Unplanned Purchases and Retail Competition

I propose a framework in which consumers have biased beliefs about their future purchase probabilities, leading them to make unplanned purchases. Using this framework, I examine the phenomenon of below-cost pricing and the welfare effects of banning it. When the market is covered, a ban on below-cost pricing raises social surplus, although consumers need not gain—they are only guaranteed to benefit if the market is perfectly competitive. When the market is not covered, a ban always hurts at least some consumers. Also, there is a pro-competitive justification for the observation that larger firms sometimes charge below cost on the core product lines of smaller firms—consumer bias is crucial for this justification. Multi-product retailers sometimes sell certain products beneath cost, with the hope of attracting additional customers who will also buy other, higher-margin items. This practice, often referred to as “loss leading,” is controversial, with below-cost pricing having been banned in a number of countries, including Belgium, Germany, France, and Ireland, and in approximately half of all US states. Many US cities also have such prohibitions. In this article I examine the welfare consequences of prohibitions on below-cost pricing, in a market where multi-product retailers compete for boundedly rational consumers who practice one-stop shopping (that is, visit at most one store). When rivals are symmetric and the market is covered (so that all consumers shop), a ban on loss leading raises social surplus. But when the market is not covered, a ban presents a social welfare tradeoff: fewer consumers choose to shop, although those who do generate higher levels of social surplus. Perhaps surprisingly, for those consumers who shop both before and after a ban, a ban is guaranteed to make them better off if the market is perfectly competitive, but otherwise may harm them. Taken together, these results indicate that it is simplistic to argue that, by limiting the scope of competition, below-cost pricing bans must hurt consumers and society. But I also assess below-cost pricing laws in the presence of asymmetric competition, as when a “large” firm with a full product line competes against a “small” firm with a limited product line. In a number of markets including that for groceries, a serious concern of antitrust authorities is that larger firms often price below cost on the core product lines of smaller I thank Heski Bar-Isaac, Daniel Benjamin, David Gill, Michael Grubb, David Myatt, Ted O’Donoghue, Marco Ottaviani, Michele Polo, Manoj Thomas, and Michael Waldman for helpful comments, as well as seminar participants at the University of Bocconi and Cornell University. Samuel Curtis Johnson Graduate School of Management, Cornell University. Email: [email protected]. See the prepared testimony, “The Impact of Sales-Below-Cost Laws on the U.S. Retail Gasoline Market,” by Ronald N. Johnson, from February 1999. As of 1992, a total of 22 US States had general below-cost pricing laws. Some states without such general laws nonetheless had laws that specifically banned the practice for gasoline.