Discretionary pricing can lead to reduced revenue

Who knows a store’s local competitors and local customers better than the manager at the local store? You might expect these managers to have a better sense of how to price products to improve sales revenue locally. Gies College of Business professor Iris Wang examined this in a recent study and found that having this type of discretion does not necessarily lead to a store manager being able to increase sales revenue.

In the scenario that Wang and her coauthors examined in the paper, "Examining Behavioral Biases in Discretionary Pricing: Evidence from Field and Lab Experiments," pharmacy managers of a large Chinese chain were given the ability to adjust pricing on certain items in their store. Wang and her research team examined this situation to answer three research questions: (1) How do managers make pricing decisions under such discretionary pricing situations? What is the overall effectiveness of discretionary pricing on sales performance? (2) What are the behavioral mechanisms behind managers’ pricing decisions? (3) Is there any moderator that can alleviate any bias effect?

The pharmacy managers receive a portion of the revenue their store earned, so they are rightly incentivized to adjust product prices to maximize revenue. It turns out that when managers were able to use discretionary pricing, they often raised prices and also, often, ended up with reduced sales.

“Revenue is just price multiplied by demand,” said Wang, an assistant professor of business administration at Gies. “We have to either increase the price of the product or increase the demand of the product. We can’t really tell how the demand will change, so behavioral-wise we have a tendency to increase the price – because we can directly see how our margin is going to change. And we will probably overlook the extent of decreasing demand.”

Rather than increasing revenue, the action caused customers to go elsewhere, resulting in reduced sales revenue. However, there was a noticeable difference when the experience of the managers is taken into account.

“Granting pricing power to experienced managers did not result in significant sales or revenue losses, whereas it did for inexperienced ones, suggesting that experience levels mitigate behavioral issues in discretionary decisions,” Wang said.

In the paper, which was published in Production and Operations Management, Wang and her colleagues then conducted some lab experiments to see if they could determine why managers acted as they did. In particular they examined salience bias, the tendency to give more weight to what is most easily noticed and ignoring less obvious considerations. In the case of these pharmacy sales, they wanted to examine the extent to which sale price (which is most obvious) is emphasized when making discretionary decisions,  while product demand (something less obvious) may not be.

These lab experiments were not limited to the same company used for the field experiments, yet the results were similar. Participants still gravitated to increasing prices as a way increase profits, regardless of other considerations, and revenue in the model decreased.

“What we have observed in most trials in practice is that allowing human managers change prices or make decisions without any constraints almost always leads to worse outcomes,” said Wang.  

“The main purpose of this paper was to understand why salience bias happens in this pricing scenario and try to find ways to alleviate such biases in the human decisions so that we can still incorporate the human part into business decisions without just being impacted by the biases,” Wang said. “For all the managers, the price impact is very salient. Whenever you charge a price to a consumer, you directly know what is going to be the change in the product price, what is going to be the margin. But how the price change actually affects the demand is something that is less well known.”

Wang and her colleagues had some suggestions for companies interested in allowing discretionary pricing at their stores. Training is needed to enable managers to use such pricing strategy effectively, that is, to accurately account for possible, less obvious changes in demand and the effect on revenue. Firms should also work to incorporate additional pieces of information – particularly nearby competition – in a way that would prove useful for the store managers. Wang said, “If you are able to offer the manager some information – or at least just a label that indicates some item is a very price-sensitive product – you can help managers understand how changing the price will affect the performance.”