A Structural Econometric Model of Dynamic Manufacturer Pricing: A Case Study of the Cola Market

Abstract

We study the pricing decisions of cola manufacturers. The cola market is characterized by demand dynamics that arise on account of consumers being inertial in their brand choices over time. Normative analytical models of oligopolistic pricing account for the fact that in such inertial markets, competing firms have, on the one hand, an incentive to price low in order to invest in building consumer demand for the future, but, on the other hand, an incentive to price high in order to harvest the reduced price-sensitivity of its existing inertial customers. In this study, we estimate a structural econometric model of oligopolistic pricing and, on that basis, explicitly disentangle the relative impacts of the two opposing, i.e., investing versus harvesting, incentives on the pricing decisions of cola manufacturers.

We find that the cola category is characterized by significant inertia in demand, with estimated brand-level switching costs of $0.30 and $0.13 for the two consumer segments. Ignoring the investing incentives in manufacturers’ dynamic pricing, leads to a sizable (~29% for Coke, ~40% for Pepsi) overestimation, while additionally ignoring the harvesting incentives leads to a smaller, but still sizeable, overestimation (~19% for both brands), in the estimated profit margins of cola brands. The net impact of the harvesting and investing incentives in our data is that the equilibrium prices of both brands are lower than those in the absence of inertia (by 4.6% and 3.1% of costs, for Coke and Pepsi, respectively). We find that each brand’s profit would decrease by 5% if it were to engage in myopic pricing when its competitor engages in dynamic pricing.

A counterfactual simulation reveals that increasing the discount factor from 0 to 1 initially increases, and eventually decreases, the profits of the two brands. Another counterfactual simulation reveals that each brand’s profits increase in its own discount factor and decrease in its competitor’s discount factor. A third counterfactual simulation reveals that profits of both brands increase with increasing levels of inertia, with the investing incentive dominating at low to moderate levels of inertia, and the harvesting incentive dominating at high levels of inertia.

Keywords: Dynamic Pricing, Cola Market, Inertia