Testing Models of Strategic Behavior Characterized by Conditional Likelihoods

Marketing expenditures in the form of pricing, product development, promotion, and channel development are made to maximize profits. A challenge in evaluating the effectiveness of these expenditures is that decisions such as whether to lower prices or run promotions are made based on managers' knowledge of how sensitive consumers are to these marketing activities. Although marketing control variables are explanatory of sales, they are often set in anticipation of a market response, which reflects strategic behavior on the part of a firm. A challenge in developing a model of strategic behavior is that the process by which marketing expenditures are made is often not directly observable. We propose tests for comparing supply-side model formulations in which input variables are strategically determined. In these models, the joint likelihood of demand (y) and supply (x) can be factored into a conditional factor of demand given supply and into a marginal factor of supply. We illustrate our approach using data from a services company that operates in multiple geographic regions.