A Price Discrimination Model of Trade Promotions

Abstract

Critics have long faulted the wide-spread practice of trade promotions as wasteful. It has been estimated that this practice adds up to $100 billion worth of inventory to the distribution system. Yet the practice continues. In this paper, we propose a price-discrimination model of trade promotions. We show that in a distribution channel characterized by a dominant retailer, a manufacturer has incentives to price-discriminate between the dominant retailer and smaller independents. While offering all retailers the same pricing policy, price-discrimination can be implemented through trade promotions as trade promotions induce different inventory-ordering behaviors on the part of retailers. Differences in inventory holding costs have been shown to be an important determinant of consumer promotions. Our analysis suggests that differences in holding costs are also potentially an important driver for the use of trade promotions. The implications from our model explain a number of anecdotal and/or empirically observed puzzles about how trade promotions are practiced. For example, our analysis explains why chain stores welcome trade promotions but independents do not. Our analysis outlines implications for managing trade promotions.

Keywords: channels of distribution, channel power, trade promotion, forward-buying

JEL Classification: D24, D42, L11, L12, L23, L43, M11, M31