The Impact of Household Level Heterogeneity in Reference Price Effects on Optimal Retailer Pricing Policies

The field of marketing has witnessed substantial improvement in modeling household level heterogeneity. However, relatively little has been written about how modeling household heterogeneity translates into better marketing decisions. In this paper, we study the impact of household level heterogeneity in reference price effects on a retailer's pricing policy. Reference prices are certain anchors or standards that households use to compare the observed purchase price of a product against. If the observed price is greater than the reference price it is perceived as a "loss". On the other hand, if the observed price is less than the reference price it is perceived as a "gain". In order to study the impact of heterogeneity in reference price effects on retail pricing, we use a hierarchical Bayes nested logit model that provides estimates for gain and loss effects at the household level. Using these household level estimates, we develop a normative pricing policy for a retailer maximizing category profit. In the empirical analysis, we find that although at the aggregate level (i.e. average across households) the impact of a gain and loss is about the same, for a number of households a gain has higher impact than a corresponding loss. Our results indicate that the optimal pricing policy derived from the heterogeneous case is qualitatively different from the case when heterogeneity is ignored. We suggest that when there is household heterogeneity in reference price effects, it is important for a retailer to (a) consider the joint distribution of gain and loss effects among the households and (b) promote brands that have a higher preference among the "gain-seeking" households. Retail pricing policy based upon a model that incorporates household heterogeneity is also shown to be more profitable. Further, the purchase incidence increases when household heterogeneity is considered in the pricing policy. The primary contribution of this paper is to demonstrate the pricing and category profit implications of incorporating heterogeneity in reference price effects for a retailer. We show that for an important marketing problem pertaining to a retailer, the optimal pricing decisions for various brands in a category are inextricably related to household heterogeneity in reference effects and brand preference