Why do supermarkets cut the price of medicine when people are getting ill?
Posted May 4, 2008on:
When I was at the supermarket I grabbed some Nurofen for my partner who has a head cold. I seemed to be in luck when I was at the supermarket as there was a half-price special on Nurofen – how convenient.
Then I realised that almost everyone I knew had a cold, and most of these people were likely to take Nurofen so they could keep working through the cold. In this case the demand for Nurofen would increase, and the demand curve is likely to be inelastic at the previous price – as a result, why were they slashing the price of Nurofen?
Here are a couple of possible explanations:
- An increase in demand was anticipated – however it was smaller than expected,
- Store-to-store demand for Nurofen is relatively elastic, and the purchase of Nurofen acts as a complement to the purchase of other goods.
The first explanation was that an increase in demand was anticipated given the sudden change in weather as we head into Autumn. In this case the supply of Nurofen is highly fixed in the short run (can only sell what is in the store room and on the shelves), but the supply curve is perfectly elastic in the long run (assuming the unit cost of Nurofen is constant for the supermarket, but that it takes time to get this stock in).
As the supermarket expected an increase in demand, they increased their short run supply of Nurofen in order to accomodate this. However, doing so takes up stock space that could be used to hold other goods that they wish to sell. If demand did not increase by as much as they anticipated, there would be excess supply of Nurofen – and precious stock space would be wasted.
As a result, viewing that there was excess supply, the supermarket slashed prices to get rid of stock, to make room in their store-room for other items. This is the type of behaviour I experienced when I worked part-time at the Warehouse.
However, I am not convinced that this is what happened in the current case. For one, the special was on the coupon card – implying that all the firms stores are doing it. The incentive to clear stock is not as strong over an entire firm as it is over the limited resources of an individual store (as the unit storage costs are substantially lower at off-site storage areas).
Also, a lot of people have fallen ill – demand for Nurofen seems to be relatively elevated. This brings us to our next explanation.
Elasticity and complements
We assumed that demand for Nurofen was inelastic – just like demand for petrol is inelastic. However, just like in the case of petrol, if there are a number of sellers then the demand faced by an individual seller will be more elastic than market demand (as people can substitute between stores).
Now given this I could make the argument that “tacit collusion breaks down” during high demand periods – this is a cool explanation, and is consistent with the theory provided by Rotemberg-Saloner 1986. However, there is incredible debate about whether collusion breaks down during high demand or low demand periods – as both can be justified under different assumptions, which would require a post of its own to justify 🙂 .
Instead I am going to look at the relationship between Nurofen and other products the supermarket sells.
Supermarkets are high volume low margin businesses – ultimately, they want to get people in the door to buy things, as the marginal cost is low (given that some of the products act like sunk costs given the structure of contracts with managers in the businesses).
Furthermore, supermarkets sell a variety of products. People will often come in and buy a bunch of things from supermarkets, in order to minimise the transaction cost associated with going around and finding all these products themselves (the search cost). Supermarkets can then extract some surplus given this.
As a result, a supermarket may advertise a special on a product like Nurofen in order to get people in the door. Once they have people in the door, people are more likely to buy other products from the supermarket in order to avoid the transaction cost associated with buying products from other places around town (note that this transaction cost is rising as fuel prices rise!). This acts as a type of complementarity between the quantity of Nurofen sold and the demand for other products.
Given that we have experienced a large increase in demand for Nurofen, it may be in the supermarkets best interest to cut the price in order to ensure that more off this additional demand comes through their doors. Once customers are there – they will buy other products thereby increasing the profit of the supermarket.
This explanation seems consistent with the idea that may people are sick and want Nurofen and also the fact that this special is in place in all New World branches.
Supermarkets are filled with exciting economics – what great places!!