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Effects of inflation on consumer choice
cts of Inflation on Consumer Choice Yehoshua Liebermann and Meyer Ungar, Bar-llun University
Possible eflects of’s nonhomogeneous inflation on consumer choice among brads of energy-using durables are considered. For this purpose price d$erentials among braA are regarded as “investments,” while operating costs differentials are viewed os “returns.” Using a life-cyle-cost approach, it is shown how inflation may aflect consumers’ critical implkit rates of return and ultimately their brand choice. Empirical observations which support the theoretical results are provided.
Although in the last decade inflation has become a persistent and bothering problem to many industrialized states, very little is known about its microeffects, especially those Iwhich influence the behavior of the individual consumer. Indeed, economists have tried to understand how individuals form inflationary expectations in or&r to investigate the relationships between expected and actual rates of inflation [ 1,3,9, 10, 11, 171. However, it seems that not too many microaspects of inflation have been treated in the economics literature. A similar picture appears in marketing studies of inflation which mostly have a faint bearing to inflationary effects on consumer behavior [ 181. Inflation, Implicit Discount Rates, and Consumer Choice Consumer choices are based on their preferences which, among other things, are a function of product (or service) attributes. 6~. of many possible attributes consumers usually use a limited number to form their preferences [2:250] and in many instances relative price is one of the key attributes [ 121. In a period of high inflation, however, one may etxpect a strong variability in relative prices [6, 151 aurd ultimately in consumer choices. Sometimes, changes in consumer choice may be due to less explicit, though not less important, price effects. Quite often consumers buy products which apart from their purchase price require also incurring an operating cost over time. Examples of this type of products are * The authors thank Kent Monroe, the journal’s associate editor. and two anonymous referees for many valuable comments on a previous draft and Shlomo Lev for programming assistasce. Address correspondence to Yehoshua Lkbermann, Department of Economics. BarI&anUniversity, Ramat Gan, Israel. Journal of Business Research 11,379-388( 1983) @ Elsevier Science Publishing Co., Inc. 1983 52 Vanderbilr Ave.. New York, NY 10017
37’9 0 I38-2%3/83/$3 .OO
automobiles (which have to he maintained and fueled up) and electrical appliances (that are associated with electricity consumption). Under certain conditions, a consumer’s decision to choose a given brand of an electrical appliance can be considered as an investment. Suppose that the price of brand A is PA and the price of brand B is Ps, where PA > PB. Suppose further that the per period operating costs to the consumer of ‘both br&ds are CA and CB, respectively, so that CA < CD. Now, if the consumer opts for brand A his choice is comparable to an investment in the amount (PA- Ps). On this “investment’ ’ he enjoys a “return” of -C,) per Clearly, in respect, consumers’ reflect their individual discount The rate which consumers be indifferent brands A B (I=*) be derived equating the differential P, with the value of cost savings, shown in ( 1). N represents usage life both appliances: -PB
N CB - c* . = c t= 1 iI11+ Y(-J)f
If the individual’s r, is greater than r,, then brand B (with the lower purchase price but the higher operating costs) will be preferred to brand A f since under these conditions the consumer attaches less importance to future operating cost differentials than to the current “investment. ” Some estimates of such discount rates have been produced in two recent studies [5,7]. Whereas these estimates are static in that they describe a distribution of implicit discount rates at a given point in time, to the marketer it seems more interesting, and also more important, to check changes in the distribution over time. Keeping all other choice attributes constant, a producer or a seller may wonder why he loses sales or market share to cormpetitors whife still maintaining his previous absolute, and even relative, competitive edge. Such a situation can be the result of a change in the implicit discount rate. To illustrate, suppose that the general price level rises by a constant rate of p per period and that operating costs increase at a corresponding rate of y, where 7 > p. According to Fisher’s [4] law, the discount rate will be augmented by the general rate of inflation and the denominator will become ( 1 + r) (1 t p). At time zero, the real discount rate under inflationary conditions-which will be denoted by rf (instead of ro)--can be found by solving (2) for T,: PA -PB
=
zN ccl3-@‘(lCAMl + y)’
t=1
(1
+
+p)’
-*
(2)
381 Net
Present
Value
(of future cost sovings over inlti6l price
I
differential
w r (%I r>
(B
preferred
1to Atwhen, , r= p =O) A preferred f(r)
A
p ,o
i I I 18 preferred
to 6:
I /A
to A
I preferred
1
, to 8 (when’ , f>P,Ol
I
r
i%)
FIGURE 1. Effect of a Change in the Implicit Discount Rate on Consumer’s Choice.
Here all the future cost savings have been augmented by a factor of ( 1 + y), while the d iscount factors have been augmented by a factor of ( 1 + p), so that both sl‘des of the equations are couched in real terms. Obviously, if 7 > p then rj. > r (), as is also shown in the upper panel of Figure 1. If the distribution of prospective buyers’ real discount rates remains unchanged under inflationary conditions, then those buyers whose discount rate is between r. and r,. will now-as a result of the inflation-tend to prefer brand A to brand B more than before. The magnitude of this change is reflected in the shaded area in the lower panel of Figure 1. Thus, the differential inflation rate, which may be passed unnoticed by the seller, has a potentially considerable effect on his market performance. The question whether the potential effects of inflation will materialize depends mainly on two aspects of the actual behavior of consumers in the market. The first aspect, which is more general, regards the role of price differentials in determining consumers’ choices. The second, and more specific, aspect concerns the question whether operating cost differentials are regarded by consumers as relevant price information.
Yehoshua Liebermann
382
and MeJler Ungar
Referring to the first issue, Monroe [ 141 in his survey of buyer’s subjective prceptisns of price, concludes that we know very little about how price affects a buyer’s perception of alternative purchase oflea and how these perceptionsaffect his response.” 61
.
.
.
Nevertheless, most studies reviewed by Monroe, which render the inconclusive findings, have examined brands of relatively inexpensive daily consumption items. It seems reasonable to assume that in the case of heavy durables like refrigerators, price differentials0will become more important to the consumer, as they represent a higher fraction of his income. Ac$ually , this assumption is central to the economic information theory as formulated by Stigler [ 161. Further, under conditions of high inflation price changes of heavy durables (AP’) may be quite considerable. Thus, we may similarly assume that when m is compared with a nzference point as the initial price of the durable P, the ratio M/P will be sufficiently high to triger a consumer% response. The second problem is whether operating cost differentials are perceived to be reflected in product prices. Two recent studies (McNeil1 and Wilkie [ 131 and Hutton and Wilkie [8]) seem to indicate that this is the case, although both provided price and energy use information in a laboratory setting, rather than under actual market conditions. However, there are several reasons which cause us to beli’eve thlat the same is true for the real world, at least in the Israeli refrigerator market (our data source). First, most Israeli buyers of new refrigerators are consumers with relatively high income. The traditional positive relationships between income and education makes it plausible to assume that these buyers are capable of collecting and processing market information reasonably well. Second, in 1979 and 1980 the Israel Electricity Company engaged in considerable demarketing efforts aimed at reducing electricity consumption by Israeli consumers. These efforts included an advertising campaign which extended over 10 months as well as direct distribution of information leaflets to consumers. Thlird, the representative Israeli consumer was then more likely to absorib the disseminated energy-saving information because of the adverse effect of the rapid changes in electricity prices on his real income. By using Eq. (2) and talking about differential inflation rates for different products, we actually refer to changes in the distribution of relative prices rather than to inherent effects of the inflationary process. However, these changes 21re an effect of inflation, due to the following factors: Changes in relative prices during periods of price stability are Hcely to be more moderate as compared to inflationary periods. It is
Inflation
arld Cormmer
Choice
383
especially under an accelerated inflation that relative prices will; change so strongly and rapidly as to potentially produce fast and mwked changes in preferences, choice and ultimately sales and/or market share. Second, the rates p and y can be interpreted as representing the forces of demand and cost inflation, respectively. Finally, if consumers purchase heavy durables as a hedge against inflation, then changes in implicit discount rates may result in different portfolios which are used as a means of hedging against in flation. Inflation and Consumer Purchase Decisions: An Empirical Examination The possible effects described are examined in light of some empirical data. The data concern the Israeli refrigerator market at two points in time: December 1979 and December 1980. The market in point is practically a duopoly, composed of two Israeli industrical giants: A.~cor and Tudiran, who dominate the relatively narrow sales of imported refrigerators. Approximate market shares are 40% to Amcor, 35% to Tudirun and 25% to imports. Each local firm produces several models, where the term “model” is hereby used to denote also different sizes and technological properties. The data about the various models come from two sources: The December 1979 data, which refer to five models, have been published by the Israeli Consumer Council. The December 1980 data source is the Israeli Institute of Standards, which conducted a comparative efficiency test of nine models, incl.uding the five examined in the first survey. To facilitate comparisons between different models, which sometimes are of different sizes, both surveys used a standardized unit of measurement, namely efficient cubic foot (ECF). The term “efficient” refers to the cooling capacity of the model, accounting for pertinent differences between the refrigerator and its freezer. Adopting this perhaps somewhat simplistic measurement method (lacking any other viable alternative), we computed purchase price per ECF for the four major models appearing in both surveys. Correspondingly, we calculated operating cost figures by multiplying monthly electricity consumption per ECF (as measured identictilly in both surveys) by current electricity prices. (Note that the operating cost does not inc1ud.e &preciation allowances, as they are accounted for by the discounting process.) Price and cost data, per ECF, appear in Table 1. 0ur purpose is to identify and anal:. L1~the effect of inflation on the implicit rates of return associated with each relevan, pair and consequently on their possible influence on actual choice decisions. A relevant pair includes two models A and B, such that price, > price,, whereas
3184
Yehoshua
Liebermann
and Meyer Ungar
Table 1: Initial Purchase Price and Operating Cost Figures per ECFa _~~ December 1979 Survey
Model Amcor 1600 Amcor 1900 Tadiran 400 Tadiran 440
December 1980 Survey
InitiallPurchase Monthly Operating Initial Purchase Monthly Operating Price per ECF Costs per ECF Price per ECF Costs per ECF 226.94 257.34 244.27 246.74
0.912 0.789 1.192 1.074
432.66 592.06 479.26 474.82
2.665 2.305 3.483 3.139
a All prices are in Israeli shekels.
operating cost, < operating costB . Such a pair is practically a choice set. Pairs not fulfilling this condition (as Amcor 1600 and Tadiran 400) are not included in the analysis. Actual choice decisions involving pairs of this type can be attributed to other product cues. For the relevant pairs the implicit discount rates have been calculated by means of a computer program, &ving for rf in Eq. (2). When inflation rates are homogeneous over all sectors of the economy, implicit real rates of return will remain unaffected. Usually, however, different sectors experience different inflation rates. Thus, while during 1980 Israel suffered an annual inflation rate of 132.9O0, electricity prices soared up by 192%. Such differing inflation rates have their effect on the implicit rates of return to buyers of all kinds of heavy energy-using durables. The effect specific to the case examined is shown in Tables 2 and 3. Five possible relationships between the annual rate of increase in the general price level p and the corresponding rate for electricity prices 7 are considered (1 + r)/( 1 + p) = 1, 1.25(=2.92/ 2.33), 1.5, 1.8, and 2. [Note that when (1 + r)/(l + p) = 1.0, the implied indifference point = re .] A IO-year product life is assumed. The calculations we:e carried out using monthly compounding; however, the results are presented in annualized terms. For expository purposes, one of the comparisons that appear in Tables 2 and 3 is partially illustrated in Figure 2. For example, assuming ( 1 + Ml +p) = 1.O, someone in 1979 who is colmparing an Amcor MM with a Tadirun 400, and whose discount rate is greater than 43%, would prefer the 400 model. However, when (1 + ~r)/(1 + p) = 1S, the same model would be preferred only if the consumer’s discount rate is greater than 114%. As expected, the higher the ratio (1 + r)/( 1 + p), the further to the right is the cutoff point of the net present value (NPV’)curve with the horizontal axis. If a given distribution of individual real discount
Inflation and Consumer
385
Choice
Table 2: Implicit Discount Rates (December 1979) Future Electricity Price Increase vs. GeneA Price Level Increase (1 + Ml +p) = 1
Models Amcor 1900 vs Amcor 1600 Amcor 1900 vs Tadiran 400 A mcor 1900 vs Tadiran 440 Tadiran 440 vs Tadiran 400
I.25
-12%
1.5
-
1.8
2
10%
32%
58%
76%
43%
7370
114%
156%
185%
36%
63%
103%
144%
171%
74%
118%
162%
214%
249S
rates exists, the effect is to increase the likelihood of choice of the model with thehigher purchase price but lower operating costs by the shaded area in Figure 2.
Out of the four different relevant pairs in both surveys, three comparisons are common to the 1979 and 1980 surveys. These take us to the central point of the present study. Two comparisons are external (models of different manufacturers) and one is internal (two models of the same manufacturer). Let us focus on the external comparisons only (abstracting from all other choice criteria used by consumers). The real purchase price
Table 3: Implicit Discount Rates (December 1980) Future Electricity Price Increase vs. General Price _I_--
Models ___-.
.____
1 ._--__-_--
Amcor 1900 vs Amcor 1600 Amcor 1900 vs Tadiran 400 A mcor I900 vs Tadiran 440
Level Increase (1 +yNl +p)= 1.25
--
1.5
._-___
18
2
Yeltoshua Lieberrnann
386
Net
and Meyer Ungar
Present
FIGURE 2. Amcor 1900 vs. Tadimn 400 (December 1979).
differential between Armor 1900 and the two Tadiran models did not remain constant during 1980. Indeed, the price gap hardly changed nominally, but with an annual inflation rate of over 100%) the real differentials sharply shrinked. It is not clear whether this observation is due to ;adeliberate response of Tadiran, that was intended to compensate for the sharp increase in electricity prices which took place through 1980. Nonetheless, the final outcome was to reduce the critical implicit rate of return to a point below that of 1979, as is indicated by Figures 3 and4. Given the decline in the critical implicit rate of return, it is now possible to formulate an explicit hypothesis regarding the effect of inflation on consumer choice. If the mean of the distribution of individual Israeli consumers’ discount rates did not fall from 1979 to 1980, then the decline in the critical implicit rate of return should induce at least
1979 Net
Present
Value t
\
FIGURE 3. Amcor 1900 vs. Tadiran 400; (1 + y)l(l
f (r 1 !
I
+ p) = 1.5.
Inflation and Consumer
Net
Present
Choice
387
Value
FIGURE 4. Anrcor 1900 vs. Tadimn 440; (I + yM1 + p) = 1S.
some consumers to change their preference from Armor 1980 to Tadiran 4@9 and Tadiran 448 (and also from Amcor 1900 to Amcor MM). Unfortunately, no data regarding the distribution of subjective discount rates in Israel are available. However, it seems that indirect observations support the claim that the mean of the distribution did not decline from 1979 to 1980, and perhaps even increased. Interest rates data published recently by the Bank of Ismel show an increase in the structure of interest rates between both years. For example, the nominal interest rate on bank credit rose from 89% in 1979 to 177% in 1980. The correqonding real rates were 24% and 28%) respectively. One may thus expect that the effects of inflation on consumers’ choice were even stronger. To test the aforementioned hypotheses, data about the sales of Amcor 1600, 1908 and Tadiran 400, 440 in the years 1979 and 1980 were required. For reasons unknown to the authors both companies declined to release the desired figures, a refusal which prevented carrying out the planned tests. There is, however, some empirical indication that inflation affects actual choice behavior. From 1978 to 1980 T&ran increased its overall market share in the refrigerator market from 28% to 35%. During the same period, Amcor’s share shrinked from 57% to
40%. Although these numbers are of a more general nature, they seem to render at least some support to our analysis. At this point some concluding remarks might be in order. It might be both pretentious and shortsighted to attribute these developments to the inflationary effects on the hidden discount rates to the consumers. Clearly, consumers do not base heir choices only on relative prices and implicit discount rates. Yet, the more inflation accelerates and the more rapid marked changes in relative prices take place, the more dramatic is the effect on consumers’ implicit discount rates. Thus, in an environ-
Yehoshua
388
Liehermanrt
and Meyer Ungar
ment of high and heterogenous inflation, one may expect that some consumers of certain durableswill change their actual choice behavior as a result of corresponding changes in their implicit discount rates. This possibility should not be overlooked by manufacturersof such durables. References 1.
Carlson, John A., A Study of Price Forecasts, Ann. Econ. SociaI Measure. 6 (June 1977): 27-56.
2.
Engel, James F., Kollat, David T., and Blackwell, Roger, D., Consumer Behavior. 2nd Ed. Dryden, Hi&ale 1977. 8 Figlewski, Stephen and ’ Iachtel, Paul, The Formation of Inflationary Expectations. Rev. Econ. Stat. 63 (February 198 1): l-10.
3. 4.
Fisher, Irving, The 77zeo~~ of Interest, 1930).
5.
Gateiy, Dermont, Individual Discount Rates and the Purchase and Utilization of Energy-Lrsing Durables: Comment, BelZJ. Econ. 9 (Spring 1980): 373-374.
6.
Glejser, Herbert, Inflation, Productivity and Relative Prices: A Statistical Study, Rev. Econ. Stat. 47 (February 1965): 76-80.
I.
Haurman, 1. A.. Individual Discount Rates and the Purchase and Utilization Energy-Using Durables, Bell J Econ. 10 (Spring 1979): 33-54.
8.
Hutton, Bruce R. and Wilkie, William L., Life Cycle Cost: A New Form of Consumer Irr’srmration, J. Consumer Res. 6 (March 1980): 349-359.
9.
Jacobs. Rodney L. and Jones, Robert A., Price Expectations 1947-1475, Am. Econ. Ret. 70 (June 1980): 269-277.
10.
New. York,
Juster, F. Thomas and W’achtel, Paul, Inflation
1967 (reprinted
2nd Ed..
of
in the United States:
atid the Consumer, Brooking Pap.
Icon. Activity 1 (1972): 72 -114.
Are Really Formed, Challenge 23 (Novem-
11.
Katona, George, How Expectations ber-December 1980): 32-35.
12.
Ladd, George W. and Zober, Martin, Model of Consumer Reaction Characteristics, J. Consumer Res. 4 (September 1977): 89-l 01.
13.
McNeill, Dennis L. and Wilkie, William L., Public Policy and Consumer Information: Impact of the New Energy Labels, S. Consumer Res. 6 (June 197911: l-10.
14.
Monroe, Kent B., Buyers’ Subjective (February 1973): 70-80.
15.
Parks, Richard W., Inflation (February 1978): 79-96.
16.
Stigler, George J., Economics of Information, 225.
17.
Turnovsky, Stephen J., Empirical Evidence on the Formation tions,J. Am. Stat. Assoc. 65 (December 1970): 1441-1454.
18.
Webster, Frederick F., Jr., Largay, James A., III, and Stickney, Clyde P., The ImPact of Inflation Accounting on Marketmg Decisions, J. Marketing 44 (Fall 1980): 9-17.
;nd
to Product
Perceptions of Price, J, Mwketirlg RES. 10
Relative Price Variability,
J. Pd.
Econ.
16
J. Pal. Econ. 69 (June 1961): 213-
of Price Expecta-
Possible eflects of’s nonhomogeneous inflation on consumer choice among brads of energy-using durables are considered. For this purpose price d$erentials among braA are regarded as “investments,” while operating costs differentials are viewed os “returns.” Using a life-cyle-cost approach, it is shown how inflation may aflect consumers’ critical implkit rates of return and ultimately their brand choice. Empirical observations which support the theoretical results are provided.
Although in the last decade inflation has become a persistent and bothering problem to many industrialized states, very little is known about its microeffects, especially those Iwhich influence the behavior of the individual consumer. Indeed, economists have tried to understand how individuals form inflationary expectations in or&r to investigate the relationships between expected and actual rates of inflation [ 1,3,9, 10, 11, 171. However, it seems that not too many microaspects of inflation have been treated in the economics literature. A similar picture appears in marketing studies of inflation which mostly have a faint bearing to inflationary effects on consumer behavior [ 181. Inflation, Implicit Discount Rates, and Consumer Choice Consumer choices are based on their preferences which, among other things, are a function of product (or service) attributes. 6~. of many possible attributes consumers usually use a limited number to form their preferences [2:250] and in many instances relative price is one of the key attributes [ 121. In a period of high inflation, however, one may etxpect a strong variability in relative prices [6, 151 aurd ultimately in consumer choices. Sometimes, changes in consumer choice may be due to less explicit, though not less important, price effects. Quite often consumers buy products which apart from their purchase price require also incurring an operating cost over time. Examples of this type of products are * The authors thank Kent Monroe, the journal’s associate editor. and two anonymous referees for many valuable comments on a previous draft and Shlomo Lev for programming assistasce. Address correspondence to Yehoshua Lkbermann, Department of Economics. BarI&anUniversity, Ramat Gan, Israel. Journal of Business Research 11,379-388( 1983) @ Elsevier Science Publishing Co., Inc. 1983 52 Vanderbilr Ave.. New York, NY 10017
37’9 0 I38-2%3/83/$3 .OO
automobiles (which have to he maintained and fueled up) and electrical appliances (that are associated with electricity consumption). Under certain conditions, a consumer’s decision to choose a given brand of an electrical appliance can be considered as an investment. Suppose that the price of brand A is PA and the price of brand B is Ps, where PA > PB. Suppose further that the per period operating costs to the consumer of ‘both br&ds are CA and CB, respectively, so that CA < CD. Now, if the consumer opts for brand A his choice is comparable to an investment in the amount (PA- Ps). On this “investment’ ’ he enjoys a “return” of -C,) per Clearly, in respect, consumers’ reflect their individual discount The rate which consumers be indifferent brands A B (I=*) be derived equating the differential P, with the value of cost savings, shown in ( 1). N represents usage life both appliances: -PB
N CB - c* . = c t= 1 iI11+ Y(-J)f
If the individual’s r, is greater than r,, then brand B (with the lower purchase price but the higher operating costs) will be preferred to brand A f since under these conditions the consumer attaches less importance to future operating cost differentials than to the current “investment. ” Some estimates of such discount rates have been produced in two recent studies [5,7]. Whereas these estimates are static in that they describe a distribution of implicit discount rates at a given point in time, to the marketer it seems more interesting, and also more important, to check changes in the distribution over time. Keeping all other choice attributes constant, a producer or a seller may wonder why he loses sales or market share to cormpetitors whife still maintaining his previous absolute, and even relative, competitive edge. Such a situation can be the result of a change in the implicit discount rate. To illustrate, suppose that the general price level rises by a constant rate of p per period and that operating costs increase at a corresponding rate of y, where 7 > p. According to Fisher’s [4] law, the discount rate will be augmented by the general rate of inflation and the denominator will become ( 1 + r) (1 t p). At time zero, the real discount rate under inflationary conditions-which will be denoted by rf (instead of ro)--can be found by solving (2) for T,: PA -PB
=
zN ccl3-@‘(lCAMl + y)’
t=1
(1
+
+p)’
-*
(2)
381 Net
Present
Value
(of future cost sovings over inlti6l price
I
differential
w r (%I r>
(B
preferred
1to Atwhen, , r= p =O) A preferred f(r)
A
p ,o
i I I 18 preferred
to 6:
I /A
to A
I preferred
1
, to 8 (when’ , f>P,Ol
I
r
i%)
FIGURE 1. Effect of a Change in the Implicit Discount Rate on Consumer’s Choice.
Here all the future cost savings have been augmented by a factor of ( 1 + y), while the d iscount factors have been augmented by a factor of ( 1 + p), so that both sl‘des of the equations are couched in real terms. Obviously, if 7 > p then rj. > r (), as is also shown in the upper panel of Figure 1. If the distribution of prospective buyers’ real discount rates remains unchanged under inflationary conditions, then those buyers whose discount rate is between r. and r,. will now-as a result of the inflation-tend to prefer brand A to brand B more than before. The magnitude of this change is reflected in the shaded area in the lower panel of Figure 1. Thus, the differential inflation rate, which may be passed unnoticed by the seller, has a potentially considerable effect on his market performance. The question whether the potential effects of inflation will materialize depends mainly on two aspects of the actual behavior of consumers in the market. The first aspect, which is more general, regards the role of price differentials in determining consumers’ choices. The second, and more specific, aspect concerns the question whether operating cost differentials are regarded by consumers as relevant price information.
Yehoshua Liebermann
382
and MeJler Ungar
Referring to the first issue, Monroe [ 141 in his survey of buyer’s subjective prceptisns of price, concludes that we know very little about how price affects a buyer’s perception of alternative purchase oflea and how these perceptionsaffect his response.” 61
.
.
.
Nevertheless, most studies reviewed by Monroe, which render the inconclusive findings, have examined brands of relatively inexpensive daily consumption items. It seems reasonable to assume that in the case of heavy durables like refrigerators, price differentials0will become more important to the consumer, as they represent a higher fraction of his income. Ac$ually , this assumption is central to the economic information theory as formulated by Stigler [ 161. Further, under conditions of high inflation price changes of heavy durables (AP’) may be quite considerable. Thus, we may similarly assume that when m is compared with a nzference point as the initial price of the durable P, the ratio M/P will be sufficiently high to triger a consumer% response. The second problem is whether operating cost differentials are perceived to be reflected in product prices. Two recent studies (McNeil1 and Wilkie [ 131 and Hutton and Wilkie [8]) seem to indicate that this is the case, although both provided price and energy use information in a laboratory setting, rather than under actual market conditions. However, there are several reasons which cause us to beli’eve thlat the same is true for the real world, at least in the Israeli refrigerator market (our data source). First, most Israeli buyers of new refrigerators are consumers with relatively high income. The traditional positive relationships between income and education makes it plausible to assume that these buyers are capable of collecting and processing market information reasonably well. Second, in 1979 and 1980 the Israel Electricity Company engaged in considerable demarketing efforts aimed at reducing electricity consumption by Israeli consumers. These efforts included an advertising campaign which extended over 10 months as well as direct distribution of information leaflets to consumers. Thlird, the representative Israeli consumer was then more likely to absorib the disseminated energy-saving information because of the adverse effect of the rapid changes in electricity prices on his real income. By using Eq. (2) and talking about differential inflation rates for different products, we actually refer to changes in the distribution of relative prices rather than to inherent effects of the inflationary process. However, these changes 21re an effect of inflation, due to the following factors: Changes in relative prices during periods of price stability are Hcely to be more moderate as compared to inflationary periods. It is
Inflation
arld Cormmer
Choice
383
especially under an accelerated inflation that relative prices will; change so strongly and rapidly as to potentially produce fast and mwked changes in preferences, choice and ultimately sales and/or market share. Second, the rates p and y can be interpreted as representing the forces of demand and cost inflation, respectively. Finally, if consumers purchase heavy durables as a hedge against inflation, then changes in implicit discount rates may result in different portfolios which are used as a means of hedging against in flation. Inflation and Consumer Purchase Decisions: An Empirical Examination The possible effects described are examined in light of some empirical data. The data concern the Israeli refrigerator market at two points in time: December 1979 and December 1980. The market in point is practically a duopoly, composed of two Israeli industrical giants: A.~cor and Tudiran, who dominate the relatively narrow sales of imported refrigerators. Approximate market shares are 40% to Amcor, 35% to Tudirun and 25% to imports. Each local firm produces several models, where the term “model” is hereby used to denote also different sizes and technological properties. The data about the various models come from two sources: The December 1979 data, which refer to five models, have been published by the Israeli Consumer Council. The December 1980 data source is the Israeli Institute of Standards, which conducted a comparative efficiency test of nine models, incl.uding the five examined in the first survey. To facilitate comparisons between different models, which sometimes are of different sizes, both surveys used a standardized unit of measurement, namely efficient cubic foot (ECF). The term “efficient” refers to the cooling capacity of the model, accounting for pertinent differences between the refrigerator and its freezer. Adopting this perhaps somewhat simplistic measurement method (lacking any other viable alternative), we computed purchase price per ECF for the four major models appearing in both surveys. Correspondingly, we calculated operating cost figures by multiplying monthly electricity consumption per ECF (as measured identictilly in both surveys) by current electricity prices. (Note that the operating cost does not inc1ud.e &preciation allowances, as they are accounted for by the discounting process.) Price and cost data, per ECF, appear in Table 1. 0ur purpose is to identify and anal:. L1~the effect of inflation on the implicit rates of return associated with each relevan, pair and consequently on their possible influence on actual choice decisions. A relevant pair includes two models A and B, such that price, > price,, whereas
3184
Yehoshua
Liebermann
and Meyer Ungar
Table 1: Initial Purchase Price and Operating Cost Figures per ECFa _~~ December 1979 Survey
Model Amcor 1600 Amcor 1900 Tadiran 400 Tadiran 440
December 1980 Survey
InitiallPurchase Monthly Operating Initial Purchase Monthly Operating Price per ECF Costs per ECF Price per ECF Costs per ECF 226.94 257.34 244.27 246.74
0.912 0.789 1.192 1.074
432.66 592.06 479.26 474.82
2.665 2.305 3.483 3.139
a All prices are in Israeli shekels.
operating cost, < operating costB . Such a pair is practically a choice set. Pairs not fulfilling this condition (as Amcor 1600 and Tadiran 400) are not included in the analysis. Actual choice decisions involving pairs of this type can be attributed to other product cues. For the relevant pairs the implicit discount rates have been calculated by means of a computer program, &ving for rf in Eq. (2). When inflation rates are homogeneous over all sectors of the economy, implicit real rates of return will remain unaffected. Usually, however, different sectors experience different inflation rates. Thus, while during 1980 Israel suffered an annual inflation rate of 132.9O0, electricity prices soared up by 192%. Such differing inflation rates have their effect on the implicit rates of return to buyers of all kinds of heavy energy-using durables. The effect specific to the case examined is shown in Tables 2 and 3. Five possible relationships between the annual rate of increase in the general price level p and the corresponding rate for electricity prices 7 are considered (1 + r)/( 1 + p) = 1, 1.25(=2.92/ 2.33), 1.5, 1.8, and 2. [Note that when (1 + r)/(l + p) = 1.0, the implied indifference point = re .] A IO-year product life is assumed. The calculations we:e carried out using monthly compounding; however, the results are presented in annualized terms. For expository purposes, one of the comparisons that appear in Tables 2 and 3 is partially illustrated in Figure 2. For example, assuming ( 1 + Ml +p) = 1.O, someone in 1979 who is colmparing an Amcor MM with a Tadirun 400, and whose discount rate is greater than 43%, would prefer the 400 model. However, when (1 + ~r)/(1 + p) = 1S, the same model would be preferred only if the consumer’s discount rate is greater than 114%. As expected, the higher the ratio (1 + r)/( 1 + p), the further to the right is the cutoff point of the net present value (NPV’)curve with the horizontal axis. If a given distribution of individual real discount
Inflation and Consumer
385
Choice
Table 2: Implicit Discount Rates (December 1979) Future Electricity Price Increase vs. GeneA Price Level Increase (1 + Ml +p) = 1
Models Amcor 1900 vs Amcor 1600 Amcor 1900 vs Tadiran 400 A mcor 1900 vs Tadiran 440 Tadiran 440 vs Tadiran 400
I.25
-12%
1.5
-
1.8
2
10%
32%
58%
76%
43%
7370
114%
156%
185%
36%
63%
103%
144%
171%
74%
118%
162%
214%
249S
rates exists, the effect is to increase the likelihood of choice of the model with thehigher purchase price but lower operating costs by the shaded area in Figure 2.
Out of the four different relevant pairs in both surveys, three comparisons are common to the 1979 and 1980 surveys. These take us to the central point of the present study. Two comparisons are external (models of different manufacturers) and one is internal (two models of the same manufacturer). Let us focus on the external comparisons only (abstracting from all other choice criteria used by consumers). The real purchase price
Table 3: Implicit Discount Rates (December 1980) Future Electricity Price Increase vs. General Price _I_--
Models ___-.
.____
1 ._--__-_--
Amcor 1900 vs Amcor 1600 Amcor 1900 vs Tadiran 400 A mcor I900 vs Tadiran 440
Level Increase (1 +yNl +p)= 1.25
--
1.5
._-___
18
2
Yeltoshua Lieberrnann
386
Net
and Meyer Ungar
Present
FIGURE 2. Amcor 1900 vs. Tadimn 400 (December 1979).
differential between Armor 1900 and the two Tadiran models did not remain constant during 1980. Indeed, the price gap hardly changed nominally, but with an annual inflation rate of over 100%) the real differentials sharply shrinked. It is not clear whether this observation is due to ;adeliberate response of Tadiran, that was intended to compensate for the sharp increase in electricity prices which took place through 1980. Nonetheless, the final outcome was to reduce the critical implicit rate of return to a point below that of 1979, as is indicated by Figures 3 and4. Given the decline in the critical implicit rate of return, it is now possible to formulate an explicit hypothesis regarding the effect of inflation on consumer choice. If the mean of the distribution of individual Israeli consumers’ discount rates did not fall from 1979 to 1980, then the decline in the critical implicit rate of return should induce at least
1979 Net
Present
Value t
\
FIGURE 3. Amcor 1900 vs. Tadiran 400; (1 + y)l(l
f (r 1 !
I
+ p) = 1.5.
Inflation and Consumer
Net
Present
Choice
387
Value
FIGURE 4. Anrcor 1900 vs. Tadimn 440; (I + yM1 + p) = 1S.
some consumers to change their preference from Armor 1980 to Tadiran 4@9 and Tadiran 448 (and also from Amcor 1900 to Amcor MM). Unfortunately, no data regarding the distribution of subjective discount rates in Israel are available. However, it seems that indirect observations support the claim that the mean of the distribution did not decline from 1979 to 1980, and perhaps even increased. Interest rates data published recently by the Bank of Ismel show an increase in the structure of interest rates between both years. For example, the nominal interest rate on bank credit rose from 89% in 1979 to 177% in 1980. The correqonding real rates were 24% and 28%) respectively. One may thus expect that the effects of inflation on consumers’ choice were even stronger. To test the aforementioned hypotheses, data about the sales of Amcor 1600, 1908 and Tadiran 400, 440 in the years 1979 and 1980 were required. For reasons unknown to the authors both companies declined to release the desired figures, a refusal which prevented carrying out the planned tests. There is, however, some empirical indication that inflation affects actual choice behavior. From 1978 to 1980 T&ran increased its overall market share in the refrigerator market from 28% to 35%. During the same period, Amcor’s share shrinked from 57% to
40%. Although these numbers are of a more general nature, they seem to render at least some support to our analysis. At this point some concluding remarks might be in order. It might be both pretentious and shortsighted to attribute these developments to the inflationary effects on the hidden discount rates to the consumers. Clearly, consumers do not base heir choices only on relative prices and implicit discount rates. Yet, the more inflation accelerates and the more rapid marked changes in relative prices take place, the more dramatic is the effect on consumers’ implicit discount rates. Thus, in an environ-
Yehoshua
388
Liehermanrt
and Meyer Ungar
ment of high and heterogenous inflation, one may expect that some consumers of certain durableswill change their actual choice behavior as a result of corresponding changes in their implicit discount rates. This possibility should not be overlooked by manufacturersof such durables. References 1.
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2.
Engel, James F., Kollat, David T., and Blackwell, Roger, D., Consumer Behavior. 2nd Ed. Dryden, Hi&ale 1977. 8 Figlewski, Stephen and ’ Iachtel, Paul, The Formation of Inflationary Expectations. Rev. Econ. Stat. 63 (February 198 1): l-10.
3. 4.
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6.
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I.
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8.
Hutton, Bruce R. and Wilkie, William L., Life Cycle Cost: A New Form of Consumer Irr’srmration, J. Consumer Res. 6 (March 1980): 349-359.
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New. York,
Juster, F. Thomas and W’achtel, Paul, Inflation
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in the United States:
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McNeill, Dennis L. and Wilkie, William L., Public Policy and Consumer Information: Impact of the New Energy Labels, S. Consumer Res. 6 (June 197911: l-10.
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Stigler, George J., Economics of Information, 225.
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Turnovsky, Stephen J., Empirical Evidence on the Formation tions,J. Am. Stat. Assoc. 65 (December 1970): 1441-1454.
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Webster, Frederick F., Jr., Largay, James A., III, and Stickney, Clyde P., The ImPact of Inflation Accounting on Marketmg Decisions, J. Marketing 44 (Fall 1980): 9-17.
;nd
to Product
Perceptions of Price, J, Mwketirlg RES. 10
Relative Price Variability,
J. Pd.
Econ.
16
J. Pal. Econ. 69 (June 1961): 213-
of Price Expecta-