Pricing Behavior in Markets with State-Dependence in Demand

Marketing researchers have documented significant biases in estimated price elasticities from brand choice models that ignore state dependence effects. Yet empirical research on firm behavior has thus far ignored the effects of state dependence. In this paper we investigate the supply side consequences of ignoring state dependence using household-level data from the cereal category. Our key results are as follows: We find evidence of both positive (i.e. inertia) and negative (i.e. variety-seeking) state dependence in the cereal category. Ignoring state dependence in demand biases inferences about firm behavior. Specifically, we attribute the observed prices in the cereal category to tacit collusion between manufacturers, when in fact accounting for the effects of state dependence shows that competitive behavior is indeed non-cooperative. We find that firms are forward looking in that they incorporate the effect of their current prices on future profits. However, the relative "bang for the buck," in terms of improvements in prediction and fit, is much greater from modeling state dependence in demand than from modeling inter-temporal firm behavior on the supply side