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Reference Price June 11, 2007

Posted by jyu in Qualifying.
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A reference price is an internal standard against which observed prices are compared.  It is the perceived price or the price that the consumer expects to pay for a brand or product category when entering a store.  Reference prices effects are supported by:

  1. Adaptation Level Theory (Helson 1964) – Stimuli are judged with respect to internal norms representing the pooled effects of present and past stimulation
  2. Assimilation Contrast Theory (Sherif and Hovland 1958) – A price that is outside the range is contrasted to the acceptable range and becomes noticeable
  3. Prospect Theory (Kahneman and Tversky 1979) – A value function that is defined over gains and losses
    • States that consumer’s response to losses is greater than their response to gains.
    • Have been used to justify reference price effects
    • Some reference point is assumed
    • The value function is that it is concave for gains and convex for losses, the well-known loss aversion hypothesis
    • Provide evidence that the asymetric price response regarding to loss and gain
    • One criticism is that the asymmetric effect may be because of unobserved heterogeneity.  Bell and Latin (1993) find the basic loss aversion result with organge juice data, but find that accounting for household heterogeneity in loss aversion diminishes the effect.  It is recommended for researchers to account for customer heterogeneity when assessing the effects.

There are three established empirical generalizations in the reference price literature:

  1. Reference prices have a consistent and significant impact on consumer demand
  2. “Internal” reference prices utilize past prices as part of the consumer’s information set
  3. Consumers react more storngly to price increases than to price decreases

Different Definition of Reference Price by Researchers:

  1. Observed price – reference price or reverse
  2. Based on past prices: A weighted average of past prices with varying carryover weights
  3. Based on current prices
  4. Based on past prices and other information (e.g. deal proneness, store characteristics, price trend, frequency of promotion)

Briesch et al. (1994) empirically compare choice models where the reference price is formed on current prices only (no price memory) with several where reference price is assumed to be formed based on past prices only.  The best fitting choice model utilized a reference price formation process based upon brand specific of brands available on the previous choice occasion.  Although the notion that consumers may have a category level (rather than brand specific) reference price is appealing, the analysis shows that specifying a single reference price for all brands is not appropriate and refernce price is brand-specific

Future Researches in the area of reference price:

  1. The concept of reference still needs to be fully validated.  (not certain that consumers actually form references, only that they act if they did)
  2. Consumers may use multiple reference prices
  3. Is there a reference point or a reference gap?
  4. Which past prices do consumers use in forming a reference price and how many are used?
  5. Do reference prices vary over market segments? If so, does this heterogeneity affect some of the generalizations described above?
  6. Industrial products have not been studied.
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