An estimated 60 percent of retail gasoline customers return to the same gas station to refuel, without comparison shopping, according to a recent study. Driven by factors such as habit, brand loyalty, switching costs, and search (which often leaves consumers unaware of cheaper options), these motorists represent the prevalence of “consumer inertia” in the retail gas market.
Consumer inertia is the tendency of some customers to buy or continue buying a product, even when superior options exist. Companies that can accurately account for consumer inertia when setting prices and analyzing the effects of competition have an advantage within their markets, says Alexander J. MacKay, assistant professor of business administration at Harvard Business School, who coauthored the study Consumer Inertia and Market Power with Marc Remer, assistant professor of economics at Swarthmore College.
“If consumer inertia is a big deal in your market, it could be the case that you are not pricing appropriately,” MacKay says. “You may want to reduce prices to attract repeat customers down the line.”
Companies often internalize consumer inertia by setting pricing strategies that offer discounts to new customers. Both established firms and new market entrants frequently use introductory offers to accumulate customers and then raise prices later on, assuming customers will choose to stay over the cost of switching again.
This works on some customers, but not others.
“There are different types of customers,” MacKay says. ‘Shoppers’ are extremely sensitive to price and compare prices every time they go to buy gasoline, MacKay says. ‘Affiliated’ customers, by contrast, are more locked in to repeating a previous purchase and are much less price-sensitive. Shoppers are often more visible, but assuming that all customers are shoppers leads to overestimating their overall price sensitivity.
Big lessons from a simple product
In the context of retail gas, which many consumers view as a standardized product, a station’s location and amenities, in addition to price, influence a customer’s initial decision. But consumer inertia can keep motorists coming back to fuel up, despite more appealing offerings by competitors.
“Many people, including economists, are surprised by our result, which shows that when you account for consumer inertia, mergers lead to smaller price increases.”
Gas stations are rarely featured in business research, but they were the ideal study subject for MacKay and Remer.
“One reason for using retail gasoline was that if we can show that consumer inertia is important for a relatively simple product like retail gasoline, then you can infer that it’s going to be important for many types of products,” MacKay says. “It might be really important for more complicated products, or products that you purchase less frequently.”
Through its ability to affect purchasing decisions, consumer inertia can alter the effects of competition on price and cause unexpected shifts in market power dynamics, MacKay says. Market power, which is sometimes referred to as monopoly power, refers to the ability of a firm to charge a price above the level that would prevail under normal competition.
The researchers argue that a better understanding of the interplay between competition, which determines “horizontal market power,” and consumer inertia, which generates “dynamic market power,” creates a clearer picture of market power dynamics within a given market. This can inform companies in their use of price to attract customers, as well as assist regulators examining the potential effects of a proposed merger.
“After a certain point, as we increase dynamic market power, horizontal market power decreases. What that means is that the effect of competition on price falls,” MacKay explains. “An implication is that, for a merger in a market with really high consumer inertia, you might not expect prices to increase very much.”
Helpful for M&A analysis
As part of their study, MacKay and Remer used market-share data to develop a statistical model that would allow antitrust authorities to more quickly incorporate consumer inertia into their pre-merger analyses. What they found, in the retail gas markets they studied, was that accounting for increased consumer inertia led to an estimated 3.3 percent post-merger price increase, compared with the 5.9 percent increase predicted by a static model typically used by the Federal Trade Commission (FTC) and the U.S. Department of Justice.
This could be a useful tool for a company proposing a merger, or for antitrust authorities estimating merger effects. Presently, when antitrust authorities analyze the potential price effects of a proposed merger, consumer inertia is generally not included in the calculation. This, MacKay explains, is often because of compressed investigation timelines, as well as the commonly held belief that incorporating consumer inertia would lead to higher price increases post-merger–the opposite of what the research found.
“Many people, including economists, are surprised by our result, which shows that when you account for consumer inertia, mergers lead to smaller price increases,” MacKay says.
Although using the model MacKay and Remer developed could theoretically result in higher merger approval rates, MacKay says, the research findings could also prompt new discussions about enforcement, especially in light of growing concerns about market power in the United States.
“Are there steps we could take to mitigate dynamic market power? You might be concerned if you looked at a market and realized that, due to consumer inertia, firms are able to raise prices quite a bit, without any mergers to reduce competition.” MacKay says. “That’s not something the antitrust authorities typically engage with, but maybe that’s something that we should be concerned about.”
About the Author
Kristen Senz is a writer and social media creator for Harvard Business School Working Knowledge.
[Image: typhoonski]
Related Reading:
Deconstructing the Price Tag
Commodity Busters: Be a Price Maker, Not a Price Taker
Name Your Price. Really.
What do you think of this research?
Share your insights below.