Steven M. Shugan and Ramarao Desiraju

Technological advances and other factors are rapidly changing the nature of products and cost structures. Such factors can impact product ingredients and cost components, having a sudden dramatic impact on the wholesale and retail prices of many variants within product lines such as computers, printers, digital cameras, cellular phones and kitchen electrics. Decreases in computer chip prices, for example, affect the prices of many products from cellular phones to alarm clocks; increases in wages impact most services from health care to banking; and, oil price shocks dramatically impact many products from automobiles to home insulation. These rapid changes can also lead to abrupt additions or deletions from a product line.

However, cost changes can have a disproportionate impact on only one end of the line (e.g., higher or lower quality variants) because quality differences are often caused by differences in components or ingredients. For example, increases in the price of diamonds might have a disproportionate impact on the higher quality variants of the jewelry lines (e.g., watches, earrings, necklaces, and bracelets) because, for such variants, a greater percentage of the cost comes from diamonds. Lower quality jewelry variants may contain few or no diamonds. Similarly, decreases in the prices of nickel cadmium batteries may have more impact on lower quality electronic devices (e.g., camcorders, CD players, cordless telephones, and home laptop computers) because higher quality devices use other types of batteries (e.g., manganese lithium). In yet other instances, cost changes are felt proportionally throughout the line. For instance, increases in alcohol taxes can have a proportional impact on the cost of liquor products. The cost of each wine bottle, for example, may increase by 10 percent.

One strategy for dealing with a cost change is to implement a corresponding price change; for example, wholesale cost increments (decrements) result in higher (lower) retail prices. Such strategies, however, may not consider the interactions among the variants of a retail product line. These interactions imply that in addition to considering the impact of a variant's price on that variant's profit, it is vital for the retailer to consider the impact of that price on the profits of other variants in the line.

Recent research suggests that these product line interactions may be more complex than previously believed. In many cases, products show a form of asymmetric demand relationship. Although lower quality brands are vulnerable to higher quality brand's price reductions, high-quality brands did not show this vulnerability. Research shows that many more consumers are inclined to switch up to higher quality brands than switch down to lower quality brands. Asymmetric line competition is now documented in both in-store experiments and household-level purchasing panel-data.

Whether product variants in a line exhibit asymmetric demand relationships or not, retailers must know how to adjust their prices in response to various types of cost shocks. Those adjustments must consider all product line interactions whether they are symmetric or not. Our paper answers three key questions necessary for a rapid response. First, when the costs of specific product components or ingredients change, how should retailers re-adjust the prices of the affected product lines? Second, what will be the impact on profit margins, the range of prices in the line and the average price in the line? Finally, if a product is removed, perhaps suddenly, from the line, how should the retailer adjust the other prices in the line?

We answer each of these three questions. The answers depend on the nature of the demand relationships between the variants in the line. For example, consider a simple product line with two variants. We find that when demand functions are linear and products display a symmetric demand relationship (i.e., changes in two variant's prices have the same impact on each other's demand), then changes in the cost of one variant has no impact on the optimal price of the other variant. However, when the demand function for a product line is linear and an asymmetric relationship exists, there is an inverse relationship between the cost of the lower quality variant and the optimal price of the higher quality variant.

In general, when the cost of a variant reflects its quality, there are more than two variants in the line and the line displays asymmetric demand relationships, we find the following implications to be true.

• When a variant's cost decreases, the prices of all lower-quality variants should be decreased.
• When a variant's cost decreases, the profit margins for lower-quality variants should be decreased.
• When a variant's cost decreases, the prices of all higher-quality variants should be increased.
• When a variant's cost decreases, the profit margins for higher-quality variants should be increased.
• When the cost of my variant (except the highest-quality variant) increases, the range of prices in the line should
  decrease.
• When removing a variant from the line, the lower quality variant prices should be increased.
• When removing a variant from the line, the higher quality variant prices should be decreased.
• When removing a variant from the line, the range of prices in the line should be decreased.

Beyond the implications for pricing strategies, these findings should impact other activities such as promotions and selling efforts because retailers often allocate more selling efforts to variants with increased margins. As the literature suggests. margins and price ranges impact a variety of marketing decisions including the allocation of marketing effort. Hence, by prescribing how margins should change, our analysis also prescribes how retailers should reallocate effort. Therefore, when declining costs have a disproportionate impact on low-quality products, retailer promotions should emphasize the entire line. However, when those cost declines have a disproportionate impact on the high-quality products, retailer promotions should shift emphasis to only the high-quality products.