Pricing Power: Measures, Trends and Influences on Firm Value
Yang Pan and Thomas S. Gruca, University of Iowa, and Lopo Rego, Indiana University, 2019, 19-112-03
Do you have a very good business or a terrible business? According to famed investor Warren Buffett, it all comes down to your company’s pricing power. Unfortunately, little is known about this business trait, highly desired by investors, CEOs and marketing managers. Authors disagree on how to define pricing power and no objective measures have been studied to date.
In this study, Yang Pan, Thomas Gruca, and Lopo Rego identify two crucial aspects of firms with pricing power: the ability of a firm to charge prices above marginal cost and the ability to raise price without losing business.
They measure the first aspect of pricing power using the industry-adjusted Lerner Index; they measure the second aspect using a new firm-level measure of price elasticity. These two measures of pricing power are evaluated in two large-scale longitudinal studies.
The first study estimates the two measures of pricing power for a sample of more than 20,000 publicly traded firms for the years 1976-2016.
The resulting distribution of firm-level elasticity estimates is consistent with meta-analytic studies of price elasticity conducted using product-market-level data. Industry-level variations in price elasticity are also consistent with expectations, e.g., the average absolute price elasticity for firms in the pharmaceutical/medical manufacturing industry is much lower than the overall average for manufacturers of non-durable products (i.e., the pharma industry has more pricing power than the manufacturing non-durables industry).
The average Lerner Index generally increases over time, implying a continuous increase in pricing power for public firms over time. In contrast, the average absolute price elasticity fell (implying a general increase in pricing power) from the mid-1970s until the mid-1980s. From that point on, the average price elasticity rises (in absolute value), implying a steady decrease in pricing power.
In the second study, the authors examine the ability of these two measures of pricing power to shape cash flow growth and variability – key determinants of firm value. In a sample of 3,980 public companies from 1987-2016, both measures of pricing power have significant favorable impacts on future cash flows and cash flow variability. These finding suggest that these measures of pricing power are important contributors to shareholder value.
These findings provide two alternative value-relevant metrics for managers to incorporate into their strategic dashboards. These metrics can be used by executives to benchmark rivals, evaluate potential merger partners, track standing over time -- to know whether, in Warren Buffett’s opinion, they have a great business or a terrible one.
Yang Pan is a doctoral student in marketing and Thomas S. Gruca is Henry B. Tippie Research Professor of Marketing, both at Tippie College of Business, University of Iowa. Lopo Rego is Associate Professor, Weimer Faculty Fellow, Kelley School of Business, Indiana University.
The authors thank Vinay Kanetkar, and Michael Cipriano for their insights and valuable suggestions.
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