The past decade has witnessed the proliferation of dynamic pricing practice in various industries (see McGill and van Ryzin, 1999; Elmaghraby and Keskinocok, 2003). Facilitated by sophisticated information technologies such as Enterprise Resource Planning (ERP) systems and electronic tags, price changes are becoming easier. However, these changes are not costless. Indeed, two major types of price adjustment costs are identified in the economics literature: managerial costs and physical costs (or “menu costs” in the economics literature).
Managerial costs are directly related to “the time and attention required of managers to gather the relevant information and to make and implement decisions” (Bergen et al., 2003). Typically, these costs arise within a firm as a result of information gathering, decision making and communications. Physical costs are incurred for retailers such as Best Buy and Target through the labor costs that result from manually changing thousands of shelf prices within their stores. Other physical costs that firms such as 3M, Ericsson, and Bed Bath & Beyond experience are the costs associated with producing, printing, and distributing their price books or catalogs.
Many empirical studies have shown that both managerial costs and physical costs are significant in retailing and other industries (Rotemberg, 1982b; Levy et al., 1997; Slade, 1998; Aguirregabiria, 1999; Bergen et al., 2003; Zbaracki et al., 2004; Kano, 2006). In particular, Levy et al. (1997) and Slade (1998) find through empirical studies that physical costs play a crucial role in the price setting behavior of retail supermarkets. In a relatively recent study, Bergen et al. (2003) estimate the managerial costs incurred by firms when they change prices to be more than six times the magnitude of the physical costs. Indeed, as Bergen et al. (2003) further assert, the physical costs of changing prices have been reduced because of advances in information technology, whereas the managerial costs of doing so may have actually increased due to the added complexity of dealing with on-line and in-store pricing, the added data from customers buying through websites, and the additional knowledge and systems required to understand the e-business.
In addition to these empirical findings, a number of quantitative models for analyzing optimal pricing strategies have also been developed in the economics literature. With a fixed price adjustment cost and stochastic inflation, Sheshinski and Weiss (1977) show that (s, S)-type pricing policies are optimal for a continuous-time model with deterministic price dependent demand. Caplin and Spulber (1987) consider multiple firms that adopt an (s, S) pricing policy and show that the aggregate price of individual firms changes with money supply in the market over time and thus aggregate price stickiness disappears. See Sheshinski and Weiss (1993) and references therein for further discussion on costly price adjustment and (s, S) pricing policies.
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Integration of Inventory and Pricing Decisions with Costly Price Adjustments
