous research has experimented with ad
hoc constraints on pricing, such as holding the average price level fixed. In the
current context, we are able to propose pricing such th at consumer value is fixed.
The structural approach generates a natural theory-based constraint - consumer
welfare. We propose profit-maximizing store-level prices th at are constrained to
offer consumers at least as much surplus as a chain-level pricing policy. The prices
under this policy will, by construction, make consumers better off than under
chain-pricing or, at the very least, leave them indifferent between the two policies.
Formally, the problem involves solving the following problem for each store s in
each week t:
j
max n st = y_(p3Jt - wjt)Qsjt
subject to the constraint:
A W > 0.
In the above problem, A W measures the aggregate change in consumer welfare
associated with switching from chain pricing to store-pricing, as in expression (3.7).
60
In table A. 12. we report the resulting change in profits and consumer welfare
associated with such a policy in row labeled “constr. store’’. As expected, the
constraint prevents the category manager from generating the same additional
profits as under the unconstrained store-specific pricing policy of the previous
section. However, even with the constraint, the manager is able to generate roughly
half the gains of the store-pricing, an improvement in profits of 5.6% over a u niform
chain-pricing policy, in the laundry detergent category, and 7.4% in the refrigerated
orange juice. At the same time, overall consumer welfare rises, especially in the
refrigerated juice category where unconstrained pricing led to overall losses to
consumers.
A second consideration regarding the unconstrained pricing of the previous
section is the potential complexity of coordinating a store-specific pricing policy
across the 83 stores. Clearly, one advantage of a zone policy is the simplification
of price-determination. The previous section demonstrates the ease with which
an aggregate database can be leveraged to learn about differences in consumer
willingness-to-pay. However, changing item prices in 83 stores could be costly
from an implementation point of view. Therefore, we propose an alternative zone
pricing policy. Using the store prices computed in the previous section, we con
struct share-weighted price indexes for both the refrigerated juice category and
the laundry detergent category. Using the 83 price indexes, we then rim a simple
non-hierarchical cluster analysis 15 to generate 5 zones. Constraining prices to be
15We use the non-hierarchical k-means-based cluster function in S ta ta version 7.
61
the same across all stores within each of these 5 zones, we then re-compute the
profits and welfare levels that would prevail. In the row labeled “cluster” in table
A. 12, we find that this simple 5-zone structure still generates substantial profit
gains relative to the 16-zone pricing policy used by Dominicks during the time the
d ata were collected. An interesting point is the fact th at while the clusters offer
notable gains to the retailer (relative to chain-pricing and the actual zone-pricing),
consumers are better-off with 16-zone pricing policy used by D o m in ick s.
3.7. Conclusions
Using a detailed database including weekly store-specific margins, we are able
to estimate flexible demand systems capable of generating reasonable approxima
tions of the true data-generating process in several product categories. Rather
than impose parameter restrictions, as in Montgomery (1997), we resolve the typ
ical store over-pricing problem by controlling for weekly store-specific endogeneity
in prices due to unmeasured demand covariates. We use the demand system to
investigate the impact of zone pricing on firm profits and consumer welfare. Our
results show that flexible-pricing significantly improves store profits, especially in
the case of store-specific pricing. The magnitude of the gains depends on the
category. For a necessity item like laundry detergent, we find conservative gains in
profits with small effects on consumers. However, for categories like refrigerated
orange juice, which exhibits far more demand heterogeneity across stores, we find
fairly large profit implications. At the same time, consumers experience differential
62
welfare effects. In particular, we find th at DFF’s existing zone-pricing seems to
target high prices to less affluent areas. Allowing DFF to use store-pricing exac
erbates this effect. Interestingly, the shift to store pricing would also raise prices
in areas where consumers are less able to shop.
Our results add to the growing literature measuring the sources and welfare
impact of price discrimination and price dispersion. Unlike most previous struc
tural analyses using aggregate data, we are able to measure the fit of our model.
W ith regards to the price discrimination literature, we are also able to control more
accurately for alternative explanations of price variation. Our results are relevant
to policy workers concerned with consumer welfare in the context of food prices.
However, our findings are also relevant for strategists and marketers concerned
with improving store profitability and managing their relations with consumers.
In particular, we find that not all categories benefit noticeably from zone-pricing.
We also find that managers must be weary of the impact on consumer welfare
when implementing a zoning scheme. In some stores, the losses to consumers may
in fact outweigh the profit gains. Finally, our results suggest that zone-pricing is a
method used by DFF to price discriminate based on geographic differences in con
sumer characteristics. However, there could be other explanations for zone-pricing
such as competition from discount stores, which are further explored in the next
chapter.
CHAPTER 4
Superm arket C om petition W ith M ass D iscounters
4.1. Introduction
The role of supermarkets in the grocery retailing industry has undergone dra
matic changes over the last decade. Rapid growth of alternative retail formats,
in the form of mass discounters, price clubs, and supercenters, has transformed
not only the competitive structure of the industry but also the way in which con
sumers shop. While mass discounters like Wal-Mart and K-Mart do not offer a
comparable array of perishable and nonperishable products, they do compete with
supermarkets in specific high-volume categories such as paper products, dry gro
cery, health and beauty' care products, and other general merchandise items. More
recently, the line separating supermarkets from mass discounters has blurred as
supermarkets have added more general merchandise items to their shelves while
stores like Wal-Mart have transitioned towards the food sector through their su
percenter format.
Past research on supermarket competition (e.g.. Lai and M atutes 1989, Pe-
sendorfer 2000) has primarily focused on stores that are identical in terms of prod
uct offerings, cost structure, and pricing policies. More recently, researchers have
also analyzed competition between supermarkets with different pricing formats,
63
64
for example, EDLP vs. Hi-Lo pricing (Bell and Lattin 1998, Lai and Rao 1997.
Messinger and Narasimhan 1997). This stream of research has explored issues such
as the relationship between household shopping behavior and store preference (Bell
and Lattin 1998. Bell et al. 1998), the impact on store sales due to a change in
price format (Hoch et al. 1994, Mulhem and Leone 1990), and theoretical explana
tions for the general movement towards EDLP as a positioning strategy (Lai and
Rao 1997. Messinger and Narasimhan 1997). However, the focus in these papers
has been on the competition between grocery stores, with limited attention given
to alternative retail formats like mass discounters and price clubs.
In this paper, we provide an empirical study of the impact of entry by mass
discounters on the demand for products sold by conventional supermarkets. Using
store-level data from a large supermarket chain, we estimate demand systems for
several product categories and analyze how demand changes following entry by
discount stores. In particular, we investigate how entry impacts the total level of
demand as well as consumer price sensitivity in both the short and the long run.
We then combine our demand estimates with a model of category management to
measure the implications for category pricing and profitability.
A critical difference between mass discounters 1 and EDLP grocery stores (such
as those considered in the literature) is that mass discounters do not offer the full
grocery line found in supermarkets. In terms of store choice, this implies a very
xNote th at the focus in this study is on traditional discount stores like W al-M art and Target
th at do not sell perishables. C om petition between superm arkets and the supecenter format is
analyzed in the next chapter.
65
different choice set for consumers than, say, a choice between a Hi-Lo or EDLP
supermarket. For example, consumers who prefer to buy all their groceries in a
single shopping trip would prefer to shop at supermarkets. Others may prefer to
take advantage of the lower prices of nonperishable goods at the discounter while
buying food items at the grocery store. This paper extends previous empirical
work in that it examines competition between retailers who are differentiated, not
only in their pricing formats but also in their product selection. In addition, while
the previous work has considered competition between stores and consumer store
choice in a static environment, our study considers both the short- and the long-run
impact of entry in an evolving competitive environment.
The limited academic research on inter-format competition is not entirely sur
prising for two reasons. First, the competition between supermarkets and mass
discounters has traditionally been limited to relatively few product categories.
The movement of mass discounters toward the food sector is a relatively recent
phenomenon. Second, supermarkets have typically priced their products against
other supermarkets and have viewed neighboring grocery stores as their primary
competitor. However, trends in the industry suggest that this view of competition
is flawed.
A recent survey by Supermarket News shows that while consumers point to
supermarkets as their favored destination for perishable items, they are turning to
mass discounters and price clubs to purchase nonperishable product lines. This
finding is also substantiated in a recent study, conducted by Proctor and Gamble.
66
which analyzed nine nonperishable categories. Table B .l shows that over the
last decade supermarkets have lost over 21% share ($3.4 billion in sales) in these
nine product categories, while mass discounters and price clubs have more than
doubled their share. This lost share to other retail formats is quite alarming for
supermarkets who already operate with very low margins to stimulate high volume,
with average profit margins of only about one percent (FMI Annual Financial
Review 1999). Further, nonperishables account for 70% of a store’s selling space,
driving the bottom line for most supermarket operators.
While the impact of warehouse entry on quantity demanded is quite predictable,
its impact on consumer price sensitivity and the implications for retailer pricing
are not obvious. Since the pioneering work of Hauser and Shugan (1983), a num
ber of researchers in marketing have addressed the question of optimal response
to competitor entry. The general consensus is that an incumbent facing attack
should reduce its prices and marketing spending following entry (see, for example.
Hauser and Shugan 1983. Kumar and Sudharshan 1988, Carpenter and Nakamoto
1990. Gruca et al. 1992). There are circumstances, however, in which the opti
mal response by the incumbent may be to increase prices. An interesting finding
from Hauser and Shugan’s (1983) Defender model concerns the impact of mar
ket segmentation on price response by the incumbent. The authors show th at if
the market is highly segmented, it may be optimal to raise prices with competi
tive entry (see also the recent work by Gruca et al. 2001). Similarly, Perloff et al.
67
(1996) show th at with entry by a spatially differentiated product, prices of existing
products may rise due to a better match between consumers and products.
The empirical questions addressed in this study are: (a) W hat is the impact
of entry by a warehouse store on the demand for products sold by conventional
supermarkets?: (b) How does entry impact consumer price sensitivity in the short
and long run, and how does this vary by product category?; and (c) How should a
supermarket respond in different product categories? Our approach is to estimate
demand functions for individual product categories and to analyze the changes in
demand due to warehouse entry. We study both competing products (e.g., paper
towels) as well as categories that are not sold by mass discounters (e.g., refrigerated
juices). We combine the demand estimates with a model of category management
to address the question of price response by the retailer.
We use d ata from Dominick's Finer Foods (DFF), which is the second largest
supermarket chain in the Chicago metropolitan area. Weekly store-level data are
available for about 85 stores and span a 7-year period (1990-96). This period
saw entry by two large discount chains (Wal-Mart and Target) into the Chicago
area. While we do not observe the prices charged by the competitive stores, our
demand models capture competition by using information on the distances and
opening dates of competitive stores. As discussed in the model section, we use
these com petitor distances to allow the nature of demand to vary across stores. In
particular, the information on store opening dates allows us to explicitly account
for shifts in the demand parameters due to changes in the competitive environment
68
facing each store. The long time series also allows us to tease out the short- and
long-term impact of warehouse entry.
To model demand, we use a random coefficient logit specification. This model
has recently become popular in both the marketing and economics literature for
modeling demand for differentiated products (e.g.. Berry, Levinsohn and Pakes
1995. Nevo 2000. Chintagunta 2000). It has the advantage of being much more
parsimonious than a linear or a log-log demand model. For example with N brands,
a linear or log-log demand requires estimating N 2 own and cross price parameters.
W ith a logit demand specification, consumer preferences are projected onto a set of
exogenous product attributes, which greatly reduces the dimension of the estima
tion problem. Further, by allowing consumer tastes to vary in the population, the
model is not subject to the ^proportional draw” property of the homogeneous logit.
Unobserved heterogeneity in consumer tastes plays three im portant roles. First,
since consumers are endowed with different marginal utilities from observed prod
uct characteristics, they react differently in response to promotions and changes
in the marketing mix by different brands. Second, since marginal utility from a
particular product characteristic is constant across alternatives, consumers find
products with similar characteristics to be better substitutes. Finally, in our ap
plication. allowing for consumer heterogeneity provides us with in s ig h ts into not
just the changes in the mean price response over time but also its distribution in
the population.
69
A key feature of our demand model is th at we control for the endogeneity of
retail prices. At the store level, there are factors like shelf space, shelf location,
and store coupons that will affect the choices made by consumers in th at store’s
market area. However, as researchers we do not observe these factors. As these
unobserved factors can be correlated with price, we account for this endogeneity by
instrumenting for prices in the estimation. Previous work using various weekly su
permarket data and discrete choice modeling consistently finds th at instrumenting
for prices leads to noticeably higher magnitudes in the price response parameter
(Villas-Boas and Winer 1996, Besanko. G upta and Jain 1998, Chintagunta 2001).
We estimate demand functions for three product categories: paper towels, bath
tissue, and refrigerated orange juice. Results show that Dominick’s lost significant
volume in paper products (paper towels and bath tissue) following entry by mass
discounters, while refrigerated juices showed a steady increase during the same
time period. Consistent with the P&G study, we find th at the overall sales at Do
minick’s were 16% (paper towel) to 24% (bath tissue) lower following warehouse
entry. However, there is significant variation across stores. While stores in com
petition with mass discounters lose significantly higher volume, other stores show
an increase in sales.
In terms of consumer price sensitivity, we find th at the short-term impact of
warehouse entry is to increase price sensitivity in the population. More inter
estingly, we find that the long-run mean price sensitivity in paper products is
70
significantly lower, even lower than the pre-entry period. In addition, the distribu
tion of the price sensitivity is much tighter. Our results indicate that while DFF
lost significant volume due to warehouse entry, the lost sales seem to have come
at the expense of more price sensitive shoppers. Consumers who continue to buy
paper products at Dominick's are relatively homogenous and less price sensitive.
In the long run, Dominick’s is left with lower but less elastic demand for paper
towels and bath tissue. Combining our demand estimates with a category profit
maximization framework, our results indicate that it may be optimal to raise prices
in the long run. Though not entirely obvious, this is consistent with Hauser and
Shugan's (1983) result that if the market is highly segmented, it may be optimal
to raise prices with competitive entry. Similar evidence is found by Ward et al.
(2000). who examine the impact of private labels on price response by national
brands. The authors find that an increase in share of private-Iabel goods leads to
an increase in the price of national brands.
The rest of this essay is organized is follows. In the next section we provide
an overview of the relevant literature. Section 3 presents the demand model and
discusses the main aspects of the estimation procedure. Section 4 provides an
overview of the data we use for estimation. Section 5 presents results. We conclude
in section 6.
71
4.2. C onceptual D evelopm ent
In this section we provide a brief literature review on price response to en
try. focussing primarily on studies that provide a rationale for a price increase
as an optimal response to competitor entry. The pioneering work in the market
ing literature on the issue is the Defender model proposed by Hauser and Shugan
(1983). The authors formulate a rich model of consumer and competitive behavior
to examine optimal defensive strategies in response to market entry. Their analysis
suggests th at an incumbent facing attack should reduce its price and decrease mar
keting spending. Subsequent research has shown th at the general prescriptions of
the Defender model continue to hold under less restrictive modeling assumptions
(Kumar and Sudharshan 1988. Carpenter and Nakamoto 1990, Gruca et al. 1992,
Basurov and Nguyen 1998).
One interesting finding from the Defender model which has received relatively
less attention is the impact of segmentation on the optimal marketing mix response
to entry. Hauser and Shugan show that when the market is highly segmented, and
if the competitors "out-position" the incumbent’s product in one of the segments,
it may be optimal to raise prices. Recently, Gruca et al. (2001) have extended the
analysis to consider the case where consumer tastes have a discrete rather than a
continuous distribution, and competition between products is more localized. W ith
market entry, the authors find that the direction and magnitude of optimal price
72
response depends on the position of the incumbent, and that it may be optimal
for the incumbent to raise price when it is located farther away from the entrant.
Similar intuition is provided in Judd (1985). The author uses a model of spatial
competition to analyze the response of a multi-product monopolist to entry by a
single product firm. In his model, it is optimal for the monopolist to drop the
closest product to the entrant in order to soften price competition and preempt
a price war. The interesting finding here is that in fact it might be optimal to
concede a segment of the market to the entrant rather than compete for this
segment through lower prices.
Perloff et al.(1996) show th at market entry can cause an incumbent monop
olist's price to rise or fall in a model of spatial competition. The author's show
that the incumbent's optimal price response depends on how close the entrant lo
cates in the product space. The price declines when the entrant locates sufficiently
close to the incumbent, rises when the entrant locates further away, and remains
unchanged if the products are sufficiently distant. In their study of anti-ulcer pre
scription drugs, the authors find empirical evidence for their model - price rises for
an incumbent drug in response to entry by a distant therapeutic substitute, but
falls in response to entry by a closer substitute. Similarly. Davis et al. (2001) ana
lyze entry, pricing, and product design in a model with differentiated products and
show that, under plausible conditions, entry into an initially monopolized market
leads to higher prices.
73
Evidence also exists in the empirical literature th at market entry can lead
to no response, or in some circumstances an increase in price. In an extensive
study. Robinson (1988) examines the marketing mix reactions by the incumbent
for 115 entrants into oligopolistic markets, and finds evidence of minimal reaction
by the entrant. Ward et al. (2001) study the impact of private label entry and
market penetration on brand name pricing for 32 product categories. The authors
use scanner data on retail prices and find a strong positive effect of private label
market share on brand name prices. Similar phenomena have also been observed
in many pharmaceutical markets. For example, Frank and Salkever (1992. 1997)
find th at name-brand prices increased after entry by generic products. Similarly,
Bresnahan and Reiss (1990) infer that variable profit margins rise modestly when
a second car dealership enters a market initially served by a single dealership.
Finally, in a different setting, Kadyali et al. (1999) find an interesting result where
a product line extension by a brand in a competitive setting leads to an increase
in prices and profits for both the extending firm as well as the rival.
A general consensus in the theoretical papers discussed above is that segmen
tation of preferences softens price competition. This means that when consumers
are heterogenous, entry by a differentiated competitor th at fosters market segmen
tation can lead to an increase in prices. Our focus in this study is on analyzing the
impact of entry by mass discounters on a supermarket chain. A relevant question
th at arises is why entry by a warehouse store is different from entry by any other
supermarket?
74
We illustrate this using a simple example. Consider a supermarket which oper
ates as a local monopoly and carries two products: fresh produce and paper towels.
Suppose a new competitor enters this market. If the entrant is also a supermarket
carrying both produce and paper towels, the incumbent store (barring switching
costs, loyalty etc.) is likely to lose market share in both products, and prices (in
the absence of collusion) are likely to fall. More importantly, since the entrant
supermarket is identical to the incumbent store, the consumers who switch their
purchases to the new entrant are not likely to be any different from the customers
who continue to shop at the incumbent store.
Next, suppose the new entrant is a mass discounter which competes with the
incumbent only in paper towels. Also assume that the mass discounter has lower
cost and can therefore sell paper towels at a lower price. If the incumbent super
market were a single product firm selling only paper towels, it would loose all its
elastomers to the low-cost competitor in the long run. However, since the mass
discounter does not offer the frill array of products, there will be a segment of
consumers who will continue to purchase paper towels at the incumbent in order
to avoid multiple shopping trips. Further, the new entrant is likely to attract con
sumers who are different from the segment that continues to shop at the incumbent
supermarket. They may be shoppers who have lower search costs, are heavy users
of paper towels, are more price sensitive, etc. Thus, the post-entry demand for
paper towels and the price response by the incumbent will depend on the size and
the characteristics of the customers th at continue to shop at the store.
To formalize the above argument, consider the following simple model. Suppose
there are a total of N consumers, th at are uniformly located along a segment of
unit length [0,1]. The grocery store, also called the incumbent, is located at
tj £ (0 . 1 ). Next suppose a discount store E, also called the entrant, enters the
market, initially monopolized by the grocery store, and locates right next to the
incumbent, i.e. tE — tj. Both stores sell multiple products but compete in a single
good g which is sold at prices p/ and Pe respectively. In what follows, we assume
that the incumbent and the entrant are located sufficiently far from the endpoints
of segment [0 . 1 ] so that the endpoint considerations do not enter our analysis.
Both stores do not have fixed costs, and their constant marginal costs of procuring
good g are equal to m > 0 for the grocery store, and 0 for the discount store. That
is. we assume that the discount store has a lower cost of procuring good g than
the incumbent. This assumption is motivated by the tendency of discount stores
to have more bargaining power in negotiations with wholesalers.
We let c denote the transportation cost per unit of distance, and let u be the
value of good g to the consumer. Each consumer has a choice of visiting one store,
two stores or neither store. In addition to transportation costs, the consumer
making a shopping trip to a store incurs a shopping cost s. The shopping cost s
may include the cost of finding the product, time spent in the line, etc. Thus, if
a consumer visits both stores, her toted cost is equal to the total transportation
costs plus 2s. Besides their location, consumers differ along another dimension.
We assume that there are two types of consumers differentiated in terms of their
76
utility (in addition to the net utility from good g) of visiting a particular store. A
proportion a of consumers obtain an additional utility ue from visiting the discount
store. We call these consumers type-E to reflect their preference (all other things
equal) for the discount store. Similarly, Type-/ consumers, th at constitute 1 —a
fraction of all consumers, obtain an additional utility u/ from visiting the grocery
store, regardless of whether they buy good g there or not. For example, these
could be shoppers that have demand for not just product g but also for other
food products sold by the grocery store. Similarly, if a type-E consumer visits
the discount store, she obtains utility ue irrespective of whether she buys good g
there or not. The incumbent and the entrant are uninformed of the type of each
consumer and they only have information on the fractions of type-/ and type-E
consumers. We also assume th at each consumer is of type E with probability a and
of type / with complementary probability 1 —a . T hat is. location of a consumer
and her type are independent.
Each consumer has an option of buying from an outside source instead of
shopping at the two stores. We assume that if a consumer chooses this outside
option, her utility is equal to U = 0. Note that the reservation utility is equal to 0
irrespective of consumer location and type. For the purposes of this example, this
assumption is without loss of generality.
To establish a benchmark case, we start with the scenario where the market
consists of a single grocery store. Note that a consumer may travel to the grocery
store for one or two reasons. If she is type-E, she may travel to the grocery store
77
solely for the purpose of buying good g there. While if she is type-/, there is an
additional reason of receiving utility U[ from visiting the grocery store. As long as
the value of good g to the consumer u exceeds the price p™ by the incumbent,
any consumer that visits the grocery store buys good g there. The incumbent will
set p7* < u since otherwise it will lose all of it’s customers. A consumer buys a
unit of a good as long as the net value of the good does not exceed its reservation
price. VVe assume that u — m — s > 0, i.e.. there are gains from trade between
the incumbent and type-E consumer (and. hence, type-/ consumer) located right
next to the incumbent (t = t[). Let ve = u and vr = u + uj. The utility of type-/
(/ = E. I) consumer that is located at t and buys goods g from the incumbent is
given by
(1) UJ{t.tl) =Vj - p f -c\t-t[\-s.
Thus, type-/ consumer located at t buys from the incumbent if and only if
(2) Vj —p f — c\t — t[\ — s > U = 0.
This, in turn, implies th at the maximum distance, x*m. th at a type-/ consumer
can be located from the incumbent and still be willing to purchase both goods
from her is given by
( 3) XJm =
Thus, the total number of consumers that demand good g is equal to
(4) Q . = 2axg.V + 2(1 —a )x i,V -- 2N .
The incumbent’s optimization problem can be w ritten as
78
(5) m g 2 . v { - « » ^ r - - } ( p r - m ).
Solving the first-order necessary conditions, which are also sufficient due to
concavity of the objective function in the choice variable p™, we find the profit
maximizing price:
(6 ) p'P = | [u + (1 —a)u[ + m —s ] .
The profits of the incumbent are equal to
(7) 7Tm = £ [u -r (1 - a ) u { - m - s ] 2 .
Now suppose the discount store E enters the market monopolized by the gro
cery store and locates at tg = tj. With the entry of the discount store, the con
sumers have a choice of visiting one of the two stores, both or neither. One would
expect th at for positive values of s the relative values of s, u/, ug- and m will
determine the equilibrium behavior. Given the prices set by the two stores, the
consumers decide how many stores to travel to and from where to buy good g.
Type-/ consumers choose among the following options: visit store I and buy good
g there, visit both stores and buy good g at store E. visit only store E and buy
good g there, and do not travel at all. If type-/ consumer located at t buys good
g from store / . her utility is given by
(8 ) U(t.t[) = u + ui — pff — c\t — t[\ — s.
If type-/ consumer visits store / but buys good g from store E, her utility is
given by
(9) = u + ut —pfe — c\t — t/| —2s.
79
If ty p e-/ consumer visits store E and buys good g there, her utility is given by
(10) U(t. ti) = u —p£ —c\t —t[\ — s.
Finally, if type-/ consumer does not visit any stores her utility is equal to 0.
Thus, ty p e-/ will buy good g from store I if and only if

u + ui - p dE - c \ t - tr | - 2 s;
(1 1 ) u + u; —pj —c\t —1[\ —s > max < u - p*E - c\t - t r\ - s; .
. 0
Similarly. type-E consumer decides between the following four options: visit
store E and buy good g there, visit both stores and buy good g at store I. visit
only store / and buy good g there, and do not travel at all. If type-E’ consumer
located at t buys good g from store E. her utility is given by
(12) U( tJr ) = u + uE - p E
l - c \ t - t I\ - s .
If type-E consumer visits store E but buys good g from store /, her utility is
given by
(13) U{t. ti) = u + ue — pff — c\t —f/| —2s.
If type-E consumer visits store I and buys good g there, her utility isgiven by
(14) U(t. t[) = u — pj — c|t —ti\ — s.
Finally, if type-E consumer does not visit any stores, her utility is equal to 0.
Thus. type-E will buy good g from store E if and only if

u -H uE —p j — c\t —f/| —2 s:
(15) u -r ue — —c\t —11 \ —s > max u -pf} - c\t - £/| - s;
0 .
80
If consumers have zero shopping costs then they buy good g at the store that
offers the lowest price. In this case (where s = 0 ). type-j consumer, if she has
travelled to location t.£ = tj. always visits store j. Thus, if store j is the one that
offers the lowest price of good j. type-j only visits store j. When s = 0. it is
straightforward to derive the Bertrand Nash equilibrium. The discount store sets
price equal to m, all consumers that travel to location tg = ti buy good g from
the discount store. Type-/ consumers also visit the grocery store but solely for
the purpose of collecting payoff U[. Thus, in this case, entry results in decrease
in price of g and an increase in consumer welfare. Obviously, the grocery store is
negatively affected by entry.
The simple analysis above points to the important role played by the shopping
cost. In our empirical analysis, we find many instances where discount stores
entered next to the incumbent supermarket. While these supermarket stores lose
sales in the competing products, the demand does not go down to zero, which
would be the case if discounters had lower price and consumers had no shopping
costs.
W hat happens when there are non-zero shopping costs (i.e. s > 0)? When u/
is sufficiently large such that it is greater than the difference in price between the
two stores, the equilibrium outcome entails type-/ consumers shopping at store /
and type-E consumers shopping at store E. Under this scenario, both firms do
not have an incentive to undercut the price set by the rival since it would have to
decrease the price by an amount directly proportional to the shopping cost. And
81
if the shopping cost is sufficiently large, a firm is better off serving the segment
of the consumers that have a preference for its product than trying to attract all
consumers. The equilibrium price set by the incumbent in this case is:
(16) pj = 5 [u + U[ + m — s ].
The price set by the entrant is:
(17) Pe = \ [u + uE - s].
Under these prices, the corresponding demands are equal to:
(18) <tf = - v ‘'V [u + U{ - m - s \ .
(19) cfe = [u + uE - s ] .
The profits of the incumbent and the entrant are equal to
(2 0 ) 7rj — ('l~2c' 'V (u + (1 —Q)u i —na —s )2 and

(2 1 ) ^ [u + a u E - s}2 .
respectively.
Thus when u{ is sufficiently large, the impact of discount store entry is to
segment the market. The incumbent serves the segment that derives extra utility
from shopping at its store. The sales and profits depend on the size of this segment,
and the extra value they attach to shopping at the grocery store. Also, comparing
(6 ) and (16). we observe that it is optimal for the grocery store to raise the price of
good g after entry, i.e. pj > p™. VVe next turn to empirical investigation of some
of these issues.
82
4.3. D em and M odel
This section describes the demand model used in the study. Since the model
is quite similar to that used in the previous chapter, our discussion will be brief.
We use the increasingly popular mixed logit specification (McFadden and Train
1998) to represent the underlying consumer choice model generating the observed
aggregate purchases in each store-week. This model has recently become popular
in both the marketing and economics literature for modeling demand for differ
entiated products (for example, Berry, Levinsohn and Pakes 1995, Nevo 2000,
Chintagunta 2000). It has the advantage of being much more parsimonious than
a linear or a log-log demand model. For example with N brands, a linear or log-
log demand requires estimating iV2 own and cross price parameters. W ith a logit
demand specification, consumer preferences are projected onto a set of exogenous
product attributes, which greatly reduces the dimension of the estimation prob
lem. At the same time, by allowing consumer tastes to vary in the population,
the model is not subject to the “proportional draw” property of the homogeneous
logit.
Formally, we assume th at on a given shopping trip in week t (t = 1,..., T), M t
consumers each select one of J brands in the category or opt for the no-purchase
alternative. The probability that consumer h will purchase product j in store-week
S3
t is given by:
exp(ahj - l3htpjt + 6hdjt + f -t)

= j -------------------------------- ,
exp(AZ t) + £ exp(aM - 3htp it + 6h(Ut + £lt)
1=1
(4.1) h = 1 H .j = 1 J,t = 1 T.
The parameter a hj captures household h's intrinsic preference for brand j. The
variables pJt and dJt are the price and promotion dummy for product j in store-
week t. while the parameters 3 ht and 6h capture household h's price and promotion
sensitivity. The vector. £ encompasses the effects of unobserved (to the econome
trician) in-store product attributes, such as advertising, shelf-space and coupon
availability that vary across store-weeks (BLP 1995. BGJ 1998). Finally, the vari
able Zt captures the demographic and competitive environment in store-week t.
The model also allows for the no-purchase option, which allows category demand
to increase or decrease based on the marketing mix in the category. The prob
ability th at household h will not make a purchase from the category in week t is
given by:
(4.2) P m = -----------
J
exp(AZt) + 52 exp(ahi - 3 htPit + 9h(kt + £.t)
1=1
By making the parameters household specific, the model allows the parame
ters to vary across households. There are two popular approaches to account for
consumer heterogeneity: parametric random effects (see for example, Gonul and
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Srinivasan 1993) or semi-parametric or latent class model (Kamakura and Russell
1989). In this paper we use the parametric approach. For latent class approach
using aggregate data see Berry, Camall, and Spiller (1998), and Besanko, Dube k
G upta (2001). For the parametric approach, we assume that the price sensitivity
and taste parameters are drawn from a multivariate normal distribution with mean
that is a function of demographic and competitive variables. Since in our empirical
analysis, the demographic and competitive variables may be c h a n g in g over time,
we subscript the price sensitivity parameter by both h and t. For simplicity, we
treat the price and promotion parameters as i.i.d:
J* d + lZ t
+ A i//,, where ~ N (0. /)
Ok 0
where the means. 3 and 6, the impact of demographics and competitor variables,
7 . and the vector of standard deviations. A, are parameters to be estimated.
For the intrinsic brand preference parameters, we allow for a richer correlation
structure:
Q/t ~ N (a. Z ) .
The E m atrix represents the covariance matrix of preferences across consumers
which are allowed to be correlated across brands. In the estimation, we impose a
factor structure on the covariance matrix (for details see the model section in the
85
previous chapter).
E = Lu>hu ’hL \ u/k ~ N (0 .1 ) .
For both exposition and computation, it is useful to separate Vhjt = exp(ahj —
(3 h + 7 Zt )pjt + QhdJt + €Jt) into two components: a part common to all households
and one that differs across consumers:
Vhjt = fijt + Phjt
where 6Jt = aij + ( $ - r ^ Z t ) Pjt + 0dit + f Jt is common to all consumers and =
(Pjt + x J t )Xi/h + LuJh is consumer-specific. The share qJt for product j in store-week
t is given by integrating the individual choice probabilities over the distribution
of population parameters. Because consumers consider all the available options
before making a choice, the market shares are a function of the characteristics of
all brands in the choice set:
, , on r exp(<5jt + n hjt)
(4.3) qjt = I — j----------- -- o { v ) d v .
7 -o o exp(AZt) + £ l= 1 exp( 6 tt + p h l t )
h = 1 H ,j = 0 J .f = l , . . . . r .
where ©(•) is the pdf of a standard normal. The integral in (4.3) represents the
share of consumers entering the store in week t that purchase a unit of product j,
and defines the product level demand curve. Thus, expected demand for product
86
j in store-week t is :
(4.4) Qjt = qjtMf
This completes the demand specification. The estimation approach is discussed
in detail in section 5 of the previous chapter.
4.4. D ata D escription
We use data from Dominick's Finer Foods (DFF), which is the second largest
supermarket chain in the Chicago metropolitan area. DFF operates close to 100
stores in the Chicago area. Our data consist of weekly sales, prices, promotions,
and profit margins at the individual UPC-level for a period of 7 years (1990-96).
The data are available for about 25 product categories. In addition, information is
also available on weekly customer count (number of customers entering the store
each week).
Of the 25 categories available, we use data from paper towels, bath tissue, and
refrigerated juices. Paper products (towels and bath tissue) are often used by mass
discounters as traffic generators and are promoted frequently. These categories also
get large shelf space at the mass discounters. Since our primary motive is to analyze
the impact of warehouse entry, these categories fit the criterion well. We selected
refrigerated juices as we also wanted to analyze products th at are not sold by mass
discounters.
87
4.4.1. Store Environm ent
We supplement the sales data with an extensive set of demographic and competitive
variables that capture the environment facing each store, at each time period.
Zip level demographics for each store is obtained from the Sourcebook of Zip
Demographics. These d ata are available for years 1990, 1993. 1994. and 1997.
We also use an extensive set of competitive variables. The main source of
competitive information is the database maintained by Trade Dimension Inc. The
company provided us with information on location (latitude, longitude) for vari
ous kind of stores including supermarkets, superettes (small grocery stores), mass
discounters (Wal-Mart. Kmart and Target), price clubs, supercenters, convenience
stores, and other liquor and cigarette outlets. The database also includes descrip
tive information on each store including store format, chain affiliation, store size,
number of employees, number of checkout counters, lines of business including
additional services like pharmacy, bakery and so on.
In addition to the store locations, we also use information on the opening
dates for these stores. The data on opening dates of the competitor stores allow
us to explicitly account for changes in the competitive environment facing each
store. This information was obtained from various sources. First, Trade Dimension
provided us with the dates th at the stores were entered in their database. While
this is not the exact store opening date, it provides us with a good proxy as
the database is updated on a regular basis. In addition, we contacted the major
88
competitive chains directly and obtained the opening dates for all their stores
operating in the Chicago area. We were able to obtain this information from
the two major grocery chains: Jewel (the largest supermarket chain in the area)
and Cub Foods (the largest EDLP operator). Similarly, we were able to get the
store opening dates for two main mass discount chains- Wal-Mart and Target.
Incidentally, these two chains entered the Chicago market during the period of
study. For all other stores, we use the dates provided by Trade Dimensions as
proxy for when these stores opened2.
Table B.3 describes the demographic and competitive variables used in the
study. Descriptive data is provided for years 1990 and 1996, the first and the last
years in our data set. We use two demographic variables. Ethnic (% of popula
tion th at is Black and Hispanic) and Income (median income in the store area).
Previous research (for example Hoch et al.) has found these variables useful in
explaining demand differences across regions. These variables vary significantly
across stores. For example, DFF stores cater to market areas with Black and
Hispanic representation ranging from 2 to 99% of the population. Similarly, the
median income ranges from under $2 0 , 0 0 0 to over $75,000. Overall, we find that
the proportion of ethnic population as well as median income has gone up over
time.
2In general, we found the trade Dimension information to be fairly reliable. In most cases, stores
were entered in their databse within three m onths of opening. However, in some intances, the
stores appeared in th e database much after they actually opened.
89
The next five rows of Table B.3 describe the competitive variables used in
the study. The first two rows show the average distance in miles to the nearest
supermarket and drug store. The competitive environment with respect to the
grocery and drug stores does not seem to have changed much over time. On the
other hand, the competition from mass discounters has changed quite dramatically.
While the average distance to the nearest mass discounter was over 5 miles in 1990.
on an average, there was a mass discounter within 2 miles in 1996. This is mainly
due to entry by two large discount chains, Wal-Mart and Target stores, into the
Chicago area. Further, while there were no price clubs in 1990. by the year 1996
this number had grown to over 20 .
4.4.2. Zonal P ricin g
As discussed in the previous chapter. Dominicks employs a zonal pricing policy.
The purpose of this section is to explore how Dominick's pricing zones evolved
over time and the role played by the mass discounters. A close examination of the
non-promoted prices over time reveals that both the number and composition of
these zones changes quite significantly over time. In the early time periods, we
consistently find 3 price zones. However, the number zones increase over time, and
by the third quarter of 1991. we start to see between 12 and 16 levels of prices.
Note th at this is also the time period that we start to observe entry by discount
stores and price clubs. Table B.4 shows the price levels and margins for weeks
10 and 200. In week 10, there are three price levels, with a 17 cent difference
90
between the lowest and highest prices. In week 200. the number of price levels has
increased to 15, and the dispersion has increased to 26 cents. Similarly, in week 10,
the margins ranges between 11 and 25 %, whereas for week 200 it varies between
3 and 26%. Note th at these are prices and margins are for a single UPC so that
there is no aggregation bias causing the observed price dispersion.
We next explore what factors may be critical in defining the zones. In the
previous chapter we saw that the demographic variables explained some of the
observed price differences across zones. Here we focus on the role of the competitive
variables in zone definition. To do this we examine the characteristics of the
stores at the opposite ends of the price distribution. Understanding the differences
between these stores provides insight into why they are priced differently, and
provide some rationale for the zone definitions. Table B.5 shows the distance to
nearest competitors for the four stores charging the lowest prices (Stores 59, 70,
77, and 83) and the five stores charging the highest prices (Stores 14. 32, 52. 53,
95). For the stores with the lowest price, we find that in all cases there are at least
two mass discounters located less than half a mile from the store. In contrast, for
the stores charging the highest prices, there are no stores with a mass discounter
located within one mile of the store. Although not reported in the table, the
stores with higher prices (with the exception of Store 95) have significantly higher
income as well as a higher proportion of elderly population. These comparisons
show th at both demographics and competition, particularly from mass discounters
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and EDLP operator, appear to play a critical role in zone definition. It also appears
that stores under threat from mass discounters are priced most aggressively.
In addition to an increase in the number of price zones, we also observe stores
transition from high to low price zones over time: i.e.. stores that were initially
priced high, may later transition to the low price zones, and vice versa. To explore
how changes in the competitive environment may influence transition between
zones, we consider the case of two stores that were originally priced in the same
zone but later followed very different price paths. Figure B.5 shows the price series
for Stores 14 and 71. For the first 100 weeks, both stores are in the highest price
zone so their regular price and promotions are the same. After week 100. when
the number of price zones increases from three to fourteen, the price series of the
two stores diverge. The price at Store 14 increases as it moves to the highest of
the fourteen price zones. The price for Store 71 decreases to 95 cents, putting
it in one of the lower price zone. The difference in price between the two stores
is 16 cents. With occasional exceptions. Store 71 continues to be priced lower
till about week 280, after which all stores have the same price. Table B.6 shows
the competitive environment of the two stores at the end and beginning of the
observational period. The competitive environment of both stores has evolved
over time. However. Store 14 does not have any discount store located close to it,
while Store 71 has several large discount stores located within a few miles of it.
This indicates that a possible reason for Store 71 to be priced more aggressively
than Store 14 is because it operates in a more competitive environment.
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4.5. R esults
We now discuss the results from the three product categories: Paper towels,
Bath tissue, and Refrigerated juice. Dominick’s competes with mass discounters
in the paper products category, but not in refrigerated juice. We present the
descriptive statistics for the three categories in Table B.7. These data consist
of means across all store-weeks. “Share” corresponds to the conditional shares
for each brand. The actual market shares used for estimation are computed as
total brand sales divided by the total weekly store traffic. Effectively, our model
implies that each time consumers visit the store, they either purchase a unit of
one of the alternatives or they elect not to purchase. The promotion variable is
the proportion of units sold on promotion. “Margin” is the average profit margin
on the brand. The profit margins vary significantly across categories as well as
across brands within the categories. Paper products have lower margins than juice
as they also face competition from non-grocery outlets like mass discounters and
drug stores. W ithin each category, the store brand tends to have higher margins
than the national brands.
We plot the sales for the three categories in Figures B .l, B.2, and B.3. The
figures are for the entire chain, i.e. aggregate across all stores. For paper towels and
bath tissue, we find a strong downward trend while the sales for refrigerated juices
are trending up. This is mainly due to entry by Wal-Mart and Target stores which
compete with D FF in paper products but not in juice. The impact of warehouse
93
stores on category sales is also reflected in the regressions presented in Table B.8.
The dependent variable is log of category sales while the price index is the log
of share weighted prices. The competitor variables: Wal-Mart, Target, K-Mart,
and Price Club enter as dummies and represent the presence of these stores in the
trading area (within 3 miles). We also included a dummy for the presence of a
pharmacy department. While the presence of a pharmacy is unlikely to impact the
category sales directly, it can have an indirect influence via store traffic. Finally
the regression also includes a dummy for holiday weeks and store fixed effects.
Results show th at the presence of a warehouse store significantly reduces the
category sales for paper towel and bath tissue but has a negligible influence on sales
for refrigerated juices. In relative terms, the impact seems to be higher on the bath
tissue category than on paper towels. Finally, the presence of pharmacy seems to
significantly increase sales in all categories. As seen in the data description section,
Dominick’s has added a pharmacy department to a number of stores over time. In
Figure 5 we plot the store traffic and paper towel sales for Store # 9 in the data set.
DFF added a pharmacy department in week 272 which significantly increases the
store traffic and thus paper towel sales. However, it should be noted th at adding
a new department generally involves some remodeling of the store. Thus some of
the effect on store traffic and paper towel sales could be due to these unobserved
factors related to store remodeling.
We present the results from our demand models in Tables B.9, B.10, and B .ll.
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P a p e r Towel: The first set of variables are the intrinsic brand preferences.
Note that all of the brand constants are negative because of the large share of
the no purchase option. In relative terms, we find th at Bounty has the highest
preference level followed by Scott. This is consistent with their high shares. The
next 3 variables pertain to the effects of holiday and competitive variables on
the utility of the outside good. In other words, these variables shift the overall
category demand. Holiday and Price Club variables enter as dummies indicating
a holiday week and presence of a Price Club in the store trading area. However,
both of these variables turned out to be insignificant for this category. The third
category- shifter, warehouse, is the number of warehouse stores in the store trading
area. We find that the presence of warehouse stores in the store trading area
lowers the overall category demand. In terms of the marketing mix variables, we
find promotions to increase the likelihood of purchase. Price sensitivity has the
correct negative sign and we do observe significant heterogeneity in consumer price
sensitivity. Interestingly, we find that price sensitivity rises for promoted items.
The next seven variables describe the impact of store demographic and com
petitive variables on price sensitivity. Price sensitivity tends to be higher in store
areas with large ethnic population, while stores in wealthier neighborhoods tend
to be less price sensitive. We also find that proximity to a grocery store increases
price sensitivity while proximity to a drug store has no influence. Recall th at the
95
interpretation here is that as the distance increases, the price sensitivity falls. Fur
ther, we find th at presence of a price club in the store trading area significantly
increases consumer price sensitivity.
The last two variables "Ware SR.” and "Ware LR” capture the impact of ware
house stores on consumer price sensitivity. “Ware SR” is a dummy variable that
takes a value one in the first 12 months after a entry by a mass discounter in
the store trading area. The dummy "Ware LR” captures the long run impact
of warehouse entry and takes a value one after the first 12 months of warehouse
entry unless another warehouse store enters in the store trading area (in which
case “Ware SR” takes a value one again for the next 12 months). The parameter
estimates show th at while the short run impact of warehouse entry is to increase
consumer price sensitivity, in the long run entry by a warehouse store significantly
reduces consumer price sensitivity.
Why would entry by warehouse stores reduce overall consumer price sensitivity
at the Dominick's store? Recall th at entry by a warehouse store also reduces
overall category sales. One reason why the price sensitivity goes down in the long
run is th a t this lost sales may be coming at the expense of more price sensitive
consumers. In other words, entry by a warehouse store causes the more price
sensitive consumers to shift their purchases to the warehouse store. Thus, in the
long run, DFF is left with lower but less elastic demand for paper towels. We
examine this issue in greater detail in the subsequent section.
96
B a th T issu e: In the bath tissue category we find that Scott has the high
est preference followed by Charmin. It is interesting th at Scott has the highest
preference despite its lower share, suggesting that it is important to control for
marketing mix variables. Unlike the paper towel category, we find th at presence
of a Price Club significantly lowers the category demand for bath tissue. While
this is consistent with the regression results presented in Table B.8, it is unclear
why presence of a Price Club would lower sales in bath tissue and not in paper
towel. In terms of other category shifters, we find that warehouse stores lower the
overall category demand while holidays have no impact. As expected, promotions
increase the probability of purchasing a brand and prices lower it. The price sen
sitivity exhibit significant heterogeneity. Also, price sensitivity rises for promoted
items. In terms of price interactions, we find that store areas with a large ethnic
population are more sensitive. Further, presence of a Price Club significantly in
creases consumer price sensitivity, while proximity to conventional competitors like
other grocery stores has no impact. As in the paper towel category, we find that
the short-run impact of warehouse entry is to increase consumer price sensitivity,
while in the long-run, price sensitivity is significantly lower.
R e frig e ra te d Ju ices: Consistent with its dominant position in the category,
Tropicana has the highest mean effect. We also find that store areas with warehouse
stores have higher sales for juices. It is unclear why this may be case, although
it is possible th at warehouse stores attract consumers to neighborhood from a
larger area which causes some spillover to the DFF stores. Holiday weeks have
97
a lower demand for juices. As expected, promotions increase the likelihood of
purchase. Price sensitivity has the correct negative sign and we observe significant
heterogeneity in consumer price sensitivity. We find th at price sensitivity tends
to be higher in store areas with large ethnic population, while stores in wealthier
neighborhoods tend to be less price sensitive. Proximity to a grocery store and the
presence of a Price Club increases price sensitivity. In terms of warehouse entry,
we find the short run impact of entry is to increase consumer price sensitivity
even in this non-competing product category. However, there is no change in price
sensitivity in the long run.
4.5.1. Im plications for R etailer P ricing
Our results show that entry by warehouse stores significantly lowers the demand
for paper products. At the same time, we find th at while the short run impact
of warehouse entry is to increase consumer price sensitivity, in the long run price
sensitivity is significantly lower. One explanation for why the price sensitivity goes
down in the long run is th at the lost sales at DFF stores may have come at the
expense of more price sensitive consumers. In other words, entry by a warehouse
store causes the more price sensitive consumers to shift their purchases to the
warehouse store. However, the models presented in the previous section do not
address the issue of distribution of consumer price sensitivity in the long nm. If
the impact of warehouse entry is to segment the market by attracting away the
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price sensitive consumers, then we should find a change in not just the mean price
response but also its distribution in the population.
To get a better insight into this issue, we divide our data into 3 time periods:
pre-entry, period of entry, and post entry3. Recall that we have data available
from 1990-96. a period which saw entry by two major discount chains - Wal-Mart
and Target stores. Wal-Mart entered the Chicago area in early 1990 and opened
between 5 to 7 stores every year till 1995. Target stores, on the other hand, entered
the market on a large scale, opening 25 stores between March 1993 and October
1994. In what follows, we will call the period between January 1993 to December
1994 as the period of entry. We refer to the time period before this as the pre-entry
period, while the last two years in the data 1995-96 will be called the post-entry
period. We estimate the demand models for the three time periods using data from
all available stores. Table B.12 reports the mean price sensitivity and its standard
deviation for the paper towel category. Results for the full models along with the
factor loadings are reported in the appendix.
Consistent with results in the previous section, we find that entry by warehouse
stores leads to an increase in the overall price sensitivity in the short nm (period of
entry), while in the long nm the price sensitivity is significantly lower, even lower
than the pre-entry period. At the same time, the distribution of price sensitivity
is much tighter. To visually examine this effect, we plot the mean price effect with
unobserved heterogeneity in Figures B.3 and B.4 for pre and post-entry periods.
3T his analysis is only for Paper Towel Category.
99
The results seem to imply that in the long run, consumers who continue to pur
chase paper towels at DFF are not only less price sensitive, but are also relatively
homogenous.
W hat do these results imply in terms of retailer pricing? To address the pric
ing issue, we need to make some assumption about retailer pricing behavior. Most
studies in marketing assume that retailers set prices for different brands in a prod
uct category to maximize total category profits (for example Kim et al. 1995, Raju
et al. 1995. Vilcassim and Chintagunta 1995 etc.). This objective is also consistent
with the industry trend towards category management.
Formally, we assume th at the retailer jointly sets the profit-maximizing prices,
Pj, of each of the J products in a category. We also assume that the retailer’s vari
able costs consist solely of wholesale prices, Wj and treat all store an d /o r category-
related overhead as fixed costs, Ft. Thus, in week t. a retailer solves the following
optimization problem:
Using (4.4)above, the first-order condition for a typical brand i is:
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We re-write the system of first-order conditions for brands 1 , .. ., J in m atrix form
as:
(4.5) n(p - w) + Q = 0 ,
which represents a system of J equations, one for each brand. The optimal set of
retail prices for the monopolist are determined by solving:
(4.6) p = w —Q - I q
where fi~lq isthe retailmark-up. By checking the second order sufficient con
ditions. onecanverify th at the solution to (4.6) represents an optimum for the
retailer.
We report the predicted margins in Table B.13 . The numbers represent the
median across all store-weeks. Not surprisingly, we find that in the long-run it is
optimal to raise prices. This is of course a direct consequence of low price sensitivity
estimates. Looking at the observed margins, we find that while DFF did increase
margins in some products, they are well below the levels suggested by the model.
There are a number of reasons for this. First, the objective of the retailer may not
be category profit maximization. For example, they could be using the category
for traffic generation (Chintagunta 2001). Similarly, our model does not capture
any cross-category effects. Finally, the category profit maximization model above
101
assumes static behavior. In reality, the retailer may be concerned about factors
like store price image which could affect long-term profitability.
In spite of the above mentioned limitations, our results do suggest that under
the assumption of category profit maximization, an optimal response to entry by
warehouse stores should be an increase in price. Though not entirely obvious, this
is consistent with some of the theoretical models discussed in Section 2.
4.6. Conclusion
This paper studies the impact of entry by mass discounters on the demand
for products sold by conventional supermarkets. Alternative retail formats like
warehouse stores, price clubs, and supercenters have shown a dramatic growth in
the past few years and pose a formidable challenge to supermarkets. However,
cross format competition has received limited attention in the marketing litera
ture. We analyze the impact of warehouse entry on sales of a supermarket chain in
the Chicago area. Using a rich scanner database, we develop demand models for
three product categories and analyze the short and long-term impact of warehouse
entry. Results show th at entry by warehouse stores resulted in s ig n ific a n t loss of
sales in competing product categories. In terms of consumer price sensitivity, we
find that the short-term impact of warehouse entry is to increase price sensitivity.
More interestingly, we find th at the long-run mean price sensitivity in competing
products (paper towel and bath tissue) is significantly lower. Combining our de
mand estimates with a category profit maximization objective, our results show
102
that it may be optimal to raise prices as a result of competitor entry. There are
of course several caveats to our analysis. First and foremost, we do not have any
pricing information on the competitive stores which limits our ability to explicitly
model retail competition. Second, our demand models do not consider any cross
category interactions. Furthermore, due to the aggregate nature of the data, we
can not determine if the lost sales are actually coming from price sensitive con
sumer shifting their purchases to the warehouse stores. For example, it is possible
that all consumers continue to purchase paper products at DFF stores but some of
them have reduced the purchase quantity. We consider some of these issues with
individual level data in the next chapter of the thesis.
CHAPTER 5
Im pact o f E ntry by W al-M art Supercenter
5.1. Introduction
The previous chapter analyzes the impact of entry by mass-discount stores like
Wal-Mart and Target on a supermarket chain. The focus in this chapter is on com
petition between grocery stores and a different type of retail format—supercenters.
Supercenters are distinguished from discount stores in that they combine a full-line
discount store with a full-line supermarket. They carry general merchandise and
food, both perishable and nonperishable. They also offer a variety of ancillary ser
vices such as pharmacy, dry cleaning, hair salon, and photo development, providing
consumers with a true "one-stop shopping” experience. Although Meijer and Fred
Meyer initiated the supercenter concept as early as 1960. it was only in the 1990s
that this format experienced a dramatic growth. For example, in 1993 Wal-Mart
operated only 10 supercenters, while at present it has over 1.100 supercenters,
making it the second largest supermarket chain1. Not surprisingly, supermarket
managers see Wal-Mart as the biggest threat to the traditional grocery industry
(Progressive Grocer. 2000 Annual Survey).
lW almart plans to add between 150 to 180 new supercenters every year, a num ber of these being
converts of the exisiting discount stores.
103
104
In this chapter, we provide a descriptive study of entry by a Wal-Mart super
center on the sales of a traditional supermarket. We utilize a unique database that
records purchases for over 20.000 households before and after Wal-Mart’s entry.
The data come from a grocery store that is located in a small town on the East
coast. The suburban nature of the store’s location provides us with an opportunity
to measure the impact of Wal-Mart’s entry in a relatively controlled environment2.
We investigate the impact of Wal-Mart’s entry at three levels: (1) store, (2) indi
vidual customer, and (3) product category. This chapter addresses the following
issues:
(1) W hat is the impact of the Wal-Mart supercenter on overall store sales and
store traffic?
(2) W hat are the shopping and demographic characteristics of the customers
that defect?
(3) W hat is the impact on customer store-visit frequency and basket size, and
how does this relate to observed customer characteristics?
(4) W hat is the impact on individual product categories? How can the retailer
use the information in its database to enhance category level retention?
The study uses a frequent shopper database that records all transactions made
in the store and captures information such as time and date of the transaction, card
2As we discuss in the next section, over 75% of the households in our database own a house and
have lived a t their current residence for 14 years on average.
105
holder information (if a shopper card is used), total expenditure, unit price, quan
tity. and coupon usage for every UPC sold. Access to rich transaction-level data
allows us to investigate not only the impact of Wal-Mart's entry on overall store
sales but also the changes in store-visit frequency, basket size, and category demand
for each individual. We decompose the observed losses in store sales into compo
nents attributed to customer attrition, loss of store traffic, and reduction in basket
size. More im portant, we combine the transaction data with household-specific
demographic and shopping variables to identify and characterize the consumers
who contribute to the observed demand changes at the store level.
From the retailer's perspective, the ability to study these issues at the customer
level can have a significant impact on store-level marketing policies. For example,
if the lost sales are due to a decline in store traffic while the basket size remains
constant, then the focus should be on strategies to bring customers to the store,
such as via feature advertisements. On the other hand, if the customer count
is relatively constant but basket size decreases, the focus should be on in-store
merchandising to increase basket size. Similarly, identifying and characterizing
consumers who defect or decrease spending allows the retailer not only to target
these customers but also to identify consumers with sim ila r characteristics who
may also be at risk of defection.
We also analyze the impact of Wal-Mart's entry at the product category level.
Retailers increasingly employ category management tools where each category is
treated as a strategic business unit, and pricing, merchandising, promotions, and
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product mix are determined at the category level (Blattberg and Fox 1995). Thus,
it is critical for the category manager to identify which customers defect or reduce
expenditures in the category. We estimate a hierarchical Bayes logit model for three
product categories: bath tissue, milk, and laundry detergent. An advantage of the
Bayesian approach is that it allows parameter inference at the individual level.
Thus, customers can be characterized in terms of their sensitivity to marketing
mix or preference for specific attributes, and targeted coupons can be used for
category-level retention.
Our results show that the incumbent supermarket lost significant volume (19%)
following entry by the Wal-Mart supercenter. Further, these losses were higher in
the dry goods grocery, general merchandise, and health and beauty categories. At
the household level, we find that distance to the stores plays a critical role. In
particular, households living close to the incumbent are less likely to defect or
reduce their spending, while the opposite is true for the households living close
to the new entrant. These fin d in g s are consistent with retail site selection models
(Huff 1964, Brown 1989. etc.), as well as with findings from a recent survey by
Progressive Grocer where location was cited by consumers as the most important
factor in determining store choice. This type of information can also be employed
when d e t e r m in in g which customers to target with retention-oriented promotions.
W ith minor exceptions, our analysis finds that changes in consumer purchase
behavior following Wal-Mart's entry are not related to demographic variables. On
the other hand, shopping-related variables are quite useful in predicting which
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customers will migrate to the discount store. Our results show that big-basket
households are more likely to switch their purchases to Wal-Mart, while customers
who spend a higher proportion of their expenditure on perishables are less likely
to do so. These findings are consistent with Bell and Lattin (1998), who find
th at large-basket shoppers are more likely to choose EDLP stores. Finally, the
brand choice models indicate th at consumers who stop buying in a category are
on average more price sensitive. This is especially true for consumers who stop
purchasing in the category but continue to visit the store. This finding lends strong
support to our results in the previous chapter.
The rest of this chapter is organized as follows. In the next section we discuss
the frequent shopper d ata used in the study. Section 3 investigates the impact
of entry by the Wal-Mart supercenter on store sales and consumer purchase be
havior. Category-level results are presented in section 4. which also describes the
hierarchical Bayes model. Section 5 concludes the chapter.
5.1.1. Frequent Shopper D atabase
The original purpose of frequent shopper programs was to create store loyalty by
rewarding the best customers. Over time, their role has changed to being just
another promotional tool. While frequent shopper cards may not have succeeded
in creating loyalty, they do provide retailers with a wealth of information about
each customer. One of the objectives of this study is to demonstrate how retailers
can use this information when faced with competition.
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The frequent shopper database used in this study comes from two supermarket
stores that are located 8.5 miles apart but are in separate towns. The data consist
of all transactions made in the stores and capture information such as time and
date of the transaction, card holder information (if a shopper card is used), and
the dollar volume, unit price, quantity, and coupon usage for every UPC sold.
Both stores have over 20,000 active card members. VVe use the store transaction
data to create purchase histories for all the customers. As seen in Table C .l , the
usage of the shopper card program is quite high, with card holders accounting for
over 85% of total store sales3. Although non-card purchases account for 32% of all
transactions, the average order size is significantly lower (average of $8 compared
to $34 for transactions using the shopper card). The non-card purchases often
tend to come from the coffee or snack shop and the pharmacy. For most grocery
categories, the shopper card penetration rate is well over 90%.
D ata are available for a period of 20 months, from November 1999 to June 2001.
In August of 2000, a Wal-Mart supercenter entered 1.8 miles from one of the stores
(hereafter referred to as the focal store) and 7.1 miles from the other (referred to as
the control store4). We observe reasonably long time series both before and after
Wal-Mart "s entry. Further, since the stores are located in small suburban towns,
3About 2% of these sales are on the employee card and thus cannot be traced back to any
individual card holder.
4Note th at the control store is well within the trading area o f th e W al-M art, which industry
sources put a t 15 to 20 miles. As we shall see in th e empirical analysis, W al-M art entry also
impacted the sales of this store though to a much lesser extent.
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the d ata provide us with a unique opportunity to analyze the impact of entry by
a Wal-Mart supercenter in a relatively controlled environment.
In addition to their purchase histories, our database also contains the mailing
addresses for all the card holders. We use the addresses to compute each house
hold’s travel distance from the focal store and the new entrant5. Further, we use
demographic data from a market research firm, which provided us with block-level
demographic information. Summary statistics for the demographics and the dis
tance variables can be found in Table C.2. On average, consumers live about 3.5
miles from the focal store and 4.5 miles from the entrant. The average income is
over $50,000, although we find significant variation across households. One quarter
of the households live in rented dwellings. Finally, on average, these households
have been living at their current residences for about 15 years. In addition to
the distance and demographic variables, we construct variables th at describe the
shopping behavior of customers. These variables are discussed in the next section.
5.2. Im pact o f W al-M art E ntry
5.2.1. Store Sales
The impact of Wal-Mart’s entry on store sales is shown in Figure C .l. The plot
shows weekly store sales and the vertical line indicates the entry of Wal-Mart. The
5W hile one would prefer to use travel times rather than distance, there is some evidence th at
straight line distance is a good proxy for actual travel time. For example, Phibbs and Luft (1995)
find a correlation of .987 between straight line distance and travel tim e, although this correlation
drops to .826 for distances below 15 miles.
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figure indicates a significant change in the baseline sales of the focal store after
Wal-Mart’s entry. In Table C.3, we report the percentage change in sales, total
transactions6, and sales per transaction following entry. The first row reports the
overall change at the store level, while subsequent rows show the change at the
departm ent and category level. The numbers presented in Table C.3 are based on
a semi-log regression model which includes a price index7, a dummy for Wal-Mart‘s
entry, and month fixed effects as explanatory variables (to conserve space we skip
the actual parameter values and just report the percentage change). All numbers
in bold indicate significance at the 5% level.
Table C.3 shows th at the focal store lost over 19% sales following Wal-Mart’s
entry. At the same time, sales per transaction have increased significantly, which
indicates that the loss of sales seems to be due to a reduction in store traffic.
This pattern is repeated in the department and category level regressions. At the
departm ent level, the largest losses occurred in the Grocery, General M e rc h a n d is e
(GM), and the Health and Beauty (HBC) departments, followed by Produce and
Meat. Higher losses in the packaged goods departments are to be expected as
these products are less differentiated across stores. The corresponding numbers
for the control store indicate that the proximity to the competitor plays a major
6At the store level, transaction refers to the number of unique baskets. At the departm ent (cat
egory) level, it refers to th e number of baskets th at contain at least 1 item from the departm ent
(category).
'T o capture the price environment a t the store (departm ent) level, we use the total promotional
volume in the store (departm ent). At the category level, the price index is a calculated as the
share weighted price of the top 12 UPC’s.
I ll
role. The sales in the control store are more or less constant (many of the numbers
are insignificant) or the losses are significantly lower than at the focal store.
Two key observations from the regression results presented in Table C.3 must
be highlighted. First, the volume lost by the incumbent is quite significant. This is
particularly troubling considering that supermarkets generally operate on a prin
ciple of low margins and high volume, with profits of only about 1%. The second
consistent pattern that emerges is that the lost volume is due to a loss in the
number of transactions, and the per transaction sales have actually increased post
Wal-Mart entry. There are two potential sources for the loss in store traffic: 1)
the store has fewer customers post Wal-Mart entry but there is no change in the
visit frequency of the remaining customers, or 2) the store has same number of
customers who now visit the store less frequently. In all likelihood, the answer
is a combination of the two. We investigate this issue further by analyzing the
purchase behavior of the top 10,000 customers (in terms of dollars spent prior to
Wal-Mart’s entry8). The selected customers account for 77% of card member sales.
5.2.2. C ustom er A ttrition
When faced with new competition, a primary concern for any business is to evaluate
the number and nature of the customers th at defect. A well documented fact in the
customer relationship management literature is th at the loss of “top” customers
8Ideailv one would want to sort customers in term s of their profitability ra th e r than spending.
However, we do not observe costs in our d ata and thus rely on spending.
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is disproportionately damaging to sales and profitability (Reichheld 2001, Sasser
1996). In this regard, frequent shopper databases provide the retailer with an
opportunity not only to identify the lost customers, but also to tailor the marketing
instruments to avoid or minimize the attrition rate. Table C .4 reports the results
from a logistic regression, where the binary dependent variable takes a value 1 if
the customer has defected. Table C .4 defines defection in two ways: (1 ) In co lu m n
(a), the dependent variable '‘Defect” takes a value of 1 if the customer did not
visit the store in the last three months in our database. (2) In column (b) “Defect”
takes value 1 if the customer reduced his or her spending in the store by over 50%
post-Wal-Mart entry. Using the first definition, we find the defection rate to be
11.5%. while it is 21.5% using the second definition. The probability of defection
is modeled as a function of the following variables:
(1) Distance: household distance from the focal store and Wal-Mart (Dist-
Store, Dist-WM)
(2) Loyalty: To create a loyalty measure, we classified the households into 4
groups (in descending order) based on their expenditures prior to Wal-
M art’s entry. The base is the lowest quartile- Loyal Q4 (i.e. households
who spent the least prior to Wal-Mart?s entry) (Loyal Q l, Loyal Q2, Loyal
Q3)
(3) Basket Size: Similar to the loyalty measure, households were assigned to
quartiles based on their average basket size prior to entry. The base is the
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lowest quartile-Basket Q4 (i.e. households with the smallest basket size
prior to Wal-Mart’s entry) (Basket Q l. Basket Q2, Basket Q3)
(4) Fresh Food Expenditure: proportion of total spending on fresh produce
and meat (Produce, Meat)
(5) Demographics: household income and number of children (Income. Child)
The results indicate th at distance to the store plays an im portant role in de
termining the probability of a customer defecting. Specifically, we find that the
probability of a customer defecting increases with his or her distance to the focal
store and with proximity to the competitor. This is consistent with retail site
selection models (for example. Brown 1989, Huff 1964), as well as with a recent
study by ACNielsen where consumers cited location as the most important factor
in determining store choice (ACNielsen study on "Frequent Shopper Program”,
1999). We also find th at loyalty to the store decreases the probability of defection.
However, this effect is confounded with the distance variables, as customers living
in close proximity to the store also tend to spend more. In terms of basket size,
we find th at large basket consumers have a higher probability of defection which
is consistent with Bell and Lattin (1998) since Wal-Mart supercenter has a well
advertised every day low pricing policy. Negative and significant coefficients on
produce and meat indicate th at household’s with a higher proportion of spending
on fresh food products have a lower probability of defecting. This is not surprising
114
since industry reports indicate that Wal-Mart supercenters generally have signif
icantly lower quality of perishables9. Finally, for the demographic variables we
find th at higher income households have a lower probability of defecting, while
the number of children in the family have no significant impact. Overall all the
parameters seem reasonable and intuitive.
5.2.3. B asket Size and Store V isit Frequency
In this section we analyze the impact of Wal-Mart’s entry on household basket
size and store visits. For this analysis, we focus only on the 88% percent of 10,000
households which are still active customers (i.e. we don't include the households
that have not visited the store in the past three months). Table C.5 reports the
monthly expenditures, store visits, and basket size for this group before and after
Wal-Mart’s entry. The monthly expenditures and store visits fall by 18% and 17%
respectively. However, the average basket size has remained relatively constant,
which is consistent with the regression results presented earlier.
Table C.6 presents the results from three models: a regression of log of monthly
expenditures, a Poisson regression of monthly store visits, and a regression of log
of basket size. The explanatory variables include month fixed effects, a promotion
index, and a dummy for the presence of Wal-Mart. The parameter for Wal-Mart
is allowed to vary in the population as we expect Wal-Mart’s entry to vary across
9See for example a recent article in the January 15, 2001 issue of Superm arket Business “W ith
W al-M art, Look, Don’t Listen” .
115
households. For example, some consumers may shift their purchases to the new
entrant and hence reduce expenditures. At the same time, entry by Wal-Mart may
induce price reductions at the incumbent retailer, which may lead to an increase in
expenditures by some households. In our sample, we find th at approximately one-
third of the households increased expenditures after W al-Mart’s entry. Further,
we suspect household’s distance from the respective stores to explain part of this
heterogeneity. In all three models reported in Table C.6, we assume that the
parameter for Wal-Mart is distributed normal, with a mean that is a function of
household’s distance to the focal and the competitive store.
The results show that entry by Wal-Mart significantly lowered monthly expen
ditures in the population. The impact is magnified for consumers living further
away from the incumbent store and for those living close to Wal-Mart. However,
we also find significant unobserved heterogeneity in the population as indicated
by the large and significant standard deviation parameter. Similar effects are ob
served for the Poisson regression model, where Wal-Mart has a significant negative
impact on the mean store visit frequency in the population. For the basket size,
the coefficient for Wal-Mart’s entry is insignificant, indicating th at the basket size
in the population remained constant. However, the unobserved heterogeneity pa
rameter is quite significant indicating th at the impact of W al-Mart’s entry varied
across households.
To develop further insights we consider the purchase history of two households
and compare their shopping behavior. The first row in Table C.7 shows that
116
both households have reduced their monthly expenditure by about 30% after Wal-
M art’s entry. However there are some critical differences in the purchase behavior
of these households. For hhl, the loss in expenditure seems to come entirely from
lower store visits, while the average basket size and the number of items in the
basket have not changed. More importantly, the basket composition in terms
of expenditure over food and non-food items has not changed. In contrast, the
number of store visits for hh2 has remained relatively constant, while the basket
size and the number of items in the basket have gone down quite significa.nt.ly.
Moreover, expenses on the fresh food items have actually increased over time,
while dollars spent on dry good groceries have fallen by half. This household
seems to have divided the shopping basket strategically, buying fresh produce and
meat at the supermarket while shifting dry good expenditures to Wal-Mart.
The example presented above can have important implications for the retailer's
strategy. For households like h h l, the retailer is losing entire baskets due to com
petitor entry. However, the basket size and composition has remained unchanged.
Thus, the focus for these households should be on devising strategies to increase the
store visits. For households, like hh2. which are abandoning particular products
in the store, the focus should be on designing direct-marketing instruments that
bring them back to the more profitable departments and categories. The category
level model presented in the next section can be used to design such direct mar
keting campaigns by learning about the price sensitivity and attribute preferences
for each individual.
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5.3. Category D em and
This section describes the hierarchical Bayes brand choice model and the main
aspects of the estimation procedure10. Let the utility th at household h obtains
from alternative j on purchase occasion t be
(5.1) Uhjt = &hx h]t + €hjt, €hjt~ iid extrem e value
(5.2) h = l,...,f f , j = l,...,J , t = 1 T.
Xhjt is a matrix of choice characteristics including marketing mix variables and
other brand attributes. ,3k is a vector representing household h ’s preferences and
sensitivity to marketing mix variables, and Jt is the i.i.d. extreme value error
term (for estimation procedures when the error terms are normally distributed see
McCulloch and Rossi 1994). The coefficient vector @h is known to the consumer
but not to the researcher and is assumed to be distributed in the population as
multivariate normal with a mean vector of b and a variance-covariance matrix W ,
i.e.. 0 h ~ N (b .W )lK
Note th at while the above specification uses a parametric approach to model
household heterogeneity, a more common approach with individual level choice
models is the finite mixture or the latent class model (Kamakura and Russell,
1989; Chintagunta et al. 1991; Wedel and Kamakura, 1999, etc.). Latent class
10T his section draws from Allenby and Lenk (1994), Allenby and Rossi (1999), and Train (2001
a.b)
l l Note th a t any demographic or other household specific variables could be incorporated in the
random coefficients as in the previous chapter.
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models axe based on the idea that there are a fixed, finite number of segments in
the market. Households belong to each of these segments with some probability
which are assumed to be. a priori, invariant across households and are interpreted
as representing segment sizes. Although appealing, finite mixture models do not
capture the tail behavior of the heterogeneity distribution adequately and the
posterior distribution of the individual-level parameters is constrained to lie within
the convex hull of (generally few) mass points (Allenby and Rossi. 1999).
On each purchase occasion, the household chooses the alternative that provides
the greatest utility. We do not observe the latent utility directly, but rather the
choice th at represents the maximum utility. Let y M denote the household h ' s
chosen alternative on purchase occasion t. and let y* = (y/u,......., V h t) denote the
household's sequence of choices. Also, let the choices of the entire sample H be
labeled as Y = (y i, Vh )- Conditional on 3. the probability of household h's
observed sequence of choices is the product of standard logits:
(5-3) £W
^ n (s S )
The unconditional probability is the integral of equation 5.3 over all 3:
(5.4) L(yh\b,W ) = J L(yh\3)0(3\b,W )d3
119
where <p(3\b. W ) is the normal density with mean b and covariance W . Note
th at this is the same mixed logit probability as in the previous chapter. However,
unlike the classical approach where the parameters b and W are considered fixed
representing the true mean and covariance of 3 h's in the population, in the Bayesian
framework the b and W are considered stochastic from the researcher’s perspective
and a prior distribution is specified for 6 and W :
(5.5) k(b. W ) = k(b)k(W )
(5.6) k(b) -N (bo,S0)
(5.7) k ( W) ' I W ( K . I )
Thus, the prior on b is normal with a mean of 6o and a (large) variance S0, while
the prior on W is inverted Wishart with K degrees of freedom and scale matrix
I. a /^-dimensioned identity matrix12. The posterior distribution of the population
param eters is:
(5.8) K(b. W\ Y ) oc J J L{yh\b, W)k(b, W)

h
where k(b. Mk') is the prior as in 5.5.
12W hile these axe the prior distributions used most frequently in the hierarchical Bayesian choice
models, more flexible priors can be specified using procedures described in McCulloch and Rossi
( 2000 ).
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5.3.1. E stim ation
Our objective is to make draws from this posterior distribution which summarizes
everything we know about the parameters including information from the sample
and the prior. Analysis of such hierarchical models has been made feasible by the
development of Markov chain simulation methods which directly exploit the hierar
chical structure (Tanner and Wong 1987, Gelfand and Smith 1990 etc.). One direct
approach to making draws from the posterior is to use the Metropolis-Hastings (M-
H) algorithm. However, doing so would be computationally burdensome as each
iteration of the M-H algorithm would require calculating the choice probability
L(yh\b. W) which does not have a close form. A more common approach is to
use Gibbs sampling which allows the researcher to take draws of one parameter
(or a subset of parameters), conditional on other parameters (Casella and George,
1992). The basic idea is to construct a Markov chain defined on the support of
the parameters such that the Markov chain has a stationary distribution equal
to the posterior distribution we are interested in. In the model described above,
the Gibbs sampler works by treating each j3h also as a parameter along with the
population parameters b and W. The Markov chain is constructed by repeatedly
sampling from the conditional posteriors for the three set of parameters b, W , and
121
(5.9) K(b\W,i3hVh) ' N (.3 . W / N ) where 3 = ^ 3 J N

h
(5.10) K{W \b, 3 M - I W (K + N . {K I + N S) / (A' + JV)),
(5.11) where S = ^ ( , / 3 h —b) (3h ~ &)' /

h
(5.12) K W i. W. * ) oc n =
Given our priors, the conditional posteriors for the population parameters are
known distributions. However, there is no simple way to draw from the posterior
of each person's 3. so the M-H algorithm is used in step 3. Note however that the
right hand side of equation 5.12 is easy to calculate and just involves a product
of logits and o (3 h\b. IV') which is a normal density. The M-H algorithm to make
draws from equation 5.12 works as follows:
(a) Start with some initial value ,3% and make K independent draws from a
standard normal density, r?1
(b) Create a trial value for 3}, as 3h = 3%. + P ^ t)1. where p is a scalar specified
by the researcher and L is the Choleski factor of W
(c) Draw a standard uniform variable t^and calculate the ratio
122
(513) L(yh\0l)<t>(plh\b.W )
L (y M )o t3 ? h\b,W )
(d) If u 1 < F, then accept 3 h as the new value, i.e.; 3 i = 3h- If u 1 > F,reject
3k and put 3 lh = 3%.
(e) Repeat the process many times and for high enough t. 3h is a draw from
the posterior.
Thus, it is relatively straightforward to make draws from the conditional poste
rior of each parameter. The Gibbs sampler works as follows. Start with any initial
values for 6°. W°. 3% V/,. Take a draw for each parameter from its conditional
distribution:
(1) Take a draw of b conditional on values U'°. 30h from its conditional
posterior (equation 5.9)
(2) Take a draw of W conditional on value of b from step 1 and 3h Vh from its
conditional posterior (equation 5.10)
(3) Take a draw of 3h W conditional on values of b and W from steps 1 and 2
from its conditional posterior (equation 5.12) as discussed above.
When these three steps are repeated for many iterations, the resulting values
converge to draws from the joint posterior of b, W , and 3h W :
123
(5.14) K (b.W ,f3hVk\Y) o c H L ( y h\(3h)4>(f3h\b,W )k(b.W )

h
Once the converged draws from the posterior are obtained, the mean and stan
dard deviation of the draws can be calculated to obtain estimates and standard
errors of the parameters.
5.3.2. R esu lts
We now present the results from the model presented above. Our main motivation
in using the Bayesian approach is to make inference at the household level. We
then relate the individual parameter estimates to the observed household behavior
post Wal-Mart entry. We are particularly interested in analyzing the preference
and price sensitivity for the households that stop purchasing in the category. Our
hypothesis from the previous chapter is that entry by the discount store causes
more price sensitive customers to shift purchases to the discount store. However,
due to the aggregate nature of the data used in the previous chapter, we only
observed changes in the overall demand at the store level rather than changes in
the purchase behavior of individuals. The hierarchical Bayesian model discussed
above is ideal in this regard as we obtain the entire posterior distribution for each
household as a by-product of the Gibbs sampler.
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The product categories studied are bath tissue, laundry detergent and milk.
As is typical of most consumer packaged goods, these categories contain more
than 60 unique UPCs. Such a large number of products dictate some aggregation
of products. Further, in selecting brands one needs to balance between category
representation and aggregation bias. Our approach to selecting and aggregating
products was to run a correlation of prices across weeks, and then b u n d lin g those
UPCs that shared a common set of attributes and had a price correlation of 0.8
or more. In other words, we only aggregate across UPCs th at had the same mean
price, and whose prices co-move highly enough to believe th at they are priced
jointly.
Summary statistics for the three categories are presented in Tables C.8. C.9 and
C.10. In the milk category, there are 12 products which account for 84% of total
category sales. The category is dominated by the private label which accounts for
over 75% of the category volume. The selected 12 products differ in terms of their
brand name. size, and fat content. In the bath tissue category, we use data from
15 products th at account for 66% of the total category volume. These products
differ in terms of their brand names and number of rolls. Scott has the highest,
market share, capturing nearly one-third of the total category volume. Finally,
for laundry detergent we use data from 16 products th at capture 81% of the total
category volume. Tide is the market leader in this category with over 30% market
share. We also report the prices for each brand before and after Wal-Mart’s entry.
Surprisingly, we do not find much difference in the prices in any category.
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Our sample includes all households that have made at least 5 purchases in the
category. Further, we use data from the entire 20 months rather than before and
after time periods (as in the previous chapter). Since our primary objective is to
obtain parameters for individual households, we want to have as long a purchase
history as possible. For our final sample, the average number of purchases in
the three categories are 17.3 for bath tissue, 23.0 for milk, and 10.6 for laundry
detergent.
The results for the three categories are presented in Tables C .ll, C.15, and
C.13. Note that we have used an attribute structure where each product is defined
as a combination of attributes. Fader and Hardie (1996) show that including
attributes which vary within brand greatly improves the fit of traditional choice
models. In addition, this hedonic approach also gives us insight into the household
preference for specific attributes which can then be used for targeting purposes.
In the milk category, we find that the preference in the population is higher
for the smaller size. On average, consumers prefer 2% milk and the store brand.
However, the large standard deviations attached with all the parameters suggest
th at households are very heterogeneous in their price sensitivity and preference for
these product attributes. The covariance and correlation m atrix of the parameters
presented in Table C.12 also shows a number of significant off diagonal elements
suggesting th at allowing for correlation across parameters is necessary.
The results for bath tissue and laundry detergent categories are presented in
Tables C.13 and C.15. In both categories, consumers have a higher preference for
126
the smaller sizes. Also, brands Scott and Tide, which have the highest market
share in their respective categories, also have the highest preference. All brand
and size parameters show significant heterogeneity across consumers. Similarly,
households are quite heterogenous in their price response.
We now turn our attention to the individual level param eter estimates. Our
hypothesis from the previous chapter is that entry by the discount store causes
more price sensitive customers to shift purchases to the discount store. We examine
this issue by analyzing the individual level price parameters. In Table C.16, we
report the price sensitivity estimates for four groups of customers. The first group
labelled 'defect’ consists of households that purchased in the category before Wal-
M art’s entry, but stopped doing so after entry. The second group is a subset of
‘defect' but only includes households that stopped purchasing in the category, but
continue to visit the store. The third group consists of all households that have
increased or maintained their expenditures in the two time periods. Finally, the
fourth group labelled ‘Hi Before Hi After’ consists of households th at are heavy
buyers (spend more than average) in both before and after time periods.
Table C.16 shows that customers who stop purchasing in the category, par
ticularly those who continue to visit the store but do not buy in the category,
are much more price sensitive. This phenomenon holds up in all three categories.
This lends strong support to our hypothesis in the previous chapter. However, one
needs to keep in mind th at 30 to 35% of these households fall in the right tail of
the distribution, i.e. they are less price sensitive than the population in general.
127
Thus, price sensitivity is not the only explanation for why people stop purchasing
in the category. Finally, from a managerial perspective, Table C.16 also points
out the importance of households that fall in the fourth group. Not only do these
customers spend more in the category, they are also less price sensitive.
We now discuss how the retailer can use the individual param eter estimates for
customized target marketing. Table C.17 reports the individual parameter esti
mates from the milk category for 2 households. These are the same two households
that were used in Section 3. Recall from our earlier discussion th at h h l’s spending
after Wal-Mart’s entry had gone down only because of store visits, while the basket
size was constant. The retailer can use the preference parameters reported in C.17
to target this household and induce store visits. For example, the most preferred
product for h h l is the store brand, in large size and 1% fat content. Note that
this is quite different from the average preference in the population, where the
most preferred product is the store brand in the small size with 2% fat content.
Further, h h l is quite price sensitive and thus needs only a small price cut to induce
purchase, especially if the price coupon is for her most preferred product.
CHAPTER 6
C onclusion
The supermarket industry has undergone dramatic changes in the past few
years. Alternative retail formats such as mass merchandisers, price clubs, and su
percenters have encroached upon supermarket sales to pose a serious threat. One
way supermarkets have reacted to this growing competition is by building large
d ata warehouses. The impetus behind these data collection efforts is a hope that
d ata can be used to improve marketing decisions and thereby improve retailer
positions vis-a-vis new competitors. However, despite the large sums of money in
vested in creating point-of-sale databases, the goal of creating improved marketing
policies has often proven elusive. In a series of three essays, this thesis developed
econometric models th at can help supermarket managers make better use of their
databases, especially when confronted with new competitors.
The first essay demonstrates how a retail chain can utilize its point-of-sale d ata
in setting up a more profitable pricing policy. In addition to developing profit-
enhancing pricing policies for the focal retailer, the study also develops metrics
to determine the impact of change in prices from the consumer perspective. A
constrained pricing policy, which enables the retailer to capture a large portion of
the gains from the unconstrained pricing scheme while also mitigating consumer
128
129
losses, is proposed. Further, to minimize the potential complexity of computing
store-level prices for a chain that has a large number of stores, the study proposes
clustering of stores into a small number of zones based on the estimated demand
parameters. Results indicate that the suggested pricing schemes can significantly
improve retailer profitability.
The focus in the second essay is on analyzing competition between mass dis
counters and a traditional supermarket. This study develops a conceptual model
of how entry by discount stores impacts the sales of competing products at the
incumbent grocery store. The empirical analysis uses data from a large super
market chain in the Chicago area to analyze the impact of entry by two discount
chains, Wal-Mart and Target. Results show that the incumbent supermarket lost
significant volume in competing products following competitor entry. In terms of
consumer price sensitivity, we find that the short-term impact of warehouse entry
is to increase price sensitivity in the population. More interestingly, the long-run
mean price sensitivity in competing products is significantly lower, even lower than
the pre-entry period. The results indicate that in the long run, the incumbent is
left with lower but less elastic demand for competing products. Combining the de
mand estimates with a category profit maximization objective, the results indicate
that it may be optimal to raise prices in the long run.
The last chapter of the thesis analyzes the effect of entry by a Wal-Mart su
percenter into a local market. Wal-Mart supercenters are seen by supermarket
managers as the biggest threat to the traditional grocery industry. The study uses
130
a unique frequent shopper database that records purchases for 1 0 ,0 0 0 households
both before and after Wal-Mart’s entry. Results show that distance to the store
and shopping-related variables are more important than demographics in predict
ing which customers will defect to the new entrant. The brand choice models
indicate th at consumers who stop buying in the category are on average more
price sensitive, confirming our findings from the previous chapter.
This thesis makes several contributions to marketing theory and practice. Past
research on supermarket competition has primarily focused on stores that are iden
tical in terms of product offerings, cost structure, and pricing policies. More re
cently, researchers have also analyzed competition between supermarkets with dif
ferent pricing formats, for example. EDLP vs. Hi-Lo pricing (Bell and Lattin
1998, Lai and Rao 1997, Messinger and Narasimhan 1997). However, the focus of
these papers has been on competition between supermarkets, with little attention
given to the growing competition from mass discounters and supercenters. Like
wise, while supermarket managers realize the threat from discount stores, little
is known about the impact of these stores on store-visit frequency, basket size,
and individual category demand. This thesis contributes to this emerging area by
addressing how consumer behavior changes when a low-priced competitor enters
the market and how traditional supermarkets should alter their pricing strategies
when faced with such competition.
This research is also salient to the growing body of literature focusing on data
base marketing. The first essay of this thesis shows how supermarket managers
131
can use their databases in setting up profitable pricing policies while m in im iz in g
the loss in customer goodwill. Similarly, the third essay demonstrates how retailers
can exploit the information contained in their frequent shopper databases to under
stand and respond to their most valuable customers. This is a vital topic because,
although the information contained in frequent shopper databases is commonly
assumed to be valuable, many retailers are struggling to leverage this information.
The potential difficulty of converting data into valuable marketing strategies is
illustrated by the case of Safeway PLC (UK), which abandoned its customer card
program, citing a potential saving of $80 million per year in a d m in i s t r a t i v e costs
(Jardine 2000). Thus, this research sheds light on the uses and value of purchase
history information, especially when faced with competition.
The fundamental limitation of this thesis rests in the nature of the data used
to study retail competition. All three essays use data from a single supermarket,
with no information on the prices charged by the competitive stores. Similarly,
consumers' purchases are observed only at the focal stores and not in the com
petitive stores. A second limitation in terms of methods employed in the research
involves the restrictive assumption of category profit maximization. The objec
tive of the retailer from particular categories may not be to maximize profits, as
different categories may play different roles for the retailer (Blattberg and Fox
1995). For example, the retailer could be using the category or particular brands
in the category for traffic generation (Chintagunta 2001). Further, the category
profit maximization model also assumes static behavior. In reality, the retailer
132
may be concerned about factors, like store price image, that could affect long-term
profitability.
Although the limitations of the research are quite apparent in and of them
selves. they are not crippling. Supermarkets in general have access to data from
their own stores and make decisions based on what they observe in their stores.
Further, while the assumption of category profit maximization used in the study
may be restrictive, it is consistent with the industry drive towards category profit
maximization. From an academic perspective, these limitations can be overcome
in future research as consumer panel data th at record purchases from all stores
(including mass merchandisers) are being developed by market research firms like
IRI and Nielsen.
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APPENDIX A
Tables and Figures for C hapter 3
142
143
C a te g o ry B ra n d Size S h are P r ic e ( $ /u n it) C o st ( $ /u n it)

Refr OJ MM 64 oz 2 1 .2 % 2.24 1.69
MM 96 oz 4.1% 4.09 1.99
Dom 64 oz 24.4% 1.65 1.15
Trop Prm 64 oz 20.5% 2 .6 6 1 .8 8
Trop SB 64 oz 17.7% 2.37 1.62
Trop Prm 96 7.7% 4.51 2.18
Florida 64 oz 4.3% 2.18 1.90
Ldry Detergent SURF 64 6 .2 % 4.09 3.01
WISK 128 7.0% 8 .1 0 3.31
WISK 64 14.1% 4.14 3.53
ALL 64 1 2 .8 % 3.11 2.41
ALL 128 10.9% 5.72 2.19
CHEER 64 6.3% 4.20 3.62
CHEER 128 5.3% 8 .2 0 3.42
TIDE 128 18.9% 8.30 3.52
TIDE 64 18.4% 4.38 3.79
Table A.I. Descriptive Statistics
___________________________ Laundry P et. Rfj. OJ

Price Variation across weeks 0.72 0.77
Price Variation across stores 0 . 1 1 0.06
Share Variation across weeks 0.78 0.76
Share Variation across stores 0.02_________ 0.05
Table A.2. R-square values are medians across each of the products
in the category
Variable Mean Std Dev Minimum Maximum

AGE60 17% 6% 6% 31%
ETHNIC 15% 19% 2% 99%
HHLARGE 12% 3% 1% 22%
HVAL150 34% 24% 0.40% 92%
SHOPINDX 74% 24% 0% 99%
JEWELDIST 1.29 (mi) 0 .8 6 0.06 3.96
EDLPDIST 5.03 (mi) 3.48 0.13 17.85
Table A.3. Demographics measured as percent of population
144
Demographics
ZO NE P ric e In co m e Age60 E th n ic S h o p in d x HVAL Jew el E D L P
(S) (log $) (%) (%) (%) ($’0 0 0 ) (miles) (miles)
1 3.48 10.56 0 .2 0 0.26 0.62 166.52 1.29 7.24
2 3.27 1 0 .6 6 0.17 0 .1 1 0.79 147.37 1.19 4.20
3 3.38 10.62 0.18 0.03 0.89 143.83 1.04 2 .1 0
4 3.28 10.80 0 .2 1 0.05 0.80 160.00 2.47 1.63
5 3.26 10.59 0 .2 2 0.07 0.83 111.59 1.76 2.80
6 3.20 10.71 0.14 0.08 0.87 135.32 1.26 1.14
7 3.48 10.43 0 .2 1 0.23 0.42 190.35 1.35 8.51
8 3.27 10.56 0.13 0.15 0 .8 8 121.19 0.34 11.65
10 3.46 10.57 0.26 0.15 0.75 116.41 1.83 7.28
11 3.38 1 0 .1 0 0.15 0.46 0.25 97.37 1.58 9.53
12 3.26 10.74 0.16 0.14 0.84 152.75 0.93 4.89
13 3.26 10.72 0.09 0 .1 1 0.94 151.07 3.91 6 .6 8
14 3.26 1 0 .8 8 0.09 0.07 0.76 179.07 1.43 3.10
15 3.25 10.57 0.14 0 .2 1 0 .8 8 100.39 1.80 4.41
16 3.19 10.78 0.06 0.08 0.81 139.06 1.72 2.60
M EAN 3.31 10.62 0.16 0.15 0.76 140.82 1.59 5.18
T a b le A .4 . D e m o g ra p h ic s a n d C o m p e titiv e V a ria b le s b y Z o n e
145
par am s.e.
Surf -6.273 2.654
Wisk -7.216 2.786
All -5.316 2.554
Cheer -3.305 2.550
Tide - 1 . 8 6 6 2.541
price -7.843 4.082
s.d. price 0.348 0.393
promo 0.749 0.068
price* promo -1.106 0 . 1 1 2
64-oz 0.742 0.008
holiday 0.227 0.026
income 0.412 0.262
age60 -0.907 0.420
ethnic 0.064 0.207
shopindx 0.436 0.255
hval -0.009 0 . 0 0 1
Jewel -0 . 0 0 2 0.029
EDLP -0 . 0 1 0 0.008
price* income -0.713 0.421
price*age60 3.296 0.672
price*ethnic -0.641 0.324
price*shopindx -0.273 0.410
price*hval 0 .0 2 0 0 .0 0 2
price* Jewel 0.050 0.046
price*EDLP 0.053 0.013
Table A.5. Demand for Laundry Detergent
146
«U RF
U i-
1h
0.5 i-
OrCIDE
CHEER
-0.5 - -
-1 - -
-1.5 -
OMSK
*2 o o!i 1 1J 2 2J 3 3.5
Figure A.I. Perceptual Map for Laundry Detergent

0.4 r
OOMINICKS
OJh
01- FLORIDA
-OJ -
CROP SB
•0.4 - CROP PRM
-0 .0 -
-0 J -
3.4
Figure A.2. Perceptual Map for Refrigerated Orange Juice
147
par am s.e.
MM 10.858
1.823
Dom 9.8021.924
Trop Prm 11.953
1.817
Trop SB 11.008
1.814
Florida 8.724
1.969
price -50.389
4.443
s.d. price 0.874
-0.033
promo 0.079
1.632
price*promo -3.694
0 .2 1 1
96-oz size -0.485
0 .0 1 1
holiday 0.031
0.198
income -0.921
0.186
age60 -1.933
0.284
ethnic 0.147
0.375
shopindx -0.062
0.170
hval -0.015
0 .0 0 1
Jewel 0 .0 1 2 0 .0 2 0
EDLP -0.029 0.006
price* income 2.950 0.459
price*age60 8.096 0.693
price*ethnic -0.436 0.346
price*shopindx -0.004 0.419
price*hval 0.049 0 . 0 0 2
price* Jewel -0.062 0.049
price*EDLP 0 .1 2 0 0.013
Table A.6 . Demand for Refrigerated Orange Juice
Category Income Age60 Ethnic Shopindx Jewel EDLP

Laundry Detergent -0.107 0.126 -0.018 0.160 0.024 0.067
Refrigerated O J 0.751 0.109 0 . 0 1 0 -0.026 0.003 0.036
Size (purchase prob.)
148
Category Brand dim 1 s.e. dim 2 s.e.

Laundry Detergent Surf 1.766 0.396 1.750 0.421
Wisk 3.005 0.592 -1.689 0.582
AH 1.080 0.252 -0.277 0.387
Cheer 0 .1 2 0 0.463 -0.344 0.653
Tide 0 .1 0 0 0.368
Refrigerated OJ MM -0.138 0.678 0.763 0.338
Dom 0.056 1.207 1.226 0.512
Trop Prm 0.008 0.444 -0.341 0.418
Trop SB -0 . 0 2 0 1.160 0.117 0.591
Sunny D -0.440 1 . 0 0 2
Table A.8 . Latent Brand Factors
Laundry Det. Rfj. OJ

store 1.844 2.499
zone 1.210 1.463
chain 1.329 3.025
Tab e A.9. Minimum Distance Criterion
Brand Size (oz) Conditional Share TRUE Store Zone Chain

Surf 64 6 .2 % 25.8% 19.5% 2 2 . 1 % 22.3%
Wisk 128 7.0% 17.9% 2 2 .8 % 26.4% 26.6%
Wisk 64 14.1% 14.9% 21.5% 25.2% 25.4%
All 64 1 2 .8 % 22.3% 2 2 . 1 % 24.2% 24.3%
All 128 10.9% 23.2% 23.9% 26.1% 26.2%
Cheer 64 6.3% 13.6% 14.4% 15.6% 15.7%
Cheer 128 5.3% 16.4% 15.1% 16.3% 16.4%
Tide 128 18.9% 14.7% 14.4% 15.5% 15.6%
Tide 64 18.4% 13.5% 13.8% 14.6% 14.8%
Table A. 10. Predicted Margins for Laundry Detergent
149
Brand Size (oz) Conditional Share TRUE Store Zone Chain

MM 64 oz 2 1 .2 % 23.7% 32.2% 30.6% 30.5%
MM 96 oz 4.1% 26.2% 30.1% 26.9% 26.5%
Dom 64 oz 24.4% 28.2% 38.7% 38.8% 38.4%
Trop Prm 64 oz 20.5% 28.1% 30.8% 28.4% 27.8%
Trop SB 64 oz 17.7% 30.1% 33.4% 30.7% 30.6%
Trop Prm 96 7.7% 27.0% 28.9% 25.4% 24.7%
Florida 64 oz 4.3% 31.6% 41.8% 42.4% 42.1%
Table A .ll. Predicted Margins for Refrigerated Orange Juice
Category Aggregation Profit Change Change Change

Profit Profit ($) Welfare ($)
Laundry Chain $1,148,500
Detergent Zone $1,155,400 0 .6 % $6,900 $9,058
Store $1,258,200 9.6% $109,700 $125,915
Constr. Store $1,212,500 5.6% $64,000 $103,381
cluster $1,192,500 3.8% $44,000 $45,082
Refrig. Chain $3,336,000
OJ Zone $3,388,400 1 .6 % $52,400 $32,609
Store $3,878,200 16.3% $542,200 $384,100
Constr. Store $3,582,400 7.4% $246,400 $295,013
cluster $3,623,400 8 .6 % $287,400 $130,500
Table A.1 2 . Welfare Implications of Pricing Policies
400 - ■ ■ *■ ■ ■ - -- ‘ ■ ‘
0 to 20 30 40 50 90 70 0 0 9 0
nor*
Figure A.3. Consumer Welfare Gains and Losses with Zone-Pricing

(Laundry Detergent)
151
600 (-
«* -200 r
-*00 -
-600 r
60
Figure A.4. Consumer Welfare Gains and Losses with Store-Pricing

(Laundry Detergent)
152
10000
5000 r
«•
•5000 L-
30
Figure A.5. Consumer Welfare Gains and Losses with Zone-Pricing

(Refrigerated Orange Juice)
153
10000
5000
w»
•5 0 0 0
40
Figure A.6 . Consumer Welfare Gains and Losses with Store-Fricing

(Refrigerated Orange Juice)
154
p a ra m s .e . t-s ta t
h o lid a y - 0 .3 8 0 .0 9 -4 .0 9
d e m o g ra p h ic s in c o m e -1 .6 9 0 .3 6 - 4 .7 3
h v a lm e a n 0 .0 2 0 .0 0 8 .9 1
ag e6 0 -1 .1 1 0 .6 8 - 1 .6 3
e th n ic 0 .2 3 0 .4 6 0 .5 1
s h o p in d x 2 .0 9 0 .3 7 5 .6 2
je w e l 0 .3 1 0 .0 3 8 .9 0
e d lp - 0 .0 4 0 .0 1 - 4 .0 7
L og P ric e In d e x A n a lg e s ic s 1 .9 5 0 .3 3 5 .9 3
B a th so ap 0 .5 8 0 .1 3 4 .3 0
B eer - 5 .1 2 0 .7 9 - 6 .4 5
B o ttle d ju ic e s - 3 .5 7 0 .8 6 - 4 .1 3
D is h d e te rg e n t (liq ) 0 .4 8 0 .7 2 0 .6 6
C a n n e d e a tin g so u p s - 1 .8 7 0 .5 0 - 3 .7 6
F ro n t-e n d c a n d ie s 0 .5 0 0 .5 2 0 .9 7
F ro zen d in n e rs 1 .5 1 0 .3 9 3 .9 1
F ro z e n e n tre e s 1 .7 3 0 .3 4 5 .0 6
F ro z e n ju ic e s -0 .7 4 0 .3 4 -2 .1 4
F a b ric s o fte n e rs - 1 .2 4 0 .9 6 - 1 .2 9
G ro o m in g p ro d u c ts - 1 .1 5 0 .4 2 -2 .7 3
L a u n d ry d e te rg e n ts - 1 .1 0 0 .8 2 - 1 .3 4
N o n -s lic e d ch eeses 1 .5 0 0 .4 9 3 .0 5
D is h d e te g e n t (p o w d e r) -0 .9 2 0 .5 0 - 1 .8 2
C a n n e d s a lm o n , c ra b s , e tc 1 .0 6 0 .3 6 2 .9 8
O a tm e a l - 2 .8 3 0 .6 6 -4 .3 0
P a p e r to w e ls -3 .1 1 1 .2 4 - 2 .5 1
R e frig e ra te d ju ic e s -0 .2 0 0 .1 6 - 1 .2 1
S lic e d ch eeses 3 .0 9 0 .6 6 4 .7 0
S o ft d rin k s 2 .0 5 0 -6 4 3 .2 4
S h am p o o s 0 .7 0 0 .7 9 0 .8 8
S n ack c ra c k e rs 1 .6 5 0 .5 9 2 .8 1
S o ap s 1 .3 8 1 .3 9 0 .9 9
T o o th b ru s h e s - 4 .6 0 1 .0 9 -4 .2 2
C a n n e d tu n a - 0 .4 3 0 .2 6 -1 .6 4
T o o th p a s te s - 0 .8 3 0 .5 0 -1 .6 4
B a th ro o m tis s u e s - 3 .8 9 0 .8 5 -4 .5 9
c o n s ta n t 4 4 .1 4 5 .1 5 8 .5 7
o b s e rv a tio n s 1 4 8 6 .0 0
R -sq u a re 0 .3 7
Table A. 13. Store-Choice Regression based on share of market for

store trips
APPENDIX B
Tables and Figures for C hapter 4
155
156
Product Categories: Paper Towels, Detergent, Hair Care. Bath,

Dental, Diapers, Coffee, Fabric Softener, Peanut Butter
Retailer Type 1989/90 1998/99
Grocery 75.6% 54.5%
Mass Discounters 13.1% 26.9%
Price Clubs 3.5% 9.6%
Other 2.4% 2 .2 %
Table B .l. Changes in Market Share for Non-Perishable Categories
N um ber o f Stores
1990 2000 % Change
All Grocery Stores 145,000 127.980 -11.7%
Supermarkets ($2,000,000+) 30,750 31,830 3.5%
Chain Supermarkets 17,460 20,825 19.3%
Independent Supermarkets 13,290 11,005 -17.2%
Other Stores (Under $2,000,000) 58.250 37.310 -35.9%
Convenience Stores 56,000 58,000 3.6%
Table B.2. Consolidation in the Supermarket Industry
157
A verage A cross S to res: 1990 1996

D em o g rap h ic C h a ra c te ris tic s
% of Ethnic Population 15% 17%
Average Income 42,486 51,825
C o m p e titiv e C h a ra c te ristic s
Average Distance to Warehouse Store 5.96 1 .8 8
Distance to nearest Grocery Store 0.98 0.79
Distance to nearest Drug Store 0.76 0.64
% of stores Supercenter in trading area - 39%
S to re C h a ra c te ristic s
% of stores with a Pharmacy 28% 74%
% of stores with Video Rental 47% -
% of stores selling Beer/Alcohol 80% 92%

Table B.3. Demographic. Competitive and Store Characteristics
Prices and Margins over Time

Week 10 Week 200
Prices $ Margins % Prices $ Margins %
0.89 11.24 0.85 3.41
0.97 18.56 0.89 7.75
1.06 25.47 0.93 11.72
0.94 1 2 .6 6
0.95 13.58
0.99 17.07
1 17.9
1 .0 1 18.71
1 .0 2 19.5
1.04 21.05
1.05 2 1 .8
1.06 22.54
1 .1 25.36
1 .1 1 26.04
Table B.4. Increase in Price Zones Over Time
158
Stores with the highest price level for Bounty:

_____________ Distance in Miles to Closest Competitor_____________
Dominicks Grocery Stores Mass Discounters and Price Club
Store Jewel Cub Foods Walmart Target Kmart Sams Club
14 2.49 10.62 7.08 5.01 2.62 6.19
32 1.74 10.37 7.48 3.94 3.08 5.62
52 3.06 5.78 4.39 8.52 3.18 4.39
53 1.25 6 .2 0 13.07 1.54 1.53 2.34
95 0.55 4.77 7.47 4.67 2.39 7.63
Stores with the lowest price level for Bounty:
Distance in Miles to Closest Competitor
Dominicks Grocery Stores Mass Discounters and Price Club
Store Jewel Cub Foods Walmart Target Kmart Sams Club
59 2.50 0.24 0.39 10.26 0.14 0.47
70 0.87 0.36 0.36 4.58 0.36 0.40
77 1.36 10.59 0.38 0 .1 2 8.09 26.75
83 3.02 14.25 1 2 .2 2 1.76 0.04 0.41
Table B.5. Competitive Characteristics of the Highest and Lowest

Price Zones
Distance in Miles to Closest Competitor

Store Jewel Cub Foods Sams Club Walmart Target Kmart
Before - 71 5.11 9.42 23.31 5.43
After - 71 2.18 7.53 3.59 1.54 2.69 1.42
Before - 14 2.40 10.65 18.93 5.53

After - 14 1.40 10.30 6.45 7.07 5.00 2.27
Table B.6 . Distance to Nearest Competitor
159
B a th T issu e
Share Price/4 roll Margin Promotion
Angel 5.8% 1 .1 0 21.9% 36%
Cottenelle 19.8% 1.52 15.0% 36%
Charmin 26.7% 1.45 13.8% 21%
Dominick’s 6 .8 % 1.27 24.6% 17%
Northern 21.9% 1.26 16.1% 26%
Scott 12.9% 2.27 1 0 .6 % 25%
Green Forest 6 .1 % 0.90 25.2% 31%
P a p e r Towels
Share Price/roll Margin Promotion
Sparkle 4.1% 0.82 25.8% 35%
Mardi Gras 11.7% 0.75 25.6% 32%
Bounty 25.7% 1.13 13.8% 18%
Dominick's 16.8% 0 .6 6 28.5% 29%
Brawny 8 .1 % 1.04 20.4% 25%
Scott 20.9% 1.03 14.6% 30%
Viva 1 2 .6 % 1.09 15.6% 38%
R e frig e ra te d J u ic e
Share Price (64 oz.) Margin Promotion
Florida 7.0% 2.42 30.4% 41%
Minute Maid 21.7% 2.26 26.8% 36%
Dominick's 26.1% 1 .6 8 31.8% 43%
Tropicana 37.9% 2.45 26.2% 42%
Sunny D 7.3% 1.59 30.7% 26%
Table B.7. Descriptive Statistics
160
D ep en d en t Variable: Log W eekly C ategory S ales (1990-96)

P aper Towel B a th T issu e R efrigerated Ju ices
P aram eter E stim ate t-valu e E stim a te t-valu e E stim ate t-valu e
Holiday -0.014 -3.84 -0.144 -25.09 -0.019 -5.27
Price Index -0.998 -84.46 -0.677 -50.6 -1.024 -105.76
Pharmacy 0.072 14.72 0.124 16.31 0 .1 2 0 23.15
Wal-Mart -0.117 -21.74 -0.161 -19.09 -0 . 0 1 2 -2.35
Target -0.081 -11.24 -0.096 -13.62 0.003 0.65
K-mart -0.047 -10.34 -0 . 1 0 1 -8.97 0.031 4.37
Price Club -0.009 -2.04 -0 . 1 0 2 -15.51 -0 . 0 0 2 -0.51
R-square: . 6 6 R-square: .45 R-square .72
Note: Price ndex is log of share-weighted prices. Includes Store Fixed Effects
Table B.8 . Impact of Mass Discounters on Category Sales
JMOOO .
I
%
Figure B .l. Paper Towel Sales
161
P a p e r Tow els
Param Se
Sparkle -3.865 0.077
Mardi Gras -2.837 0.075
Bounty -0 . 8 6 8 0.083
Dominicks -3.005 0.070
B ra n d F E Brawny -2.653 0.081
Scott -1.478 0.081
Viva -1.846 0.081
Warehouse -0.116 0.004
C a te g o ry S h ifte rs Price Club 0.034 0.026
Holiday 0.008 0.009
Prom 0.600 0.029
M a rk e tin g M ix Price -2.575 0.130
Price Std. 0.549 0.127
Price* Prom -0.262 0.030
Price*Ethnicitv -0.566 0.017
Price*Wealth 0.117 0.015
P ric e In te ra c tio n s Price* Drug -0.003 0 . 0 0 2
Price*Groc 0.016 0.003
Price* Pclub -0.926 0.025
Price*WareSR -0.077 0.009
Price*WareLR 0.5346 0.009
Table B.9. Estimation Results: Paper Towels
162
B ath T issu e
Par am Se
Angel -3.971 0.025
Cottenelle -1.729 0.032
Charmin -1.343 0.028
B ra n d F E Dominick’s -2.982 0.025
Northern -1.938 0.025
Scott -0.985 0.040
Green Forest -3.633 0 . 0 2 1
Warehouse -0.059 0.005
C a te g o ry S h ifters Price Club -0.402 0.017
Holiday -0.026 0.009
Prom 0.576 0 . 0 2 1
Price Std. 0.335 0.080
Price* Prom -0.054 0.014
Price*Ethnicity -0 . 1 0 2 0 . 0 1 0
Price*Wealth -0.017 0 . 0 1 0
P ric e In te ra c tio n s Price*Drug -0 . 0 0 2 0 . 0 0 1
Price*Groc -0 . 0 0 1 0 . 0 0 2
Price*Pclub -0 . 2 0 2 0 . 0 1 1
Table B.10. Estimation Results: Bath Tissue
163
O range Ju ice
Par am Se
Florida -3.251 0.113
MM -2.091 0 . 1 1 2
B ra n d F E Dominick’s -2.477 0.106
Tropicana -1.276 0 . 1 1 2
Sunny D -3.693 0.104
Warehouse 0.055 0.005
C a te g o ry S h ifters Price Club 0.055 0.046
Holiday -0.033 0 . 0 1 0
Prom 0.167 0.049
Price Std. 0.387 0.061
Price*Prom 0.038 0.024
Price*Ethnicity -0.064 0.009
Price*Wealth 0.242 0.009
P ric e In te ra c tio n s Price*Drug 0 .0 0 0 0 .0 0 1
Price* G roc 0 .0 1 2 0 .0 0 1
Price* Pclub -0.716 0 . 0 2 2
Table B .ll. Estimation Results: Orange Juice
Paper Towels
Before (1991-92) Entry (1993-94) After (1995-96)
Number of new stores 8 34 6
Mean Price Sensitivity -2.34 -3.83 -1.44
Std. Price 0.42 0.61 0.13
Table B.12. Paper Towel Price Sensitivity: 3 periods
164
Margins
Actual Predicted
Before After Before After
Sparkle 27% 29% 30% 49%
Bounty 14% 14% 29% 46%
Brawny 23% 19% 28% 51%
Scott 14% 17% 31% 48%
Mardi Gras 24% 32% 31% 43%
Viva 17% 17% 30% 47%
Store 27% 28% 35% 41%
Table B.13 Margins for Paper Towels
Iw y c t of Phn ip i on Cyrtow f Count and P T o — I t a lii : Slora • t
9000
4900
4000
Fapar lawn 1:0 at rate

3500
3000
2900
2000
1900
1000
500
4 p ar. M m a * (COUNT) - * p ar A g.
Figure B.2. Impact of Adding Pharmacy Department
98
-3.6 -3.1 -2.6 -2.1 -1.6 - l.l -0.6
Figure B.3. Distribution of Price Sensitivity: Before
-18 -13 - 1.8 - 1.3 - 0.8
Figure B.4. Distribution of Price Sensitivity: After

Before (1991-92) Entry (1993-94) After (1995-96)
Par am se Par am se Param se
Sparkle -2.73 0.50 -3.51 0.09 -4.63 0.35
Mardi Gras -1.08 0.43 -2.62 0.07 -5.17 0.37
Bounty 1.15 0.24 -0.31 0.09 -1.56 0.08
Dominick's -2 . 0 2 0.34 -3.10 0 .1 0 -2.80 0.17
Brawnv -0.45 0.36 -3.26 0.15 -4.08 0.24
Scott 0.80 0.29 -0.99 0.06 -3.18 0 .2 2
Viva 0.37 0.24 -2.36 0 .1 1 -3.18 0.19
Price -2.34 0.08 -3.83 0 .1 1 -1.44 0.04
Prom 0.40 0.03 0.62 0.07 0.47 0 .0 2
Table B.14. Estimation Results: Paper Towel
166
1.15
1.1 PRCE14
1.05
1
0.95
0.9
0.85
0.8
0.75
0.7
1 31 61 91 121 151 181 211 241 271 301
Figure B.5. Transition of Store 71 to Lower Price Zone

Dim 1 se Dim 2 se
Sparkle -1.4874 0.5029 -0.6628 0.3614
Mardi Gras 0.4749 0.4911 -1.9966 0.3836
Bounty -0.1783 0.3341 -0.8375 0.2745
Dominick’s -0.0657 0.4703 -1.5105 0.3467
Brawny 0.1542 0.4392 -1.9689 0.2840
Scott 0.1901 0.3798 -1.562 0.2860
Viva -0.5734 0.3039 - -
le B.15. Latent Attributes for Paper Towels: Bef
Dim 1 se Dim 2 se
Sparkle 0.0612 0.3099 0.1747 0.408
Mardi Gras -0.6709 0.1751 -0.173 0.5125
Bounty 0.1376 0.2236 0.2495 0.2603
Dominick’s -0.8522 0.2928 -0.7322 0.3532
Brawny 0.9793 0.3119 0.9497 0.3015
Scott -0.007 0.2134 0.0035 0.3043
Viva -1.4518 0.0861 - -
Table B.16. Latent Attributes for Paper Towels: Entry-
167
Dim 1 se Dim 2 se
Sparkle -0.7489 0.3566 -0.74970.4463
Mardi Gras 0.9344 0.3551 -1.83980.2952
Bounty 0.3703 0.2578 -0.1662 0.2944
Dominick’s 0.7381 0.2849 -0.1605 0.3926
Brawny 0.7581 0.3025 -0.835 0.3228
Scott 0.2448 0.2807 -1.2556 0.2405
Viva 1.2625 0.2025 -
Table B.17. Latent Attributes for Paper Towels: After
APPENDIX C
T ables and Figures for C hapter 5
168
169
No card Employee card Card Member

Sales 12.4% 2 .0 % 85.6%
Transactions 36.0% 3.0% 61.0%
Basket size $8 . 0 $16.6 $33.5
Table C .l. Penetration of Frequent Shopper Card
Mean Std Dev Minimum Maximum

Dist. Store 3.44 5.27 0 .0 2 91.76
Dist. WM 4.55 5.16 0.18 91.38
Income 51.79 34.64 5 145
Children 0.36 0.76 0 5
Rental 0.24
Length of Residence 14.78 11.19 1 40
Table C.2. Summary Statistics: Distance to Stores and Demo-
graphic Variables
T e M a m S ta
700000
aoooool
(A 9 3
WMt
Figure C .l. Impact of Wal-Mart Entry on Store Sales
170
Focal Store Control Store

Sales Transactions Sales Transactions
Store -19.3% -28.9% -3.7% -3.9%
Grocery -16.8% -23.0% -4.0% -4.7%
Meat -13.0% -17.9% 0.5% - 6 .8 %
Produce -13.3% -18.7% -3.0% - 8 .0 %
GM -17.4% -26.1% -2 .0 % -8.3%
Deli -0.9% -3.9% 9.3% 9.0%
HBC -17.8% -21.9% -3.6% -8 .2 %
Pharmacy -52.2% -59.3% -3.7% 1.9%
CSD -14.8% -19.6% 4.9% 2.3%
BreadRolls -18.5% 16.8% -0.9% -2 .0 %
Milk -18.0% -2 2 .1 % -2 .0 % -8.5%
Cereal -17.9% -17.4% -6.4% -7.5%
Cheese - 2 1 .0 % -23.0% -9.7% -15.4%
Processed Meat -17.9% -21.3% -1.9% -9.1%
Salty Snacks -17.4% -15.0% -3.9% -7.2%
Beer -29.1% -33.6% 0 .8 % -3.0%
Coffee -26.4% -25.6% -23.0% -19.0%
Soup -17.5% -17.3% -8 .1 % -7.1%
Bot. Juice - 1 1 .0 % -14.3% 5.3% -0.5%
Cookies -17.5% -18.9% 3.8% - 1 .1 %
Rfj. Juice -3.9% -6.4% -4.6% - 6 .8 %
Bath tissue - 6 .8 % - 2 1 .6 % 8 .8 % -9.4%
Table C.3. Regression Results for Changes in Sales, Transactions.
and Sales per Transaction Following Wal-Mart Entry-
171
Col (a)_____________________ Col (b)

Defection Measure: No store visits in 3 months Reduced expenditure by 50% +
Defection = 13.1% Defection = 23.4%
Parameter Std Error Parameter Std Error
Intercept -1.383 0.136 -0.455 0.107
Income -0.009 0 .0 0 1 -0.008 0 .0 0 1
Child -0.006 0.058 0.061 0.043
Dist-store 0.139 0.030 0.103 0.025
Dist-Wm -0.127 0.031 -0.090 0.025
Produce -1.855 0.746 -2.744 0.587
Meat -1 .1 0 1 0.533 -2.073 0.427
Basket Q l 0.817 0.073 0.645 0.058
Basket Q2 0.224 0.073 0.253 0.056
Basket Q3 -0.146 0.075 -0 . 1 1 2 0.057
Loyal Q l -0.928 0.088 -0.640 0.062
Loyal Q2 -0.254 0.075 -0.179 0.056
Loyal Q3 0.442 0.068 0.368 0.054
Table C.4. Model of Probability of Defection
Before Wal-Mart After Wal-Mart

Mean Std Mean Std
Monthly Expend. 160 105 131 110
Monthly Visits 4.2 2.7 3.5 2 .8
Basket Size 46 30 44 30
Table C.5. Change in Shopping Behavior Following Entry
Log(Monthly expd) Monthly Store visits Log( Basket size)

Param Std Param Std Param Std
Intercept 4.456 0.037 1.332 0.017 3.623 0.018
Prom Index 1.229 0.292 1 .1 0 0 0.135 -0.318 0.140
Wal-Mart -0.367 0.024 -0.323 0.014 -0.014 0.013
Wal-std 0.560 0.016 0 .2 0 2 0.006 0.171 0.005
Wal*DistStore -0.123 0.016 -0.086 0 . 0 1 0 0.017 0.009
Wal*DistWm 0.108 0.017 0.067 0 .0 1 0 -0.005 0.009
Table C.6 . Model to Determine Impact of Walmart on Purchase
Behaviour
172
hhl hh 2
Before After Before After
Monthly Expd 490 357 594 410
Monthly Visit 5.2 3.9 7.9 7.2
Basket Size 94 92 75 57
No. of Items in basket 58 56 67 39
Exp on dry Groc 290 210 361 198
Exp on fresh Food 117 81 119 134
% expd on dry Groc 59% 59% 61% 48%
%expd on fresh food 24% 23% 20% 33%
Table C.7. Comparison of Household Shopping Behavior
Before After
Brand Size Fat Share Price/unit Share Price/unit
Store 1 / 2 gallon Full T8% 1.302 7.0% 1.386
Store 1 / 2 gallon 2% 11.5% 1.287 9.7% 1.377
Store 1 / 2 gallon 1% 6.5% 1.272 5.8% 1.370
Store 1 / 2 gallon FF 7.7% 1.283 7.1% 1.368
Store Gallon Full 12.2 % 2.452 13.6% 2.493
Store Gallon 1% 11.0% 2.389 12.6% 2.424
Store Gallon 2% 19.7% 2.371 21 .8 % 2.428
Store Gallon FF 10.8% 2.398 12.2% 2.410
Crowley Gallon Full 3.7% 3.060 3.0% 3.026
Crowley Gallon 2% 3.6% 3.061 3.1% 3.033
Crowley Gallon 1% 2.7% 3.052 2 .0 % 3.000
Crowley Gallon FF 2.9% 3.049 2 .0% 3.011
Table C X Summary Statistics: Milk
173
Before After
Brand Size-Roll Share Price/roll Share Price/roll
Kleenex 4 4.6% 0.623 8.0% 0.651
Charmin 4 9.0% 0.636 9.9% 0.659
Charmin 12 4.7% 0.541 7.6% 0.600
Charmin 24 10.5% 0.262 5.7% 0.282
Store 1 4.3% 0.549 4.0% 0.619
Store 4 5.9% 0.490 5.2% 0.532
Store 12 2.2% 0.476 1.4% 0.497
Northern 4 6.2% 0.691 6.8% 0.691
Northern 12 6.0% 0.325 3.3% 0.325
Northern 24 5.2% 0.302 4.2% 0.288
Marcal 1 7.7% 0.586 7.6% 0.593
Scott 1 10.6% 0.655 6.6% 0.726
Scott 4 3.5% 0.698 3.4% 0.705
Scott 12 10.7% 0.623 19.1% 0.627
Scott 24 8.9% 0.593 7.2% 0.638
Table C.9. Summary Statistics: Bath Tissue
174
Before After
Size Share Price/lOOoz Share Price/lOOoz
Wisk 100 10.5% 6.00 5.5% 6.28
All 100 7.4% 5.03 7.7% 4.91
Pur ex 100 8.2% 4.66 8.2% 4.23
AH 100 5.3% 4.50 4.6% 4.37
Dynamo 100 4.5% 5.41 8.4% 5.39
Era 200 3.7% 4.92 4.4% 5.07
Era 100 12.7% 4.65 13.7% 5.14
Tide 100 18.5% 6.16 16.6% 6.28
Tide 200 6.3% 6.39 11.0% 6.36
Brtwtr 128 3.5% 2.12 3.3% 2.21
Pur ex 200 3.6% 3.08 3.6% 3.34
Tide 50 5.6% 6.98 5.2% 7.55
Brtwtr 50 1.4% 3.44 0.9% 3.73
Store 128 4.5% 2.56 3.5% 2.95
Store 64 1.9% 3.11 1.4% 3.11
Xtra 128 2.4% 2.32 1.9% 2.28
Table C.10. Summary Statistics: Laundry Detergent
Milk Price= Price/10 oz.

Parameter Standard Error
Price -21.11 0.61
Std-Price 16.67 3.70
Size (1 gallon) -0.56 0.04
Std-size 2.64 0.04
Fat-FF -0.29 0.09
Std-FF 6.08 0.10
Fat-1% 0.25 0.08
Std-1% 5.63 0.08
Fat-2% 1.72 0.05
Std-2% 4.23 0.06
PC 2.19 0.05
Std-PC 1.96 0.07
Table C.l] . Model Results: Milk
175
Covariance Correlation Matrix- Milk

Price Size FF 1% 2% Store
Price 2 77.7 4 -0.19 -0.05 -0.15 -0.23 0.12
Size -1 0 .9 4 6 .9 7 -0.04 0.01 0.00 -0.18
FF -6.76 -0.61 3 6 .9 6 0.71 0 .4 8 -0.07
1% -18.41 0.08 24.22 31.73 0.67 -0.06
2% -2 1.00 0.01 12.22 15.90 17.88 -0 . 0 4
Store 5.10 -0.91 -0.86 -0.61 -0.30 3.83
Table C.12. Covariance Correlation Matrix: Milk
Bath Price=:Price/Roll
Price -16.67 0.23
std-price 11.55 0.20
Single roll 1.62 0.08
std-single 4.50 0.09
12-Pk -2.84 0.07
std-12pk 3.59 0.07
24-Pk -5.39 0.18
std-24pk 4.54 0.17
Charmin -0.85 0.18
std-charmin 3.55 0.18
Store 1.10 0.07
std-store 5.72 0.07
Northern -1.13 0.15
std-north 3.38 0.13
Marcal 2.35 0.09
std-marcal 6.01 0.07
Scott 3.96 0.08
std-scott 6.26 0.08
Table C.13. Model Estimation Results: Bath Tissue
176
Covariance Correlation Matrix-Bath

Price Single roll 12-Pk 24-Pk Charmin PC Northern
Price 133.37 0.06 0.03 0.01 0.30 -0.08 0.28
Single roll 3.31 20.29 0 .4 2 0.45 -0.18 0.56 -0.07
12-Pk 1.18 6 .77 12.88 0.88 -0.10 0.46 -0.35
24-Pk 0.29 9.11 14.38 20 .6 0 -0.29 0.57 -0.17
Charmin 12.14 -2 .8 6 -1.24 -4 .7 4 12.63 -0.08 0.38
PC -5.52 14.53 9.38 14.80 -1.72 32 .6 9 0.16
Northern 11.05 -1.02 -4 .2 7 -2 .5 8 4.61 3.09 11.44
Mareal -1 4 .0 4 12.32 12.10 17.30 -2 .1 7 30 .0 8 1.80
Scott -1 9.65 14.35 13.75 18 .4 4 -3 .3 8 2 8 .5 6 0.36
Table C.14. Covariance Correlation Matrix: Bath Tissue
177
Laundry Price= P rice/100 oz.

Price -2.864 0.025
std-price 1.594 0.021
200 oz -3.562 0.071
std-200 2.210 0.071
50 oz 0.838 0.090
std-50 3.015 0.085
Wisk 10.901 0.094
std-wisk 8.225 0.105
All 8.477 0.079
std-all 5.892 0.079
Pur ex 6.090 0.079
std-purex 4.568 0.081
AH 5.919 0.109
std-ah 5.273 0.085
Dynamo 6.549 0.087
std-dyn 5.750 0.097
Era 8.804 0.081
srd-era 6.642 0.069
Tide 12.438 0.127
std-tide 8.759 0.129
Brtwtr -1.134 0.113
std-brtw 2.933 0.094
Xtra -0.922 0.122
std-xtra 3.486 0.091
Table C.15. Model Estimation Results: Laundry
178
Category Customer Type Median Mean % below population mean

Milk Defect -22.2 -22.51 53%
Milk Defect-visit store -28.03 -25.75 66%
Milk Maintained -20.36 -21.51 49%
Milk Hi Before-Hi After -17.13 -19.84 42%
Bath Defect -22.1 -19.6 69%
Bath Defect-visit store -22.9 -20.4 71%
Bath Maintained -16.38 -16.25 49%
Bath Hi Bef-Hi Aft -15.6 -15.8 46%
Laundry Defect -3.22 -3.11 59%
Laundrv Defect-visit store -3.47 -3.25 66%
Laundrv Maintained -2.88 -2.84 51%
Laundry Hi Bef-Hi Aft -2.26 -2.43 36%
Table C.16. Estimated Price Sensitivity, By Group
Milk Category
hhl hh2
No. of obs 45 57
% change in exp -29% -42%
Price -41.47 -30.16
Size 1.53 0.25
FF 2.43 -1.20
1% 6.46 -1.70
2% 4.12 1.74
Store 0.56 0.94
Table C.17. Household Comparison: Milk

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Consumer Behavior and Firm Strategies in a Changing Retail Environment

supercenters have encroached upon supermarket sales to pose a serious threat.

A concurrent trend in the supermarket industry, in part driven by growing com­

petition. is the movement towards developing customer databases. The impetus

demonstrate how the information contained in retailers databases can be used to

confronted with new competition.

research on supermarket competition has primarily focused on stores th at are iden­

supercenters. This thesis contributes to this emerging area by addressing how

a supermarket manager can use point-of-sales data to develop profitable pricing

exploit the information contained in its frequent shopper database to understand

and interact with their most valuable customers.

List of Tables vii

Chapter 2. The Grocery Retailing Industry 7

2.1. Evolution of the Industry 7

2.2. Alternative Retail Formats 8

2.3. Response by Supermarkets 11

Chapter 3. Cross-Sectional Variation in Demand 13

3.6. Impact of Zone Pricing 53

4.2. Conceptual Development 71

4.3. Demand Model 82

4.4. D ata Description 86

4.6. Conclusion 101

Chapter 5. Impact of Entry by Wal-Mart Supercenter 103

5.1. Introduction 103

5.2. Impact of Wal-Mart Entry 109

5.3. Category Demand 117

Chapter 6. Conclusion 128

Appendix A. Tables and Figures for Chapter 3 142

Tables and Figures for Chapter 4 155

Tables and Figures for Chapter 5 168

A .l Descriptive Statistics 143

A.3 Demographics measured as percent of population 143

A.4 Demographics and Competitive Variables by Zone 144

A.5 Demand for Laundry Detergent 145

A.6 Demand for Refrigerated Orange Juice 147

A.7 Marginal Effects of Store Characteristics on Category Size

(purchase prob.) 147

A.8 Latent Brand Factors 148

A.9 Minimum Distance Criterion 148

A. 10 Predicted Margins for Laundry Detergent 148

A. 11 Predicted Margins for Refrigerated Orange Juice 149

A. 12 Welfare Implications of Pricing Policies 149

A. 13 Store-Choice Regression based on share of market forstore

B.2 Consolidation in the Supermarket Industry 156

B.3 Demographic, Competitive and Store Characteristics 157

B.4 Increase in Price Zones Over Time 157

B.5 Competitive Characteristics of the Highest and LowestPrice

B.6 Distance to Nearest Competitor 158

B.7 Descriptive Statistics 159

B.8 Impact of Mass Discounters on Category Sales 160

B.9 Estimation Results: Paper Towels 161

B.10 Estimation Results: Bath Tissue 162

A concurrent trend in the supermarket industry, in part driven by growing com

research on supermarket competition has primarily focused on stores th at are iden

compete with supermarkets in specific high-volume categories such as paper prod

Another trend in the supermarket industry, in part driven by growing compe

line found in supermarkets. The conceptual framework models consumer hetero

category is treated as a strategic business unit and pricing, merchandising, promo