How to give the best discount

Manel Baucells | Updated on January 15, 2018 Published on November 03, 2016

Discounts galore! (Photo used only for representational purpose)

Make markdowns large enough to attract new customers, yet just small enough so that they don’t wait too long

Will your customers buy an item immediately? Or hold out for a sale?

If they’re waiting, what can you do to spur a purchase?

My new research reveals that retailers can grow profits by cutting prices sooner and more deeply than conventional modelling suggests.

We can look at a model which I call dPTT (discount, probability and time trade-off) to account for how consumers’ buying habits are influenced by “psychological distance”, a measure of how sensitive a consumer is to delays and risks in product availability, whether perceived or real. In a series of experiments, this model helps understand that the optimal markdown using dPTT could be about twice the discount advocated by the standard markdown model (for example, 20 per cent instead of 10 per cent in their base cases situation). Further, because it better approximates the ways humans actually behave, dPTT has the potential to increase markdown revenue 20 to 25 per cent, and overall revenues by 1.5 per cent. A typical retailer operates with a net margin of 3 per cent, which means that each per cent of extra markdown revenues translates into major profit increases.

Effectively, every time a customer enters the store, he or she mentally ‘solves’ a buy-or-wait problem. The idea then is to set a markdown that is large enough to attract new customers, yet small enough to control strategic waiting.

Markdown mania

Given the prevalence of markdowns and the complexity in manging them, retailers are always looking for more effective strategies. According to the research, nearly one-third of items are sold at discounted prices, generating about 20 per cent of retail revenues.

In the past, retailers would slash prices — on average 50 per cent — hoping to attract new customers.

Price discounts were seen as a form to expand the market by selling to consumers that are not willing to pay the full price. But the cannibalisation effect — the loss of sales at full price — was difficult to calculate and often ignored. The implicit assumption here is that consumers were myopic, and would ignore the possibility of waiting and buy at a discounted price.

Of course, this backfired: Customers became accustomed to waiting for sales.

Researchers came up with a new model: Discount expected utility, or DEU, which advocated either an “everyday low price” strategy or very modest (e.g. 10 per cent) discounts. DEU has multiple strengths and is directionally correct. It holds under a broad set of circumstances, yields exact formulas for the price discounts, and predicts how many consumers will buy now and how many will wait. Its main weakness, however, is that it assumes consumers behave rationally at all times.

Rational, but not completely

In reality, consumers fall into a grey area. Actual consumers are not irrational, but they are not 100 per cent rational either. dPTT is, in essence, a modification of DEU that better approximates how individuals feel about time and risk trade-offs.

For instance, the DEU model assumes that consumers treat changes in time and availability in a consistent, linear way. For instance, under DEU, a one-week delay in getting a product is a consistent level of “penalty,” whether it is a new delay that takes away immediate availability, or an extension of an already existing wait.

In reality, the typical consumers will be reluctant to wait for one week instead of getting the product today, but may not mind waiting for four weeks instead of three.

Additionally, a customer is going to feel a risk more keenly in a product selling out when it was previously perceived as fully available than when the chances of getting it looked remote to begin with.

In summary, the buy-or-wait decision is a multidimensional trade-off and by factoring in how consumers weigh risks and delays, dPTT creates a pricing model that can be more credible and useful.

Manel Baucells is UVA’s Darden School of Business - Associate Professor of Business Administration

Published on November 03, 2016

A letter from the Editor

Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!


Support Quality Journalism
This article is closed for comments.
Please Email the Editor
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.