Tuesday, November 20, 2007

Supply, Demand, and Holiday Sales

Economic theory suggests that as demand increases, sellers will be able to increase prices of scarce products. With an increase in demand, the new demand curve would intersect the supply curve at a higher equilibrium price. Why, then, do we actually see steep price discounts during the holiday shopping season when consumers are seeking to buy a large amount of goods?

        • Demand requires a willingness to pay in addition to an interest buying in the item. Therefore, it cannot be definitively concluded than an increase in demand has actually occurred.

        • There is high substitutability among many gift items. Although some shoppers are intent on buying a specific gift for an individual—such as a particular toy requested by a child—most consumers have considerably more leeway in choosing between numerous suitable gifts for an individual. A book, a DVD, or a T-shirt may all be suitable for an individual. Within each of these categories, there are a lot of choices—both among brands and retailers. The ready availability of substitutes decreases demand, resulting in a lower equilibrium price.

        • Increased elasticity among consumers during the holiday season will encourage retailers to discount. Retailers which offer low prices are likely to both attract more shoppers and sell more merchandise to each. This is especially the case in densely populated areas where traffic—and finding a parking space at the mall—may be difficult, thus making “one stop” shopping convenient. Consumers may choose to other, higher-margin merchandise while in the store when they come to find the “loss leader” items. For children who may receive multiple gifts, sales may especially encourage greater quantity purchases.

        • Retailers compete intensely among themselves. Each retailer competes not just with others selling the same brand and category, but with all who offer substitutes. Antitrust laws in the U.S. prevent retailers from getting together to “fix” prices. With the proliferation of discounters, everyone competes against the lowest price. Large discounters such as Wal-Mart and Target have considerable bargaining power due to the volume they purchase, so these can negotiate very low prices and, because of the high price elasticity among consumers, will find it optimal to pass much of the savings on to customers. Over the last two decades, a large number of “category killer” retail chains have emerged. Chains such as Circuit City, Best Buy, Staples, and Office Depot specialize in a limited assortment of goods. Within these categories, the “category killers” move large volumes, resulting in considerable bargaining power. In addition, many of these chains will make very large volume orders on items in targeted categories well in advance in return for exceptionally low prices. All these retailers must in turn compete against warehouse clubs such as Costco and Sam’s Club.

        • Since much of the merchandise ordered for the holiday season will lose considerable value after the holidays, it is important to “move” this merchandise before Christmas. Extreme examples of this involve ornaments and wrapping paper, but even categories such as jewelry are heavily affected since there will be few major gift occasions during the subsequent months.

        • Because of a tradition of heavy pre-Christmas discounting, retailers must try to “one-up” each other to stay competitive. Historically, there were few major before-Christmas sales. Back in the days when the retail environment was less competitive, the plan was to discount little before and then hold “after Christmas” sales as needed. However, in years with a sluggish economy, retailers often got nervous over the large amount of inventory remaining and, fearing that they would be stuck with merchandise, they concluded that sales would be the lesser of two-evils. In subsequent years, then, stores had to second guess each other, trying to discount before they did. Gradually, then, these sales became institutionalized, with consumers being reluctant to buy before discounts, spurring on the vicious cycle.

        A November 14, 2007, article in the Wall Street Journal suggested that discounts might be less extreme this year than they have been in recent years. Retail stores now have access to better price optimization software and are, in some cases, less dependent on the holiday season due to the growth of store brands. There may well be some modest “cooling off” this year for these reasons, but it is unlikely that discounting will decline dramatically. The retail environment is, if anything, getting more competitive. Further, with Thanksgiving falling on November 22 in 2007—the earliest it can fall in any year—many retailers may, ironically, be overly optimistic in their sales expectations and may, therefore, stock too aggressively. Although consumers have longer to shop, there is also a potential for much more merchandise to remain at critical points. Even if retailers, on the average, order the right amount, those which have over-ordered may have to discount heavily and, in return, spur on the competition. They “category killers” and discounters are here to stay, and their effects spill into the entire retail market.

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