An Economic Model of Price Comparison with Consumers’ Internal Standard

Consumers evaluate retail prices based on their internal standard of anticipated prices to make purchases. The internal price standard has been operationalized as rational expectation of price beliefs. Without observing internal standard, its promotional effects estimated in descriptive specifications have limited applicability to firms' counterfactual prediction and optimal pricing. This paper proposes a normative framework that calculates an option value incorporating an agent's price belief distribution as outside good. The option value represents an expected maximum attainable utility per unit monetary value, which defines an appropriate price for a certain level of utility of each inside good. This price standard reflects the uncertainty around price expectation and quality variation across substitutes in a category. The proposed model improves holdout prediction of choices in an empirical application relative to the extant operationalizations of internal price standard. Our quality-normalized price standard enhances predictive accuracy of demand curves by decomposing brand-specific price premiums from price sensitivities