The New Substitution Effect

Loosely speaking, when economists talk about the "substitution effect," they are referring to the fact that as the price of one good or service rises relative to another, consumers will tend to favor the latter, cheaper option.

If, for example, people are genuinely indifferent to whether they eat chicken or beef for dinner, a rise in the price of steaks may cause some to choose drumsticks instead. Of course, this is a simplistic example, because any number of other factors can also influence the decision.

As it happens, some have argued that the United States' primary gauge of inflation, the consumer price index, is distorted by simplistic assumptions about the substitution effect.

Apparently, if steak-fanciers start buying chop meat this month, at a price not much different than before, because ribeyes have suddenly become more expensive, government number-crunchers take that to mean that prices have remained relatively stable, at least in this category.

Leaving that issue aside, many consumer product industry insiders and Wall Street analysts have long held that the substitution effect is muted or even nonexistent when comparisons involve no-name generics and the popular, brand-name favorites marketed by large, well known companies.

Recent evidence suggests that this relationship is no longer holding true in the current economic environment. As the Wall Street Journal reveals in "At the Supermarket Checkout, Frugality Trumps Brand Loyalty," severely constrained budgets are forcing a structural shift in consumer spending habits.

When Summer Mills visited her local CVS drugstore recently, to save a few dollars she bought the store-brand facial scrub rather than the Olay version she normally uses.

"I thought I'd be able to tell the difference, but I couldn't -- I looked at the ingredients and they seemed almost the same," says 30-year-old Ms. Mills, a stay-at-home mother of two in Ardmore, Okla. On her next shopping trip, "I'm going to buy the store-brand moisturizer and cleanser -- it's less money."

Many Americans are changing their everyday purchases and abandoning brand loyalty, prompted by the persistent financial pressure of rising food, gasoline and electricity prices. Over the past 24 months, consumer prices have risen 7.8% according to the U.S. Bureau of Labor Statistics. From coloring hair at home instead of at the salon to trying cheaper laundry detergents, new evidence indicates that Americans are modifying even minor household habits to save money.

Kimberly-Clark Corp. CEO Thomas Falk noted that sales of the company's potty-training pants, once one of the biggest sales-growth products in the baby aisle, have fallen off in recent months. "You're seeing consumers leaving children in diapers longer...the diaper is less expensive per piece than a training pant," he said in a recent conference call in which he announced a 9% decline in third-quarter earnings.

Shoppers are even buying toilet paper differently. "When they get to the end of the month, and they're out of paycheck, they may buy a smaller-count pack," Mr. Falk said. "You're seeing that shift in consumer behavior during a pay-period cycle more than we maybe have in the past."

Retailers are also sensing more shopper experimentation. This fall, supermarkets Safeway Inc. and Kroger Co. noted that sales of their store brands are on the rise. "In this economy, customers are much more willing to try a private-label item, and we're seeing signs that this is happening more and more as the year progresses," Kroger CEO David Dillon said on a conference call.

 To be sure, overall sales of name-brand goods are still higher than those of store brands. Still, about 40% of primary household shoppers said they started buying store-brand paper products because "they are cheaper than national brands," according to a September report by market-research company Mintel International, which interviewed 3,000 consumers. Nearly 25% of respondents reported that it is "really hard to tell the difference" between national brands and store brands of paper products. Store brands on average cost 46% less than name-brand versions, Mintel found.

"This is one category where people can definitely trade down strictly for budgetary reasons and not have to think twice about it," says David Lockwood, Mintel's director of research. "And upper-income people are changing their patterns the same way that lower-income people are."

Paper napkins suffered the steepest declines over the past year, followed by facial tissue and paper towels. "Not surprisingly, toilet tissue is holding up the best," Mr. Lockwood says.

Laundry habits are changing, too. Early signs indicate shoppers are switching to cheaper detergents and softeners, a rare shift in one of the most brand-loyal product categories.

Sales of private-label detergent rose 12% over the 52-weeks ended Sept. 6, to $189 million, according to market-data company Information Resources Inc., or IRI. Lower-priced brand-names are posting gains, too. Last week, Procter & Gamble Co. reported that volume sales of its bargain-priced Gain detergent rose 10% in the quarter ended Sept. 30, offsetting weaker results for the market-leading and pricier Tide.

Meanwhile, estimated retail sales of value-oriented Purex fabric softener, owned by Henkel AG, rose more than 60% over the past six months, the company says. "We view the economic slowdown as an opportunity for our brand," says Greg Tipsord, senior vice president of Henkel's U.S. laundry care. "It's causing the consumer to rethink what had become a habit."

To win over shoppers, Purex has tried to keep the price of its detergent and fabric softener roughly 50% or more below the price of competing premium brands, says Mr. Tipsord. Large sizes are in higher demand as consumers try to cut down on shopping trips and get a better price per ounce, he says.

Though low-income consumers have been cutting back for the past several months, now upper-income shoppers -- those with household incomes of $100,000 or more -- also are making significant changes, according to a new survey by IRI.

The report, titled "Shopper in Crisis," found that 41% of upper-income consumers reduced spending on nonessential groceries, and a fourth of these consumers said they gave up favorite brands over six months in 2008. Nearly one-third of high-income shoppers said they bought more private-label products during the second quarter, up from about 20% in the first quarter of this year.

"This isn't belt-tightening, it's belt-notching," says Thom Blischok, president of consulting and innovation for IRI. "These ritual changes are much deeper and happening much faster than we expected."

Meanwhile, 52% of consumers at all income levels said they tried to make personal-care products last longer, and a quarter of respondents said they now share more personal-care items, such as shampoo, with other household members, the IRI survey of 1,000 respondents found. Nearly half of all consumers said they went to spas and salons less often, while one-third of consumers reported doing more beauty treatments at home.

Indeed, unit sales of at-home hair-color treatments are on the rise, up 2.21% in the three months ended June 29 compared with a year ago. Though that figure has flattened in the three months ended Sept. 29, an IRI spokeswoman attributes that to women stocking up on the product in the previous period.

Meanwhile, private-label versions of soap and other bath products are up 23% in the 52-weeks ended Sept. 6, to $168 million, according to Nielsen Co. Private-label versions of skin-care items are up 16% to $182 million during the same period.

Shoppers' changing behavior prompted Procter & Gamble, the world's biggest advertiser, to alter its marketing approach and focus on in-store promotions. "More decisions are made in the store, and we have to be competitive," CEO A.G. Lafley said on a conference call with investors last week.

Comments

[Jack]

Well, lathered (cheap) hand soap is perfectly fine to use for shaving as compared to shaving cream I've found.

[Sackerson]

And the substitution of trailers, caravans and mobile homes for houses, of course.