Implications of consumer loyalty for Price Dynamics when Price Adjustment is Costly

Abstract

We study the implications of consumer switching costs on prices when price adjustments are costly. We develop a dynamic pricing model in a multiproduct oligopoly setting, in which consumers exhibit inertia in their choices and firms face costly price adjustments. Motivated by the empirical observation that most retail price movements are changes between regular (high) and sale (low) price, we formulate the problem as a discrete dynamic game of incomplete information to guarantee equilibrium existence. We apply the model to the UK butter and margarine industry and estimate it using a rich scanner data set. We find that price adjustment costs are substantial and represent between 24-34\% of manufacturers' net margins. Our counterfactuals indicate that when price adjustments are costly the effects of consumer loyalty on prices are much more pronounced than in the alternative model where firms can adjust prices freely. This result suggests that if price adjustment costs are not factored in researchers may underestimate the effects of consumer switching costs on prices.