Effectiveness of Trade Promotions: Analyzing the determinants of retail pass through

Trade promotions are temporary price cuts that manufacturers offer retailers to encourage them to reduce retail prices. While trade promotion spending as a percentage of marketing budget has increased dramatically, the inefficiency of trade promotion represents the ‘number-one concern’ among manufacturers, as indicated by recent trade surveys. At the heart of this dissatisfaction lies manufacturers' concern regarding widespread retailer opportunism with low retail pass through. Our objective is to develop a simple game-theoretic framework to examine the strategic considerations that underlie a retailer's decision to pass through a trade deal. In particular, we are interested in answering the following questions: (i) What and how do product-market characteristics impact the extent of retail opportunism? (ii) How can the manufacturer alleviate the retail pass-through problem by strategically supplementing trade promotions with advertising trade deals directly to consumers? To address these issues, we consider a stylized channel with a single manufacturer who serves two customer segments through a single (focal) retailer. We implicitly capture the essence of retail competition by allowing customers to have an outside option: other retailers that customers might search if they deem the price at the focal retailers to be ‘too high’. Customers differ in their valuation for the manufacturer's product and in the costs they incur when searching for a better price at other retailers. While customers are unaware of the existence of a trade deal in any particular time period, through prior experience they know the frequency of such deals and, furthermore, they update their beliefs about the occurrence of a deal by observing the posted retail price. The retailer decides whether to pass through a deal or not, recognizing the impact of his pass-through policy on customers' search propensity, and hence, their willingness to pay. The main message of the paper is that in an environment where manufacturer offers trade promotions, a retailer may not have the incentive to pass a low wholesale price on to consumers because consumers do not have perfect information about ongoing trade promotions. When consumers observe a high price at the focal retailer and yet are not sure if a trade promotion is on, they may not look around for a low price. Therefore, the retailer can price opportunistically to gain a higher margin by not passing a low price to consumers. However, if the retailer never passes savings on, consumers can infer opportunistic pricing based on prior knowledge of trade promotion frequency and have a higher tendency to shop elsewhere, thus reducing sales volume. The retailer resolves the conflicting incentives by occasionally charging a low price when a trade promotion is on, while posting a high price on other occasions. We find that the extent of retail opportunism depends on product-market characteristics, such as the retailer's clientele and the heterogeneity in consumer search costs, as well as on the characteristics of the manufacturer's trade promotion policy, such as the frequency of trade promotion and the depth of discount offered. When the low-valuation consumers have search costs that make them exit the market when the focal retailer posts a high price, the manufacturer will intervene by advertising his trade promotion directly to consumers, thus performing a channel coordination function. We consider several extensions of the base model – explicit retail competition, differentiated retailers, and heterogeneity in consumers' knowledge about the frequency of trade deals – and show that our results still hold.