Price Commitments with Strategic Consumers: Why It Can Be Optimal to Discount More Frequently … Than Optimal

In many markets consumers incur search costs, and firms choose a long-run pricing strategy that determines how they respond to market conditions. A pricing strategy may involve commitments to take actions that do not optimize short-term revenue given the information the firm learns about demand. For example, as already suggested in the literature, the firm could commit to a single price no matter whether demand is strong or weak. We introduce a new strategy—charge a “high” price only if demand is indeed “high,” otherwise offer a discount. This strategy discounts more frequently than would maximize revenue conditional on demand. Nevertheless, the frequent discounts attract consumers. We show that (i) the discount-frequently strategy is optimal (whether capacity is adjustable or not), (ii) discount-frequently is often much better than other pricing strategies, especially if no price commitment is made, and (iii) “overbuying” capacity (e.g., inventory) to attract consumers (by signaling availability and the likelihood of discounts) is a poor strategy. Contrary to some recommendations in the literature to limit markdowns and to purchase ample capacity, our results provide support for a strategy that embraces frequent discounts and moderate capacity.