Differences in the Ability of Structural and Reduced-Form Models to Improve Pricing Decisions

Although structural modeling as a means to improve pricing decisions often appears in prestigious academic journals, its consideration in pricing textbooks remains rather limited, and knowledge about its benefits and limitations in comparison to reduced-form models is scarce among “structural nonexperts”. This article outlines for these “structural nonexperts” which different abilities structural and reduced form models have to improve pricing decisions. Therefore, it uses a popular textbook example that fails to consider the abilities of both models, which are the abilities to capture the effects of consumers' responses and changes in cost structure on prices. It outlines that the major advantages of structural models are the ability to capture competitors' reactions and the description of new market equilibriums, which come at the costs of assumptions that usually prevent structural models to further improve prices. The beauty of the simple example provided is that it enables nontechnical readers to easily understand the major differences between structural and reduced-form models