What’s the Right Price?

By Ted O’Callahan

Big box stores are national, with the same familiar branding and the same products everywhere. But the prices are different depending on whether you’re in Manhattan or Missoula. Why?

In some retail chains, the prices are set by the individual store. But Home Depot and Lowe’s, the two biggest home improvement chains in the country, use zone pricing; that is, they segment the country into a few regions and headquarters determines what stores in each zone charge. What does that mean for the prices we see on the shelves?

A new study co-authored by Kevin Williams, associate professor of economics at Yale SOM, shows that, from a consumer perspective, zone pricing benefits rural areas at the expense of urban areas. The study also shows that while theoretical models suggest pricing store by store or market by market could yield greater profits, the reality is more complicated. By painstakingly collecting empirical pricing evidence, the authors determined that the best approach depends on a number of factors, with competition being among the most important.

Read the study: “Zone Pricing in Retail Oligopoly”

Variations in pricing are both familiar and mysterious, Williams says. “We know when we go to the airport the food is expensive. We’re used to that. But if I buy a sheet of drywall, should it be the same price everywhere?”

Economists can’t offer a definitive answer to that question. The right price will depend on the specifics of the product, the consumer, the retailer’s organizational structure, and competition. And because firms have been reluctant to share actual pricing data, academic researchers have largely been stuck proposing theoretical models or using very small data sets.

Williams and his co-author, Brian Adams of the U.S. Bureau of Labor Statistics, wanted real-world evidence, even if it was for a narrow set of circumstances.

“Twenty years ago, this sort of research would have required driving around and recording prices on a piece of paper,” Williams said. “Now, at least with some firms, the information is on their website, so it’s just a matter of clicking many, many times.” They focused on drywall as an undifferentiated product which isn’t significantly impacted by online retailing, and scoured the Lowe’s and Home Depot websites in 2013 and 2014 until they had gathered 801,498 prices from nearly 4,000 store locations.

Lowe’s and Home Depot dominate the $130 billion home improvement segment. Home Depot operates 2,274 stores, the fourth largest retailer in the U.S. by revenue. Lowe’s, with 1,857 stores, is the eighth largest. The third ranking home-improvement retailer, Menards, has just 295 stores.

Both Lowe’s and Home Depot divide the country into zones encompassing multiple states and a variety of distinct markets; headquarters-based category product managers set prices for each zone. Williams and Adams wanted to understand how zone pricing impacts both consumers and the businesses themselves.

For those of us who buy drywall, the answer is, it depends on where you live. The authors write, “There are clear winners and losers of retail chains using zone pricing.” And the winners are those in rural areas, where a local Home Depot or Lowe’s isn’t likely to face as much competition. If local stores were setting prices on their own, isolated stores could raise prices without worrying that their customers would go elsewhere. But since the zones encompass both urban and rural areas—for example, one Home Depot zone includes cities like Salt Lake City, Utah, and Boise, Idaho, as well as small towns in Idaho, Nevada, and Wyoming—prices stay lower in rural stores.

In effect, the authors write, “[t]he existing pricing zones shield rural consumers from high prices at the expense of slightly higher prices in urban markets.”

What does zone pricing mean for the profitability of Home Depot and Lowe’s? Williams and Adams attempted to answered that question by looking a scenario where the two companies moved from zone pricing toward finer pricing as well as one where they set the same price at all stores.

Since rural stores tend to be the monopoly locations and Home Depot has more of them, the company would see 8.4 % higher profits if both chains moved from zone pricing to a finer-scale model, they found. Lowe’s is the opposite. With more stores in competitive areas, it would see a nearly 5% boost to profits if both chains moved toward coarser pricing.

So why doesn’t Home Depot set prices locally?

Looking broadly across retail, William said, “I think that firms are working on implementing finer pricing. It’s not clear to me that it will yield a lot of gains.” For one thing, there are practical challenges. “Firms face frictions when they make pricing decisions. It’s costly to figure out what the right price is. It’s costly to adjust prices on the shelf.”

Setting prices locally intensifies competition in markets where firms compete, reducing the potential firm benefits of finer pricing. The study found if a chain could implement finer pricing without the competitor responding, splitting up pricing zones yields sizeable profit gains. However, competitors would likely respond; if they did, this would reduce the profit gains by up to 80%.

So does the current approach, considering strategic theory and operational realities, lead to a “right” price?

“Well, from whose perspective? From the firm’s or the consumer’s perspective?” Williams asks. “From the firm’s perspective, the right price is the one that maximizes profits—and that price may be better for some consumers and less so for others.”