The Price is Right... Or Not

It took three years to convince the journal Marketing Science to accept a paper Amit Pazgal, Professor of Marketing, wrote with Ganesh Iyer at HAAS School of Business, UC Berkely.

By Weezie Mackey

“They didn’t believe our conclusions,” Pazgal said. “We had to gather more data for six months. But when it came out, there was a lot of interest because people were starting to analyze buying online. It was one of the first theoretical models that had the support in reality.”

As with all Pazgal’s research, one of his well-cited papers, ‘Internet Shopping Agents: Virtual Colocation and Competition,’ reflected the firm’s perspective. Back in 2003, it found that firms using an Internet shopping agent — a website that allows a consumer to compare prices between stores — varied their prices substantially for any given search of identical goods … even though common sense might dictate that competition would lead to uniform prices and maybe even a drop in price to stay competitive.

The research problems he was interested in at the time posed two questions: 1) How does the firm decide which of those shopping agent sites to join if at all, or should it join several; and 2) How does the firm price, given the fact that some customers are searching for the lowest price and others come to the website directly because they are store loyal?

The research began where it typically does for Professor Pazgal. “From looking at the world,” he said. “For instance, I used a shopping agent online and thought this is a new world, things are changing. What would that mean for firms? Are firms changing with it or not?”

No one was researching Internet shopping deeply at the time. “We said, let’s see what happens. We followed it for a while and saw prices change a lot. Why do prices change a lot? Let’s say everybody in the world compared prices and went for the cheapest; if everyone knows that my price is set, then it’s very easy for my competitor to undercut me by five cents, and they will be above me on the list, and everyone will buy from them. What do I do? I keep changing the price because I don’t want them to be able to anticipate what it will be. That’s fine. Now, can you quantify it? Can you come up with a mathematical model that actually predicts that?”

The answer was yes, and they did.

Standing firm on firms

Recently appointed academic director of operations management, Pazgal joined the Jones School in 2006 after nine years at Olin School of Business at Washington University in St. Louis. With a B.S. in physics and mathematics, magna cum laude, an M.S. in mathematics and operations research, summa cum laude — both from Tel Aviv University — and a Ph.D. from Kellogg at Northwestern, he could’ve taught math. “I look at problems that are slightly more mathematically challenging. I want real-life problems that are not solved immediately by intuition.”

He considers himself somewhat unique in marketing. “I have a diverse background, and I care about different problems. Along with marketing, I do a lot of research which is considered economics and a lot of research which is considered operations.” Some of what Pazgal researches involves the Internet, some is retailing or even commitment mechanisms. “But all of my research has to do with pricing. I’m intrigued by all aspects of pricing. I’m interested in understanding real institutions and in twists that show that our everyday intuition fails to explain common firm strategies.”

On the first day of class, he asks his students: ‘If you could choose any price in the world, what would be your best price?’ And he almost always gets the same answer. “They say zero … like, free. I tell them that’s because you’re thinking like consumers. And it shows people that we tend to think as consumers even though we’re managers and executives now. What’s good for you as a consumer is not always good for the firm.”

When Pazgal talks about pricing, it’s about how firms price. “Marketing has another area that studies how consumers perceive prices. I take that as a given. For me the consumers are taken as a black box. They behave in a certain predictable way, and I’m the firm, which is a rational, profit-maximizing entity that tries to get as much money out of the consumer as possible.” In 2003, when the Internet shopping agent research was published, companies found Professor Pazgal and wanted to know more. “So I gave a talk to some of them. They liked to see that someone was thinking about their problems, but it showed me that they’re interested in minute implementations, and I’m interested in ideas.”

Strategic consumers

Although Pazgal explored firms’ perspectives and considered consumers black boxes, he made one consistent assumption about consumers over the years. “They are sophisticated.” He illustrated their impact in a paper published in 2008, ‘Optimal Pricing of Seasonal Products in the Presence of Forward- Looking Consumers.’ The research discussed pricing strategies of retailers in brick and mortar stores, and how forwardlooking customers changed the environment completely.

It was the lead article in Manufacturing & Service Operations Management, an operations journal. “This stream of research has to do with pricing and selling of limited inventory items, and how a retailer can make the most profit from it. Operations management literature talks a lot about inventory. That’s what they care about — inventory and replenishment of inventory. But we care about prices.”

Despite being relatively new, the paper he published with a former colleague at Olin, Yossi Aviv, was one of the first in the operations management literature to analyze the impact of strategic consumers. For this reason the paper, like the Internet shopping agents paper, was well cited. It was also a driver in the new literature stream analyzing consumer impact on sales practices.

Pazgal and Aviv looked at seasonal inventory, in this case bathing suits. “You’re trying to sell it until the end of the season, and the question is: what’s the optimal thing to do? It seems trivial. The retailers should have thought about it a long time ago. They did, but they didn’t always account for the fact that consumers know and anticipate that there will be discounts.”

As Pazgal said, consumers are not ignorant. “They know there will be a sale or that prices will drop. They’ve bought bathing suits in the past. If I come in a week, it will probably be cheaper. Maybe if I know there is a 4th of July sale for bathing suits, I’m going then. If it’s not there anymore, that’s okay.”

What happens to the inventory that doesn’t sell by the end of the season? It’s heavily discounted. Conventional wisdom might suggest that retailers should figure out that they will have excess inventory at the end of the season and buy less. “We say, no. They know that they will be left with a certain amount of product at the end of the season with some probability, but they need to have enough and then experiment with the really high prices at the beginning of the season. The benefit is huge if they get some people to buy at the $300 level, for example, before they drop it to $200. The retailer knows that at the end of the season they will be left with 20-30 items per store. They take it into account, and still they make more money than they would by not having those 20 or 30 items and starting at a lower price. The problem is it’s statistical. There’s some fluctuation with demand.”

Yield management

A firm’s goal is to sell their inventory by the end of the season. Do they tell their customers that there will be a discount of 40 percent on a certain date from the beginning or not? If they do, how will it change the customer’s behavior? What should the firm do? “Our research shows how you should price during the entire selling period, and you should pre-commit to a sale. But there is an area called yield management, which is on the border of marketing and operations. It talks about pricing of limited quantities that you have to get rid of, like airline tickets and rooms in hotels. Our research shows that retailers need to take into account the fact that their consumers are sophisticated and react to the pricing strategies they see.”

From the firm’s perspective, what would be the best price for seasonal items? “The best price would be the one that makes the most money. But what is that? They face potential consumers who care about prices and consumers who don’t and consumers who must have the item immediately and some who are happy to wait in order to save money.” Pazgal and Aviv wrote a simulation software that could tell retailers what their price should be at any given moment based on their initial inventory, sales so far and where they were in the selling season. “So literally you could change your price every hour. We told retailers: you should start with high prices and experiment a lot at the beginning. The retailers said no.”

Even when they explained their findings, the firms were reluctant to implement their strategy. “We told them they were pricing incorrectly. We told them the bottom line can be improved by three percent, which is huge for them, but they were afraid. We had talks to try it in a particular store and, as one of the managers bluntly told me, it’s my job on the line, not yours.”




A new way of looking at things

When a piece of research is nominated for any award, but more specifically a long-term impact award, what does it say about that research? In 2012, Pazgal’s Internet shopping agents paper was recognized nearly a decade after it was published. “There were hundreds of papers, and we were one of five nominated,” he said. “People were interested in what we were saying. We created a slightly new way of looking at things.”

That is the point. “Even today, people teach that paper in Ph.D. programs because, although it’s old in Internet time, the mathematical modeling still applies. It’s not an off-the-shelf type of model. It has a twist.”

In a recent ongoing research project, Pazgal and his co-authors, David Soberman from Toronto and Raphael Thomadsen from UCLA, investigate competitive environments where new entry or shrinking consumer markets are actually beneficial for the existing firms. “The common belief is that competition is bad for companies. I want to say, ‘not necessarily.’ Of course, there is the standard line that competition fosters innovation. That’s great. But I wanted to investigate and show cases where the entry of a competitor into your industry actually makes you better off without your having to come up with new products.”

In the Marketing Science paper ‘Profit Increasing Consumer Exit,’ they demonstrate the counterintuitive result that firms may benefit if a segment of indifferent consumers leaves the market. Profits can increase for all firms even if the exiting consumers have strong preferences for only one of the products in the market. The reverse — lower profits when markets grow — can also occur for similar reasons.

In a manuscript — ‘Location Choice and Profit-Increasing Entry’ — still under review with Management Science, Pazgal and the same co-authors show that a competitive entry of a new firm into the category may result in higher prices and even higher profits for all incumbent firms. The new entrant captures a certain part of the market, allowing the existing firms to concentrate on their more loyal consumers, the ones who prefer their products (similar intuition to the Internet case where more competition causes the firms to give up on the price sensitive shopper and concentrate on the more loyal consumers), charging them higher prices that may more than compensate for the loss of some market share.

Researchers don’t always know when they dive deep into a subject if it will come out with a twist or something counterintuitive that will change the way business is conducted. They don’t always know if something that takes years to publish is going to make any kind of lasting, significant impression. “My paper with Yossi [seasonal pricing] was very difficult to publish. We had a previous version circulating for a few years and nobody wanted it. But after it was published, it won the long-term impact and the pricing award … in operations.”

Showing the field — marketing, operations or any other — something it didn’t know before, illustrating a new way of thinking about a problem, opening up a new area of inquiry is no easy task. Amit Pazgal, his natural curiosity and open approach to scholarly topics, has contributed to the big ideas of academia and business practices in a way that earned him not only research and teaching awards but also stimulated a fresh conversation about research at the Jones School.

This article is from the Spring 2014 issue of Jones Journal