Why Markdown as a Pricing Modality?

Markdown as a pricing modality is ubiquitous in retail whereas everyday-low-price (EDLP) remains relatively rare (despite its several advantages, such as simplicity). Using a stylized model, we explore whether and why retailers can use either of these pricing modalities as an effective defense against a competitor entering the market with the alternative pricing modality to sell an identical product. Various studies have shown that consumers are strategic and heterogeneous in their valuation of a product. Consumers are also shown to be regret-prone and anticipation of regret affects their purchase decisions. They may experience availability regret when unable to purchase a product due to a stockout, and high-price regret when missing an opportunity to purchase the product at a low price. Considering such factors, consumers decide whether, when and from which retailer to purchase the product. In such a market environment, we find that the possible entry of a competitor should deter retailers from using the EDLP pricing modality, but not markdown. We also identify a new reason for the markdown retailer to ration stock (in addition to the reason of discouraging consumers to wait and attempt a purchase at the discounted price). In particular, we show that inventory rationing can be used to preclude a cutthroat competition and bankruptcy after the entry of an EDLP retailer. We also quantify how consumer regret affects both retailers’ decisions and resulting profits. In particular, because of competition, the EDLP retailer is indirectly affected by consumer regret and cannot simply disregard consumer regret. We show that high-price regret and availability regret have complementary effects on the markdown retailer’s rationing strategy and the EDLP retailer’s price decision. Finally, using a proprietary price data set from a large department store, we show that ignoring regret factors causes the markdown retailer to leave up to 20% of its profits on the table. In addition, in a competitive market, the markdown retailer rations too aggressively when regret is ignored, and as a result leaves some of the forgone profit to its competitor – the EDLP retailer. Retail industry is often characterized by its slim profit margins. In such an environment, aforementioned results also suggest that retailers should seriously consider investing in developing the capacity to estimate and quantify the role of regret in consumers’ purchase decisions.*