How ads increase pricing power

As Reuters reported this week, Pepsi has raised prices on popular products, has received little pushback on price hikes and says there is room for more this year. What gives brands the power to do so? More directly, how can they reduce their customers’ price sensitivity? This is the $64 M question managers needs answers to, especially with today's inflation and increase in the Consumer Price Index:

Based on 7 years of data for 350 brands in 39 categories of fast-moving consumer goods, Professors Berk Ataman, Shuba Srinivasan, Marc Vanhuele and yours truly, demonstrated the power of brand advertising to reduce brand price sensitivity. Our hierarchical Dynamic Linear Model links own and others’ advertising in the category to brand price elasticity directly and indirectly through their impact on own and competitive mindset metrics (number of consumers considering and preferring the brand). We quantify the importance of each path in their conceptual figure, and explain any variation as a function of observable characteristics of the brand (quality, expensiveness) and category (purchase frequency and complexity, i.e. the number of products in the category).

The results show the importance of different paths through which advertising can affect price sensitivity. The price sensitivity impact of advertising is mainly direct (97.5%) and partly indirect (2.5%), through brand preference. The direct effect (path 1) shows that advertising predominantly decreases price sensitivity among the consumers who already consider the brand and among the consumers who already prefer it. In other words, advertising primarily reduces existing customers’ sensitivity to prices by reminding them of the bond they have with the brand and, to a lesser extent, by persuading consumers to (re)establish a bond with the brand. Thus, building a customer base is key to pricing power, and to enable raising prices without much resistance.

While this main result was robust across brands and categories, the authors also uncovered significant differences. Brands with lower-than-average perceived quality obtain 20% higher incremental revenue gains than the average brand, whereas brands with higher-than-average prices obtain 79% higher gains. Moreover, brands in more complex and frequently purchased categories enjoy 127% and 51% higher incremental revenue gains than the average, respectively.

Thus, the monetary gains from this increased pricing power are especially pronounced for expensive brands in complex and frequently purchased categories. In the paper, the authors dive deep into the reasons. For instance, advertising’s reminder effect intensifies as category complexity increases.

Bottom Line: your existing customer base and your current advertising reduce price sensitivity, enabling you to increase prices without much sales decrease. This long-term benefit of advertising translates to superior performance benefits for higher-priced brands, in complex and frequently purchased product categories. Thus, advertising may be an important weapon for brands in helping them sustain performance in the face of private-label competition or low-cost rivals, which are likely to gain ground in recessions. Given doubts on the power of advertising to incrementally increase sales, as popularized in Freakonomics podcasts, the role of advertising to increase the brand’s price power becomes even more important when arguing for its budget.