Demand inelasticity occurs when changes in price yield smaller changes in the quantity demanded; the demand curve is said to be very steep. Or, in Economics jargon, when the absolute value of the percentage change in price divided by the percentage change in quantity demanded is less than 1.0, the demand curve is said to be "inelastic." In layman's terms, demand is said to be unresponsive to price changes.
There are certain products that exhibit such a demand curve. Items for which there are no reasonably acceptable substitutes (especially in the short-run) are good examples, such as gasoline and milk. No matter what the price, people will continue to consume the product (perhaps in lesser amounts), until a substitute can be found.
Two other product categories have been shown to have fairly inelastic demand curves: tobacco and alcoholic beverages. Once a person becomes hooked on tobacco, it is hard to quit, so, regardless of price, the consumer will keep on buying. It is also easy to become physically, and more than likely socially, hooked on alcoholic beverages as well.
Knowledge of this inelasticity is useful for Marketers and legislators alike. The former can thus price their products so that profit can be maximized; the latter can tax these products so that tax revenues can be maximized. In other words, because the demand is so strong, supply does not even have to enter the equation, because consumers will likely continue buying. Price can be raised at will with little or no resistance.
Case in point: Each year during the summer, and again during the winter holidays, the price of gasoline takes a substantial jump. Industry spokespersons blame it on increased demand and dwindling supplies. But demand has little to do with it. The demand is seasonal, and very predictable. Americans take vacations in their cars during the summer, and often travel to visit family during the holidays. Given that these behaviors are unlikely to change, a price hike can be passed on to consumers, all to the benefit of the Marketer.
Gasoline and tobacco products have proven
to have highly inelastic demand curves, which has caused the government
to levy taxes on their sale. Consumers have not shown a high degree
of resistance to these artificially higher prices. How high would gasoline
prices have to go to cause you to alter your driving habits? How high
would cigarette prices have to go before users would curtail their consumption?
But what about the government? They see products with inelastic demand curves as prime candididates for taxation. For example, of the price of a gallon of gas, over 40 cents is accounted for by federal, state, and local taxes. Furthermore, about one-half of the price of a pack of cigarettes is also taxes.
While little can be done about the ability of the government to impact the price of products via taxation, it is of vital importance for Marketers to have an intimate understanding of the demand curve for their products. Although one may argue that a Marketer that raises prices simply because the demand curve allows it is being unethical, it has done nothing illegal (in most cases). Of course, it should be remembered that, in so doing, the Marketer may be inviting competition from emerging substitute product markets, as well as public scrutiny. It may not be worth violating the public trust just because the opportunity exists to raise prices.
Issue #7: Discriminatory Pricing
While discrimination seldom if ever occurs for consumers, it is still a common phenomenon in the trade. Although the Robinson-Patman Act of 1936 sought to control for discriminatory pricing practices at both the consumer and trade levels, it was only successful in the former.
The RP Act essentially made it illegal to offer preferential pricing to different customers. The identical price offering had to be made to all customers, be they consumers or the trade. While it would be difficult to ever discriminate to end consumers today, it is still very possible to discriminate to the trade.
This "discrimination" is very legal, and it achieves the goal of being able to reward certain accounts with better pricing. For example:
- Quantity discounts are set at very high levels so that only the biggest customers could ever afford to buy, thereby blocking the smaller customers from the discounts.
- Credit terms are "sweetened" as volume increases, progressing from C.O.D. or net 30, to 2/10 net 30, 3/15 net 45, and sometimes even 4/60 net 120. Again, the smaller clients will never be able to take advantage of these terms.
- Freight charges are often changed from FOB origin to FOB destination, meaning that, with large quantity purchases, the shipper pays for the freight. Once more, only the larger customers will receive this benefit.
The RP Act also sought to control for predatory pricing, which is the act of pricing at artificially low levels (i.e., at a loss) in order to effect a change in the competitive arena such that others are forced out of business.
Historically, proving intent to put others out of business has been difficult. But, Wal-Mart was taken to task (at least for a while) in 1993. An Arkansas judge ruled that Wal-Mart was guilty of trying to run a handful of small-town drug stores out of business by selling merchandise below cost. The court ordered Wal-Mart to stop selling drugs and personal care items below cost, and to pay nearly $300,000 in damages to the plaintiffs. Wal-Mart appealed, however, and the Arkansas Supreme Court overturned the original decision.
Wal-Mart was able to show that competitors had not been harmed, and that the overall market condition in Conway (where the suit was filed) had actually improved since Wal-Mart opened its store there. Furthermore, the Arkansas Supreme Court showed prudence in examining the overall impact of Wal-Mart, rather than examining one product category and the effect on one or a few competitors. As things turned out, Wal-Mart's effect on the total economy was far from negative.
Supporters of the RP Act contend that predatory pricing will lead to monopoly power and exhorbitant prices, while critics argue that this is merely a myth. These critics say that it is entirely irrational for a firm to engage in long-term predatory pricing, because no one can continue to operate at a loss indefinitely.
Conspiracy theorists and protectionist members of Congress are likely to fall for the notion of predatory pricing, for it shores up their phobias of international takeover of vital domestic industries, as well as becomes a politically popular move during election season. The reality, though, is that large companies are no more equipped to endure a long-term price war than anyone else is; their losses will be much larger than those of the smaller competitors, and these cannot be absorbed forever.
Truth be known, much fear about predatory pricing is really an over-reaction to a company offering temporary low prices (maybe even below cost) for selected items or categories, and not the entire product mix. This is merely a short-term promotion and a shrewed business move, not predation.
Vertical competition occurs whenever a firm at one level in the channel of distribution is forced to compete with a firm at another level in the channel of distribution, for the same customers. This can occur in the following ways:
- A manufacturer that sells through wholesalers begins selling directly to retailers, thus forcing the wholesaler to compete with the manufacturer for the same retail accounts.
- A manufacturer begins selling directly to end consumers, forcing retailers to compete with the manufacturer for the same customers. This occurs when manufacturers establish their own mail-order operations (on top of traditional channel arrangements), as well as when manufacturers open outlet stores (as in the popular outlet malls gracing America's freeways).
As in most marketing channel disputes, power is the determining factor in conflict resolution. "He who has the power, wins," is the best way to summarize the nature of these channel relationships. If the manufacturer has more power than the distributors, then there is little that middlemen can do aside from refusing to carry the manufacturer's product. If the manufacturer's product is a big seller, then the middleman may have no choice but to continue carrying the item.
Many manufacturers have tried to enact a compromise of sorts, by not locating outlet malls near other retail outlets. Thus, it is not surprising to find outlet malls built in out-of-the way locations, along lonely stretches of interstate highway (e.g., Stroud, OK, Castle Rock, CO, Cabazon, CA), far from traditional shopping malls where retailers carry the same brands at full retail price.
Consumers have taken kindly to the outlet malls, though, often delaying purchases of some items (e.g., clothing) until they will be near an outlet mall. Still, it is easy to understand the potential for conflict because of the outlet stores: if the outlet sells at less than retail price, other retailers will complain of predatory pricing and unfair competition; if the outlet sells at full retail price, then other retailers will complain that the outlets have higher gross margins, which they will also find to be patently unfair.
But with over 300 outlet malls in the US (and the number is still growing), it seems that this practice is bound to continue for quite some time.
Issue #10: OEM vs. Wholesale Pricing
The OEM/Wholesale Dilemma occurs when a manufacturer simultaneously sells parts through traditional channels for the after-market, as well as sells parts to be used as components on new finished goods (the companies who buy component parts like this are called OEMs, which stands for original equipment manufacturers).
The problem occurs when a manufacturer buys far more component parts than it could ever use, and then sells the surplus to retailers, like mail order houses. OEM prices are often 15-20-percent lower than wholesale prices that traditional retailers must pay. Thus, a large OEM will buy an enormous quantity at OEM quantity discounted prices, and then sell the surplus to mail order firms, who then pass on the enormous savings to consumers.
This practice only adds to the perceived problems with mail order firms. In addition to the cost advantages that mail order firms have (see above), this gives them the ability to buy a lot of merchandise at below-wholesale prices, which are not normally available to traditional retailers.
While this certainly give critics of mail order more to complain about, the practice is not likely to stop any time soon. Components companies are eager to have their parts spec'd on OEM products, and if it means unwittingly selling excess amounts to the OEMs, they'll do so. The ability to have your line spec'd for a production run of several hundred thousand units is well worth the risk of alienating traditional retailers.
Conclusions
As evidenced by the ten issues discussed in this lecture, price is a very critical variable in the Marketer's program, but is also the one that is most likely to raise the ire of other parties, be they consumers, the government, or the trade. In spite of the wisdom of not engaging in direct price competition, firms continue to ignore the benefits of non-price competition, and in fact contribute to much of the criticism that is levied at the field.