Geographical price discrimination in the cosmetic industry

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15 July 2015 Group 2

Dr. X. (Audrey Xianhua) Hu Academic year 2014/2015 Bachelor's Thesis and Thesis Seminar Economics Semester 1, period 3

Geographical Price Discrimination in the Cosmetic Industry

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Price differences of cosmetic products have caught more attention as globalization and parallel import make prices more transparent among countries. Take Chanel’s best selling lipstick, Coco Rouge, for example. It is currently sold at $35 in the US, ¥300 (around $48) in China and $50 AUD (around $43) in Australia. Such price discrepancy is not a unique coincidence, as it is a stylized phenomenon that price of cosmetic products prominently differs in different regions. Australia, for instance, is recognized as one of the countries where prices are remarkably higher than the average. As shown in CHOICE’s research (2013), Australians are typically paying up to 200% more for lipsticks, moisturizers and colognes than customers in the rest of the world. British color cosmetics brand Illamasqua recognized the situation and pioneered “Fight for a Fair Beauty Price” by setting prices in Australia comparable to The UK. However, this is merely a minor step. To quote the former General Manager of Elizabeth Arden Australia, “Manufacturers have traditionally seen Australia as a cash cow, particularly in the cosmetics space where there are strong margins”. The unfair pricing strategy discouraged and upset many consumers that are paying high mark-up for their geographical locations.

A minor discrepancy in prices is common, as countries carry out diverse tax and duty regulations. However, a difference of 200% cannot be justified by regulation differences. The question arises why do significant price discrepancies exist and why do profit-maximizing firms find such large price differences desirable and how are manufacturers able to sustain the mark-ups.

The cosmetic industry has been criticized for earning abnormal profits when most products take only a margin to produce. Cost cannot rationalize the differences. The other factor that affects price is demand, neoclassical economics assumes that rational economic agents behave in a way that strive for utility maximization. Predominantly, the utility is considered to be independent and intrinsic. Demand is correspondingly understood as an exclusive relationship between individuals and goods1. Still, it is often seen that consumption does not solely depend on its instrumental or functional benefits, but may also relate to inter-individual and emotional consumption experiences (Chao & Schor, 1998). Traditional economic

1_{For example, a recent survey by Deaton (1992) does not take interdependent preferences into}

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frameworks failed to recognize extrinsic factors and failed to explain the anomalies in reality. By considering psychological factors, behavioral economist realized people are not always rational. Nowadays, behavioral economics is used as an instrument in explaining the anomalies occurred with traditional economic frameworks2. It is thought-provoking to understand whether social and behavioral traits are responsible for the unfair pricing of cosmetics.

Geographical price discrimination in pharmaceutical and luxury goods industries have been discussed by several authors, however, few was done for the cosmetic industry despite the fact that cosmetic price differences have caught attention and stimulated parallel import and unsatisfying consumer experience3. The existence of grey-market imports could lead to an erosion of profit from international sales since the price would be brought to similar levels, and multinationals would loss the power to segment markets and carry out monopoly pricing. On the other hand, the parallel import could potentially harm social welfare since cross-hauling goods between countries waste resources. In the case of cosmetics, price differences are substantial and persistent, the cost of transportation usually more than justify the price gap. The purpose of this study is to examine what factors contributes to the cross-country price differences of cosmetics and if social and psychology values play a part in pricing decisions. This will be done using a cross-country analysis based on prices of identical cosmetic products packages.

The rest of the paper is organized as follows. Section 2 provides insights into behavioral economics theory and social value. Section 3 introduces the model used to detangle the price differences. Section 4 shows data resources and results of the

2_{The influence of individuals’ psychological factors on one’s decision making was once an important}

topic within Economics. Adam Smith, in his book The Theory of Moral Sentiments (1759), proposed psychological explanations of individual behavior, including concerns about fairness and justice. Later on, Veblen in his The Theory of the Leisure Class (1899) introduced the concept of “conspicuous consumption”. Following the tradition of Veblen, Harvard economist James Duesenberry (1949) indicated the existence of inter-personal comparisons. Even though, both theories proposed by Veblen and Duesenberry were considered to be classic, they are relatively neglected. When economists sought to reshape the discipline as a natural science, extrinsic values are neglected and psychology is assumed to be fundamentally rational. The rationality of economic agents was first opposed by the emergence of behavioral finance, which has revealed that rationality assumption doesn't reflect how people behave in reality. Neglecting psychological factors has led to unintended and unforeseen errors.

3One alternative for consumers experiencing high geographical mark-ups is to purchase cosmetics on heavily discounted online-only retailers who primarily deal in parallel import personal care and cosmetics. Despite the price advantages of parallel imports, the products sold on these websites may be close to expiry date, leftover from a discontinued line or be part of excess inventory stockiest is looking to move quickly. Due to the nature of the grey market, consumers may be quite limited in terms of choice and protection of consumer rights.

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quantitative study conducted with the model provided in section 3. Section 5 presents some concluding remarks.

2 Behavioral Economics and Social Value

Neoclassical economics is explicitly defined to be anti-behavioral. One central assumption of neoclassical economics is that people act independently on the basis of full and relevant information. The world is conceptualized by calculating unemotional maximizers. This perspective is also called Homo Economicus. However, unexplainable anomalies occurred. By clarifying anomalies using psychological features, behavioral attributes find its way into the economics. I will start this section by giving a brief introduction into behavioral finance and economics. Next, how social values and interdependence preferences could affect consumers’ preference towards high-end cosmetics is discussed.

It is found that unrealistic traits are included in the standard economic model of human behavior. The behavioral economist argued that people are not always rational and psychological motives could affect people’s preferences. Finance is the field of Economics where behavioral theory has made the first and greatest contributions. High quality, wide available and testable data is generated on a daily basis, which made measurement and researches easier for academics. Before behavioral elements entered the finance field, efficient market hypothesis (EMH) is the foundation for security analysis. De Bondt and Thaler (1985) challenged the efficient market hypothesis with their empirical studies. They compared two groups of stocks: extreme losers and extreme winners. Turns out that stock prices overreact: extreme losers over perform extreme winners. The excess return of extreme losers, however, cannot be justified by the risk premium of the extreme losers. De Bond and Thaler suggested that the extreme losers have become too cheap and bounce back, whereas, the extreme winners are overpriced and earn lower returns. This explanation is consistent with psychological theory4. Later on, Shiller’s work on market volatility showed that stock market is more volatile than could be vindicated by a simple

4The extreme losers are typically companies with poor news for several years in a line, investors are likely to anticipate the same for the future, thereby, undervalue the stocks. While, the extreme winners are companies with good news, intriguing overvaluation.

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pricing model, where the price is equal to he expected net present value of future dividends (1981). With psychological insights, Shleifer (2000) presented behavioral finance as an alternative to efficient market hypothesis. In his work, Shleifer demonstrated that efficient market hypothesis is oversimplified both in the assumption of perfect rationality and in the failure of arbitrage to bring the price to equilibrium. The forces supposed to bring the market to equilibrium are much weaker and limited than EMH suggested. Bringing in psychological influences, behavioral finance can explain the anomalies from the efficient markets perspective and also generated empirically confirmed predictions. The contribution of behavioral finance redirected scholars’ attention to psychological factors and guided Psychology back into Economics.

The success of behavioral finance made people reconsider the validity of independence and rationality assumptions in economic settings. Kahneman and Tversky (1974, 1979 &, 1986) demonstrated the way human form decisions might depart from assumptions of standard economic theories. They started their research from rationality assumption and then analyzed departures. They found that people have limited cognitive power. Therefore, their decisions may not be in their long-run interest nor be able to solve problems optimally. One example Kahneman and Tversky provided was that people are willing to scarify and help others, which is contradictory to the rationality assumption. By integrating insights from psychological research into economics, Kahneman and Tversky were able to model bounded rationality. Their insights were then picked up by Richard Thaler, who realized psychological theory could account for the irrationality in behaviors. Thaler collaborated with Kahneman and Tversky, blended economics and finance with psychology to present concepts such as mental accounting, the endowment effect, and other biases. Providing realistic psychological foundations, the explanatory power of economists is increased.

Consumers’ purchase decision is determined by their perceived utility. The majority of traditional works on consumer demand assume that the preference functions of individuals are independent, thereby, ruling out status consumption and other interpersonal comparison motivations. However, people are not always rational as assumed. Apart from functional value, consumers’ decision is also profoundly influenced by the social value perceived by consumers. Social value is defined as utility acquired from an alternative’s association with one or more specific social

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groups. Apart from intrinsic value acquired from consumption, extrinsic value can affect demand. Veblen (1899, pp. 16-31) proposed this concept in his book The Theory of the Leisure Class, in which he introduced the concept of “conspicuous consumption”. He believed that individuals are subject to “invidious distinctions”. To form esteem and self-respect, promoting “conspicuous consumption” is essential. In a word, spending is a crucial element in terms of establishing one’s social position, and the intrinsic attributes of goods are less important than their social meanings. Veblen’s theory is consistent with Maslow's hierarchy of needs, which suggested a set of basic human needs that serve as the motivating force for behavior (1943). Maslow systematized human needs into five general categories: physiological needs, safety needs, belongingness needs, esteem needs, and self-actualization. The need for social recognition is accepted in the esteem needs category, which includes internal desires for strength, achievement, independence, and external factors such as reputation, prestige, and recognition. From the social recognition perspective, Leibenstein (1975, pp. 5-6) referred the exertion of status expenditures as the Interstatus-Income Ratio Compression Effect. Status expenditures are expected to facilitate upward social mobility. For households, status depends on a reference group consists of “important others” who have influence on the consumption decisions of the household. The utility from such expenditures reflects the expectations of explicit or implicit approval or disapproval of the reference group. As we live in social groups, consumption means more than just basic sustenance. The motivation to achieve upward social mobility is the most powerful motivation for the individual and it is reinforced by the fear for downward social mobility (Leibenstein, 1975, p. 6).

One illustration of the presence of social value is the Bandwagon effect. The underlying cause of Bandwagon effect is the desire for belonging and acceptance. Bandwagon effect is the phenomenon where the probability of individual adoption increases with respect to the proportion that has already done so. Bandwagon consumers place excessive emphasis on the effect they make on others while consuming prestige brands. What motivates bandwagon consumers is the possibility of being fitted in or associated with one or more social or cultural-ethnic groups (Sheth, Newman, & Gross, 1991, p. 161). People who have high conformity have a tendency to "hop on the bandwagon".

On the other hand, Harvard economist Duesenberry (1949) argued in a well-known book that an individual's utility from any given level of consumption depends

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not only on the absolute level of spending, but also how the spending level compares to that of others. Chao and Schor (1998, p. 128) empirically revealed that visible status goods have a lower price-quality correlation, therefore, status premium and status motives present in purchases of women's cosmetics.

3 Model

The foundation of economic theory is that rational economic agents behave in a way that maximizes their utility. The upper limit to the price can be charged to consumers, therefore, is determined by perceived utility, which is usually the functional value. It is often seen that the purchase of cosmetics products does not solely depend on instrumental or functional benefits, but may also relate to interpersonal and extrinsic attributes. Apart from social attributes, other factors also enter into companies’ pricing strategies that could explain the discrepancy of cosmetic prices.

3.1 Income

Generally speaking, consumer demand is proportional to income. Greater demand, therefore, creates incentive for oligopoly companies to price their good higher. At the same time, high-end skincare and makeup products are considered in this paper, income should play an important role for pricing. A significant positive relationship between price level and income should be expected.

At the same time, James Duessenberry (1949) discussed the relationship between consumption and social status. He argued in his work that status expenditures are higher for higher income groups. With the movement to a higher social status, budget spent on ordinary goods is squeezed out. Since this study focuses on high-end beauty products, as income increases, drugstore products would then be replaced by high-end ones, and demand on drug-store products would decrease gradually. Congleton (1989) and Rauscher (1993) also suggested the correlation between income and status seeking. They presented theoretical models where “amplification” effect and “discouragement” effect presents. “Amplification” effect occurs when others make higher status consumption, marginal return to additional status consumption for

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an individual increase as well. Whereas, “discouragement” effect makes people drop out of the competence on account of the extra status seeking activities of others. Supposedly, people with lower income will display larger discouragement effects, and spend less on high-end commodities. Chao and Schor (Chao & Schor, p. 124) empirically discovered that women with higher incomes tend to spend more on high-end cosmetics.

3.2 Professional Success

The society appreciates and requires physical attractiveness and beauty, and attractive women have more chances of succeeding in their professional careers. Researches have shown that professional success is frequently affected by external appearance (Marlowe, Schneider, & Nelson, 1996; (Frieze, Olson, & Good, 1990; Hamermesh & Biddle, 1994). Appearance falls into broader category of non-verbal communication and people tend to be superficial. Conventionally, attractive people are perceived as having greater occupational potential than are less attractive people (Jackson, 1992). It is also empirically found that appropriate utilization of makeup is strongly associated with impressions on health, heterosexuality, and credibility in the workplace (Dellinger & Williams, 1997). One study discovered that women in high-status occupations view attractiveness as an asset in acquiring new job opportunities (Kaslow and Schwartz, 1987). Women seeking professional success and working at senior positions, therefore, tend to pay more attention to their appearances and purchase cosmetic products. In this study, percentage of women in senior management is selected as an indicator for professional achievement of women. Positive relationship is expected between professional accomplishment of women and cosmetic prices.

3.3 Individualism

Human needs and behavior are subject to the influences of learning, tradition, and cultural norms. Different cultures may exhibit substantially different motivations and actions in response to the their desire. Hoofstede's (2001) influential work on cross-cultural value systems identifies three aspects of cultures: power distance, uncertainty

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avoidance, and individualism. It is widely discussed that individualism plays an influential part when people make economic decisions (Tiessen, 1997; Zhang et al, 2007; Husted & Allen, 2008). Culture that emphasize individualism promotes pursue of one's goals and desires, value independence and self-reliance, and advocate individual superiority over a social group. In contrast, collectivism stresses the priority of groups, and importance of cohesion within social groups. Briefly speaking, individualistic cultures seek variety and diversity, whereas, collectivist culture values the conformity within group and acceptance by groups.

In terms of this study, individualism is used to measure social conformity and the importance of social value to individuals. Collectivists tend to value the acceptance and respect from others and social groups. Researches (Tatzel, 2002) have shown that materialism is related to the enrichment of status by possessing wealth. People in collectivist cultures have higher scores on materialism than those in Western culture. Therefore, collectivists are more willing to purchase high-end beauty products in order to be associated with higher income groups. Meanwhile, physical appearance is a part of non-verbal communication. Physical appearance can influence impression and one’s social prospects. Collectivists like to stay be accepted and able to stay in a group, therefore, tend to put more attention on how they look. Therefore, a negative relationship between price level and individualism is anticipated.

4 Data and Result

So far merely the presence of motives has been addressed in purchase behaviors. Uncovering evidence for the existence of such motives is of great relevance to the discipline of economics, where they are typically assumed not to exist. The relationship between price level and explanatory variables, expressed in a linear reduced form equation, will be estimated using Ordinary Least Square (OLS) method. The choice of explanatory variables is based on the demand side of the market, which is usually considered to be the determinants for pricing strategies. On the supply side, variables are left out of consideration for the monopolistic nature of the cosmetics industry.

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The sample used in the regression has been set up as follows. For each of the 27 countries and areas, recommended retail prices on 8 products are collected. To avoid biasedness, I selected the intersection of products sold by well-know brands including Lancôme, Clinique and Estee Lauder. Those eight products, with identical features in terms of brand and product line, form a package that is used to measure the price level of high-end beauty products.

The recommended retail prices were collected between December 24,2014 and February 21, 2015 from major retail chains such as Sephora and Douglas. Total price of those 8 products is used to reflect the price level of high-end cosmetics in each country. When comparing domestic prices of various countries, simply converting the prices into a common currency at exchange rate gives unsatisfying results, since most of the times exchange rates do not reflect the purchasing power of the currencies. In order to fairly compare the price level of cosmetics among the 27 countries, purchasing-power parity (PPP) result published by 2011 United Nations International Comparison Project is used to construct price indices with regard to the United States as base country. Since the products in the mix come from different companies, and major cosmetic companies have various plants over the globe, it is impossible to trace the duty paid on this cosmetic product package. For the scope of this study, only Value-Added Tax/Goods and Services Tax is taken into account. Price indices are adjusted accordingly to form pre-tax price indices. Income is estimated using Gross Domestic Product (GDP) per capita. GDP per capita in this research is retrieved from 2013 International Monetary Fund report based on PPP. The importance of professional success for women is measured by the percentage of women in senior management, which is collected by Grant Thornton in the International Business Report 2013. To estimate the significance of social value, individualism score from Geert Hoofstede’s Cultural Dimensions research is used. In his research, Hoofstede describes the effects of a society's culture on the values of its members, and how these values affect behavior. The theory presented by Hoofstede is now widely used as paradigm for cross-cultural studies. The higher the individualism score, the more individualistic the culture and the less people care about how they are perceived by others.

With all the data collected, OLS is then used to estimate the effect of income, professional success and individualism on pre-tax prices. The model that will be estimated is:

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𝑃𝑃𝑃 − 𝑡𝑡𝑡 𝑃𝑃𝑃𝑃𝑃 𝑃𝑖𝑖𝑃𝑡

= α + 𝛽1𝐺𝐺𝑃𝐺𝑃 + 𝛽2𝑊𝑊𝑊𝑃𝑖 𝑃𝑖 𝑠𝑃𝑖𝑃𝑊𝑃 𝑊𝑡𝑖𝑡𝑚𝑃𝑊𝑃𝑖𝑡 + 𝛽3𝐼𝑖𝑖𝑃𝐼𝑃𝑖𝐼𝑡𝐼𝑃𝑠𝑊 + 𝜀

The results of the OLS regression analysis will be discussed in the following part.

4.1 Income

Generally speaking, high-end cosmetic companies persist oligopolistic features and market power. They are able to set the price according to what the market will bear. Hence, prices of cosmetic products are expected to be higher in countries with relatively high GDP per capita. Nonetheless, the result of the regression tells a different story. The estimated coefficient for income is -0.08. It is small but significant at 1% level.

This negative relationship between price and cosmetics is not normal. Inverse relationship is observed in the case of Giffen goods. Giffen good is an inferior good that people consume more of as the price rises. For Giffen goods, income effect more than offsets the substitution effect, and the net effect of a price rise leads to increased demand. A Giffen good must satisfied three conditions: Firstly, the good must be an inferior good; Secondly, there must be a lack of close substitutes; Thirdly, the good must constitute a substantial percentage of the buyer’s income, but not such a substantial percentage of the buyer’s incomes that none of the associated normal goods are consumed. High-end cosmetic products, on the other hand, are certainly not Giffen goods. As people’s income increases, they are able to consume more cosmetics. At the same time, a variety of substitutes exist among high-end and drugstore levels. Neither do cosmetics constitute a substantial percentage of income.

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The contradiction of the law of demand could be explained by Veblen effect where the demand for commodity is proportional to its high price. Veblen goods are types of luxury goods such as expensive wines, jewelry, designer handbags and cars. As symbols for quality of life, power and prestige, the high price makes the goods desirable. At first sight, cosmetics are not considered to be a positional or status symbol, since they are not as visible as conventional Veblen goods. Nonetheless, cosmetics are widely defined as Veblen goods in many contexts. One definition for Veblen goods is products with exponentially higher price than a basic product in the same category. High-end cosmetics are priced at 5 to 10 times more than their drugstore substitutes. Thus, high-end cosmetics should be considered to posses Veblen features. Chao and Schor (1998) tested the existence of status-motivated demand in purchases of women's cosmetics, and empirically found that status seeking does exist. The result of this research found similar effect, where preference is not individual, and social factors do enter one’s demand. The quest for quality in life and brand identity rather than income motivates people to purchase high-end beauty products.

4.2 Professional Success

Theoretically, a positive relationship between cosmetic price level and professional success is expected, since physical appearance affects first impression and attractiveness. This positive relationship is validated empirically, given the coefficient for professional success is estimated to be 1.798. However, this relationship is not significant. With a t-value of 0.53, it is not possible to argue that women seeking

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career success spend more on their physical appearances and demand more cosmetic products. The reasoning is twofold. On the one hand, women need to look professional. They invest in outfits, heels, jewelry and handbags in order to form a good impression and enhance their career. Makeup and skincare are part of their investment in their physical appearances. This should lead to more demand for cosmetics products and therefore higher prices. Nevertheless, in order to look professional, women should not put too much emphasize on their looks. More than appropriate amount of makeup use is strongly associated materialism. Many may consider attractiveness is a liability in terms of getting along with male colleagues and being taken seriously on the job (Kaslow & Schwartz, 1987). Physical attractiveness appears to have both positive and negative consequences for women in the work place. The effect of professional success on cosmetic price level is indeterminable in this study.

4.3 Individualism

The t-value of 𝛽₃ is -5.61, meaning the coefficient for individualism is highly significant. A negative relationship between the price level of cosmetic products and individualism is present. In other words, the cosmetics cost less in individualistic cultures and cost more in collectivist cultures. The coefficient is estimated to be -6.12, which explains a significant part of the price difference among countries. This result implies that in collectivist cultures, perceived social motives do present in individual demand and companies pricing strategies. The desire for social acceptance and status is not negligible. This result is contradictory to the predictions of standard consumer theory, which would not expect any systematic differences to emerge across cultures or nations, and individual demand is considered to be independent. With the highly significant coefficient for individualism in this research, interdependent preferences suggested by behavioral economists are validated. Functional value is not the only value people receive when making purchases, and failure to model social value in economic framework could lead to systematic errors.

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5 Conclusion

The price differences across boarders have caught global attention since people are able to check the prices of cosmetics in other countries through just one click on their computers. As prices became more transparent, consumers in countries paying more are discouraged, people search for alternatives to get the products they want at a lower price. Parallel import turns out to be very appealing. However, parallel import also comes with controversies including selling near expiration products and harming social welfare. Consumers would be better protected and satisfied if the price difference of cosmetic products are not as prevailing. Therefore, it is important to understand what are the underlying causes persist price discrepancies across countries. In this article, I examined the factors that cause international price discrimination with OLS regression analysis and behavioral economics insights. Three sources for cross-country price discrimination are considered in this article: income, professional success of women and individualism. They are measured by GDP per capita, percentage of women in senior management and Geert Hoofstede’s individualism score respectively. The empirical result shows that price level of high-end cosmetics is significantly related to income and individualism. Income has inverse relationship with cosmetic price level, which contradicts what is normally expected in economic theories. The explanation for this anomaly could due to social factors and values people perceive when purchasing high-end beauty products. Since high-end cosmetics satisfies consumer’s social needs and pursuit for quality of life, they could be considered as Veblen goods which is now widely accepted. Demand for Veblen goods is proportional to its price. The high price tag makes the goods more desirable as symbols of the buyer's high social-status. The price level of collectivist culture is significantly higher as predicted. Perceived social motives do present in individual demand and companies pricing strategies. People in collectivist cultures need social acceptance, which is contradict to conventional economic frameworks that assumes individual preferences. However, the relationship between professional success of women and price of cosmetics is indecisive. This is due to the fact that physical appearance of women in professional settings has twofold effects. Attractiveness can be both an asset and a liability where women could not be taken seriously. The empirically findings suggest presence of social motives in purchases of women's cosmetics. Ignoring social factors could lead to considerably misleading results.

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Therefore, it is important to take social motives into consideration when analyzing luxury goods markets.

The evidence we have presented here provides a good first test of one set of products. For the scope of this research, there are unavoidable limitations. Since duty levied on the products is ignored, this would consequently lead to deviation when applying a real data analysis. Nevertheless, the aim of this research is reached and I hope this paper stimulates further research on a wider range of products and take duty into consideration. If additional researches yield similar findings, this should prompt researchers to rethink basic assumptions in the field of consumer demand.

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Appendix

Table 1 Product List

Lancome L'ABSOLU ROUGE

ARTLINER - Precision Point EyeLiner

Advanced GÉNIFIQUE Youth Activating Concentrate 1OZ Clinique Dramatically Different Moisturizing Lotion+ 4.2OZ

Moisture Surge Extended Thirst Relief 1.7OZ High Impact Mascara

Estee

Lauder Advanced Night Repair Synchronized Recovery Complex II 1OZ Double Wear Stay-in-Place Makeup

Table 2 Linear Regression Output

_cons 1135.277 196.915 5.77 0.000 727.9273 1542.627 Individualism -6.119613 1.090339 -5.61 0.000 -8.375152 -3.864075 Management 1.798023 3.377814 0.53 0.600 -5.189517 8.785563 GDP -.0084572 .0019658 -4.30 0.000 -.0125237 -.0043907 Priceindex Coef. Std. Err. t P>|t| [95% Conf. Interval] Robust Root MSE = 124.99 R-squared = 0.7952 Prob > F = 0.0000 F( 3, 23) = 13.91 Linear regression Number of obs = 27

Geographical price discrimination in the cosmetic industry

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