Pricing of demand-related products: Can ignoring cross-category effect be a smart choice?

Abstract

This paper studies pricing strategies of competing retailers offering substitutable products in multiple product categories. For such retailers, in addition to accounting for within-category pricing effects, cross-category effects can also influence consumers’ purchase decisions and thereby impact the retailers’ optimal pricing strategies. We model consumers’ utility for purchasing substitutable products from the same category and from other categories as well. We then solve a game-theoretic model to identify the retailers’ optimal prices and profits. Our results show that accounting for cross-category effects largely influences the retailers’ pricing and profitability. In particular, cross-category effects influence the sensitivity of prices to within-category substitution levels. While cross-category effects have an impact on retailers’ equilibrium strategies, this effect is only relevant when within-category substitution effects are present. We also find that intentionally ignoring cross-category effects leads to lower prices for categories that are either substitutable or highly complementary, and to higher prices otherwise. When not accounting for the fact that the two categories are demand-related implies lower prices than when this information is accounted for, then at least one retailer chooses to disregard the cross-category effect at equilibrium. Finally, we find evidence for prisoner’s dilemma situations where both retailers ignore cross-category effect at equilibrium while accounting for it would yield them higher profits.