Supermarket toilet paper discounts are part of their long game to attract and retain customers

Yesterday, I wrote a post about the Great Toilet Paper Crisis, using game theory to explain why people are panic buying. However, consumers' behaviour isn't the only behaviour that seems a little strange at this time. Last week, when doing my weekly shopping, I walked past the toilet paper and there was a woman who was just putting her third package of toilet paper into her trolley. She saw me looking at her, and said "What? It's on special!". And you know what? She was right. Pak'n'Save was selling some toilet paper at a discount, at a time when it is in high demand due to panic buying.

On the surface, discounting an item when demand is high makes no sense. Basic demand theory from ECONS101 suggests that when demand is higher, prices should increase, not decrease. Over on The Visible Hand of Economics blog, Matt Nolan recounts a similar story to mine, and offers some suggestions to explain the unusual discounting behaviour of the supermarkets. I want to start by focusing on this potential explanation:

Supermarkets do not sell just one good. As a result, if a special on toilet paper – along with stacks and stacks of toilet paper from wall to wall in the store – will get people in the door, then that also ensures that people will buy OTHER goods and services from the supermarket.

In other words, toilet paper and other supermarket goods are complements, and the discounts and advertising of toilet paper is a way supermarkets can get you in the door to purchase these other goods.

This broad concept has a common name called the “Halo effect“. However, as that post notes this effect is quite unclear as it is the mix of two things, the complementarity of products due to their co-location, and brand spillovers.

In this instance it is just the former we are meaning. In fact there is a better term in this context, where the supermarket may be willing to sell toilet paper at a loss to get people in the door – a loss leader.

Because of the fear of COVID-19, people are trying to find something they can control to give themselves a sense of protection – in this case toilet paper purchases.

Seeing this, supermarkets recognise that people are especially responsive to toilet paper availability and prices and so use these sales to increase demand for their other – higher margin – products.

When I cover pricing strategy in ECONS101, one of the elements of that topic is considering circumstances where a firm is better off deviating from the short-run profit maximising price. One of those circumstances occurs when the firm sells multiple products, and can increase its total profit by selling one or more products at a loss - the so-called loss leader product.

An ideal loss leader product is one that will encourage a lot of extra customers to visit the store. That usually suggests a loss leader product is one that has relatively elastic demand (so that, when price is reduced, it attracts a lot more customers to the store). In a time of panic buying of toilet paper though, it isn't clear to me that demand is relatively elastic. In fact, it is likely that demand is relatively inelastic for goods like toilet paper, hand sanitiser, and other products that people are hoarding right now. People really want these products, and would be willing to pay a high premium to avoid missing out (so they are less sensitive to price - demand is relatively inelastic).

You could argue that, since toilet paper is in short supply, if a particular supermarket has toilet paper and other supermarkets don't, then that would attract customers to the supermarket with toilet paper. But, if that were the case, they wouldn't need the discount to attract customers - they could just post a big sign that says: "WE HAVE TOILET PAPER", and sell at full price (or more!).

So, if it's not loss leading, what are supermarkets doing? Another pricing tactic that firms use is to price low in order to foster a long-term relationship with their customers. Developing a reputation as being a 'fair player' in the market is an important part of that. In this instance, a supermarket doesn't want to be seen as taking advantage of their customers by jacking up the price of toilet paper. And, if raising the price makes the supermarket the 'bad guy', then perhaps they believe that lowering the price makes them the 'good guy': "Not only can customers continue to buy toilet paper from us, we're making it more affordable for them to do so".

Supermarkets are playing a long game here (yes, more game theory, like yesterday's post). Customers tend to be reasonably loyal to their preferred supermarket. If a simple tactic like discounting toilet paper when it is in short supply can encourage some customers to switch, and after switching they become loyal to the new supermarket, then the long-run profit gains may well outweigh any foregone potential profits on the toilet paper.

Of course, if one supermarket engages in this tactic, then it makes sense for all of them to do so. Otherwise, the supermarkets that don't follow suit face the risk of losing long-term customers. So, supermarkets start out discounting toilet paper to attract new customers away from their competitors, but end up discounting in order to retain their existing customers and stop them being lured away.

This is actually an example of a prisoners' dilemma game (see this post for another example). All supermarkets would be better off if they continued to charge full price (or more) for toilet paper, but it is in every supermarket's individual best interest to discount toilet paper to try and steal customers away from the others (or to retain their existing customers, if other supermarkets are discounting). And so, we end up in a situation where the supermarkets are selling toilet paper at a discount, even as the shelves are being left bare.

This is not loss leading, at least not in the normal sense. But it is long-run profit maximising behaviour by the supermarkets.