Hal Varian: Crazy Eddie's Low-Price Guarantee

Hal Varian discusses the economics of offers to “meet or beat any price.” Surprisingly, such offers may not enhance competition:

Rethinking Why Crazy Eddie Wouldn’t Be Undersold, and Other Mysteries, by Hal Varian, Economic Scene, NY Times: It is common to see advertisements that offer to “meet or beat any price.” The most natural interpretation of such offers is that they signal strongly competitive behavior.

But on further reflection, it’s not so obvious that price matching encourages competition; such offers can have exactly the opposite effect. To see how this can happen, consider the following story.

Suppose that two retailers, East Side Tires and West Side Tires, are advertising the same tire for $50. If East Side Tires cuts its advertised price to $45 while the West Side price stays at $50, we would expect that some of those customers on the west side of town would be willing to travel a few extra minutes to save the $5. ... If the increase in sales was large enough, its profits would rise. ...

But instead of the situation just described, suppose that West Side Tires continued to charge $50 but added a promise to match any lower price. What happens if East Side cuts its advertised price?

Now, those who find West Side Tires more convenient can just bring in the East Side ad and get the discounted price. Then, East Side Tires attracts no new customers from its price cut. In fact, it loses revenue since it sells essentially the same number of tires at a lower price.

So, a vendor that offers a low-price guarantee takes away much of its competitors’ motivation for cutting prices.

Economists have written dozens of papers on low-price guarantees in the last 20 years, exploring many variations on the basic model. ... These analyses are all very ingenious but you have to wonder if such considerations are really what drives those price-matching offers.

In an attempt to answer this question, three economists, Maria Arbatskaya, Morten Hviid and Greg Shaffer, have recently published a paper in the International Journal of Industrial Organization called, “On the Use of Low-Price Guarantees to Discourage Price Cutting,” that looks closely at some empirical evidence.

The authors collected data on tire prices advertised in 61 Sunday newspapers in the fall of 1996. ... The economists paired ads from competing sellers appearing on the same day in the same newspaper that were advertising the same make and model of tires. There were 143 pairs where one seller had a low-price guarantee while the other did not. ...

So what observations would be inconsistent with the theory that low-price guarantees are motivated by the desire to discourage price cutting?

If guarantees are being used to discourage price cutting, then two sellers with the same price will each want to offer a low-price guarantee.

Similarly, a high-price seller may want to offer a low-price guarantee but there is no reason for a low-price seller to do so. Hence instances where the low-price seller offers a low-price guarantee are inconsistent with the theory, while instances where sellers with the same or higher prices offer such guarantees are consistent.

When the economists look at those cases where sellers offer to match any price, advertised or not, they find that the low-price seller makes such an offer only 14 percent of the time. In other words, 86 percent of the data is consistent with the model. That’s good news for the theory.

But when they look at cases where a seller offers to match only advertised prices, they find that the low-price seller is making the offer in 75 percent of their sample. Hence only 25 percent of these cases are consistent with the theory.

Furthermore, instances of price-beating guarantees tend to be inconsistent with theory; it is relatively common for such offers to be made by the low-price seller.

So the evidence is mixed. The data is consistent with the simple theory for cases where sellers offer to match any price, but something else seems to be the motivation for price-beating guarantees and guarantees that apply only to advertised prices. Those pages of tire ads in your local paper still contain some economic mysteries.

Tires are easier to compare than mattresses. Mattress dealers often offer to meet or beat rival prices but try finding the same model somewhere else. I don't know this literature at all, but perhaps the guarantees are an attempt to signal the firms characteristics to buyers rather than an attempt to discourage rivals from cutting prices. From the sellers point of view, it also allows price discrimination. Instead of setting the lowest price possible, set a higher price and offer a guarantee to make it appear that your price cannot be beaten. The motivated buyers will seek out lower prices and demand their refund, others won't bother (but this doesn't explain the advertised/non-advertised price difference, it seems more likely that strategic behavior is behind this difference).

Comments

[crack]

You know, Crazy Eddie was a real person. In fact the former CFO of Crazy Eddie's has a website, http://whitecollarfraud.com/. He comments frequently on Jeff Matthew's 'Jeff Matthews is not making this up' blog. He is now an anti-white collar fraud crusader. Check out his site it has the whole Crazy Eddie story.

[Ken Houghton]

If I'm honestly willing to haggle, the last thing I'm going to do is advertise my rock-bottom (BATNA) price.

The "sport" in NYC is to look at the advertised price for, say, 6th Avenue Electronics, and go in and try to haggle 20% below the advert. If you're a good haggler, it usually works.

Only if you assume an advertised "lowest price" really equals the BATNA would you not want to distinguish between advertised and not-advertised (public v. private).

[Bernard Yomtov]

My bet is on signalling. The guarantee doesn't cost much if your price is already very low. So it's a way of convincing the customer that your price is low, and that it's OK to stop shopping and buy now.

[Tom Graff]

In the real world, most products are differentiated enough that low price guarantees are hard for consumers to enforce. Plus, a smaller retailer is not going to suppose he can influence the pricing strategy of a large number of competitors. So for example, an independent electronics retailer in an urban area would not figure his low price guarantee would ensure that the local Best Buy or Radio Shack or Wal Mart would not cut prices.

So even if the pervasiveness of low price grantees does indeed result in reduced price competition, I think its a biproduct of a strategic decision on the part of the retailer.

[yartrebo]

My understanding is that it's a marketing gimmick and nothing more. I've never seen anyone or heard of anyone actually taking a store up on its offer, and why would anyone bother when they can just go to the competitor that offered the lower price and not have any hassle or chance of the store reneging on their promise.

[tommywonk]

I once worked on a consulting project with a growing mattress retailer, who told me that mattress manufacturers created a variety of models with similar features but different names and cosmetic differences to make it difficult to compare features and prices. Different product lines with different names are sold through different channels, such as department stores, bedding stores, discounters etc. If models are all slightly different, it's harder to compare apples to apples.

[Stephen Spear]

Given that these guys are playing a repeated game, guaranteeing to meet a lower price looks to me like an attempt to signal a commitment to play tit-for-tat in the Bertrand price game.

[offo]

Why not the simplest of explanations? What if someone offering a low price guarantee believes that it's the lowest possible price to sell at, and still stay in business?

In the cited example, what is left unmentioned is that the market price of tires on both East and West sides are now $45, once the price matching is in effect. Isn't this how markets are supposed to work? Competition driving down margins? The normal price discovery process?

Or is it that the businesses which can survive selling tires at $45 wont do so because they can earn more by selling at $50? And they will collude to do that?

[Lord]

It may also be a case gathering market intelligence. Having actually used this once (I would have gone to the low price store but I had already purchased the item, so matching it rather than returning it made sense to both of us.), it is very difficult to find the same item with an advertised price. Many won't list prices or will list only a rather unique item.

[Alan]

I haven't looked into this issue in decades, but back then a sharp distinciton was drawn between "meet" and "beat." An offer to beat any other price seemed to have no natural stopping point.

says...

tommywonk - in buying a mattress it is up to the retailer to equal up the mattress from another retailer. There are lists but the retailers don't make copies for you. We just bought a mattress and we found you had to go to a store to do any research - there is not much published. FYI we bought a Steans and Foster level 4. Try mattress.blogs.pennlive.com for mattress info.

What retailers know that economists don't is consumers tend to buy in the last place they shop - so the reason to advertise to "match price" is to get people to not shop any more. Then the little extras and the rip-off warrantees are where real profits are made.

[Ken Houghton]

Alan - That's pretty much the conclusion of the paper as well.

[Sam E. Antar (former Crazy Eddie CFO & ex-felon)]

Professor Hal R. Varian:

My name is Sam E. Antar and as Eddie Antar’s cousin and CFO of Crazy Eddie I helped mastermind one of the largest securities frauds of the 1980’s. Much attention has been paid to Crazy Eddie’s famous price policy – “Shop around. Get the best prices you can find. Then go to Crazy Eddie's and he'll beat it!” Even more attention has been paid to its legendary commercials featuring Jerry Carroll.

However, many people do not know the real story behind Crazy Eddie’s aggressive sales tactics. Yes, we “offered” the best price and at times it was sometimes true. However, most customers never purchased the items that they initially came into Crazy Eddie to buy. We had an entire procedure built around Crazy Eddie lingo code words described below to maximize profits for the company.

We had in Crazy Eddie lingo called an “SW” or “switch the customer” policy which was to initially seek to sway the customer to purchase a more profitable item that offered “better value.”

If the initial sales person could not SW the customer he would “TO” the customer to let another more experienced sales person “take over” the sales pitch with the customer in order to “guide” them to the more profitable purchase.

If the customer was still insistent on buying the items that they had originally come into Crazy Eddie to purchase rather than lose the sale we would sell them the merchandise but try to sell them high profit accessories and long term warranty contracts to make up for the low profit of the units purchased.

If the merchandise was not in stock we would sneak the display item off the shelf and “lunch it” or repackage it and sell it as brand new.

Finally, if a customer decided not to purchase a product for any reason after going through various phases of this process Crazy Eddie has a “NAD” or “nail at door” policy where a sales person located at the exit would try to “kosher” the customer.

The Crazy Eddie Empire was built on deceit. The massive financial fraud that followed was based on a culture of deceit the permeated from the Antar family that ruled Crazy Eddie.

There are many lessons to be learned from the Crazy Eddie frauds. Specifically as it relates to your commentary I would suggest something I learned in my first day in economics class, “There Ain't No Such Thing As A Free Lunch.”

Company’s have costs and must earn a profit. Yes, some companies can make money more efficiently than others. However, as a former criminal I can assert that old line, “If it looks too good to be true, it is probably is.”

Respectfully,

Sam E. Antar (former Crazy Eddie CFO & ex-felon)