In their paper, When to Push the Panic Button?, INSEAD professors ‘Paddy’ V. Padmanabhan and Pushan Dutt show that consumers engage in consumption smoothing both across and within product categories, and that expenditure share of durable goods falls during a crisis. Also, within durables they find that expenditure on automobiles decreases, whereas expenditure on bicycles increases.
Imagine you are the manager of the bicycle company. Assume that your marketing research staff have assessed your product’s price elasticity as minus1.5, the idea being that a drop in price of 1 per cent will result in an increase in sales of 1.5 per cent.
Suppose you decide that because of the crisis you will lower your prices by 2 per cent to make sure your bikes remain affordable. If things were normal, you would have expected such a move to potentially increase your sales by 3 per cent. Given the crisis, you probably don’t expect to see such an increase.
Imagine your surprise when you see sales gain by 5 per cent in response to your pricing change. Instinct would tell you the market has become a lot more price sensitive due to the crisis. Doing the numbers now would suggest that the price elasticity has gone to minus 2.5 from minus 1.5. But what is really happening is that consumers are shifting their expenditure across different types of durables and spending money that was earmarked for products such as automobiles or motor bikes, to bicycles.
The danger is that all bicycle manufacturers in the category will see a somewhat similar spurt. If they all follow the traditional modes of pricing analysis during a crisis, they will all draw the same conclusion – the market has become much more price sensitive. So what happens when managers believe that the market is more price sensitive? They all start becoming more aggressive in terms of their pricing and promotional strategies. The result is a price war.
The unfortunate reality is that bringing prices down further is not going to create an additional increase in sales. The fallacy in the analysis is that consumers are not becoming more price sensitive – they are just reallocating their wallet share across categories. The extra 2 per cent in bicycle sales is a consequence of consumption smoothing following a crisis and not increased price sensitivity.
Because prices are the easiest to change of the marketing mix variables, firms tend to react to a crisis by adjusting their prices immediately. Padmanabhan and Dutt say firms should be extremely wary in making pricing adjustments following a crisis. Firms need to pay attention to price elasticity. They need to pay attention to income elasticity. But, during a crisis firms need to pay critical attention to how consumers are smoothing their consumption and adjusting their wallet share. If they don’t, they are likely to draw the wrong inferences and make bad pricing decisions with ruinous consequences.