Always low prices. Always?

walmartIt is a beginning of teaching semester and this blog inevitably gets more active. One article caught my attention recently. It is related to my research, and as one can probably guess from the title, it’s about retail pricing. Particularly, Walmart and its everyday-low-prices (EDLP) policy. It turns out that Walmart’s (at least online) everyday-low-price policy becomes “everyday-adjusted-price” policy.

The article suggests that the reason for the Walmart’s pricing policy change is competition from Amazon.com. Citing the e-commerce data analytics firm 360pi, it reports that on 15% of the products, Walmart changed prices daily (very close to that percentage at Amazon.com). Furthermore, Walmart prices closely track those at Amazon.com generally staying within 5%.

Competition with Amazon.com may be one of the reason, but to me it seems it is not the only nor the main one. Retailers are in the business of converting goods into revenue, and dynamic pricing simply generates more revenue. The revenue lift is of course conditional on the fact that consumers keep buying at regular (high prices) and not just patiently waiting for bargains. This is where understanding how consumers decide whether to wait or buy becomes important.

Two recent research papers speak directly to this point. One, by my colleagues, shows that human behavior provides rationale for markdown or dynamic pricing over EDLP pricing.  The other, by me and co-authors, shows that markdowns can be set even larger than the current methods prescribe, leading to substantial revenue gains. From that perspective, Walmart is doing exactly the right thing by adopting the dynamic price policy.

Is Amazon.com cashing on consumer behavior?

I am very much tempted to answer – YES. The genesis of this post is the recent report by NPR’s Stacey Vanek Smith; the case under consideration is Amazon.com potentially raising the cost of its Prime membership from $79 to $99 per year or more.

Prime membership gives consumers free shipping on their orders and free access to numerous books, movies, and TV shows. The volume of Prime subscribers is estimated to be well over 10 million and growing rapidly. Could it be that Amazon.com has decided to curtail the growth of membership? This could be sensible if Amazon has reached capacity limitation for shipping or content streaming. Neither seems likely, though. So what is the logic behind the (possible) decision?

The report offers this explanation:

But the rationale for raising prices, may not be fast cash, speculates Michael Levin, co-founder of Consumer Intelligence Research Partners in Chicago.

“At Amazon, nothing is ever what it seems,” he laughs. “If they charge more, I think customers are probably going to spend more. So quite ironically, by raising the price of this membership, they may end up getting people to shop there even more.”

A more expensive Prime membership equals a customer who is all the more motivated to get his or her free-shipping’s worth.

Having done some research on the topic of consumer behavior, my explanation for this phenomenon is the so called Sunk Cost effect. This is a well-known phenomenon in Behavioral Economics. In simple terms, the effect occurs when consumers continue to use products that have become obsolete. Moreover, the usage increases if consumers spent more money to purchase these products. As such, this behavior is irrational in the classical economic rationality sense: a decision to use a product should depend only on the current or future cost and benefit, but not on a past one.

So by raising prices of the Prime membership, Amazon.com could be just targeting our irrational tendency to recover sunk costs. Even if there is an identical product couple of dollars cheaper, Prime members would still buy from Amazon, driven by the (sunk) cost of membership.