Friday, March 18, 2011

Operations Research 59, 6 (2011) 1361-1368

We study the dynamic pricing implications of a new, behaviorally motivated reference price mechanism, based on the peak-end memory model of Fredrickson and Kahneman (1993). This model suggests that consumers anchor on a reference price which is a weighted average of the lowest and most recent prices. Loss averse consumers are more sensitive to perceived losses than gains relative to this reference price. We find that a range of constant pricing policies is optimal for the corresponding dynamic pricing problem. This range is wider the more consumers anchor on lowest prices, and persists when buyers are loss neutral,in contrast with previous literature. In a transient regime, the optimal pricing policy is monotone, and converges to a steady state price, which is lower the more extreme and salient the low-price anchor is. Our results suggest that behavioral regularities, such as peak-end anchoring and loss aversion, limit the benefits of varying prices, and caution that the adverse effects of deep discounts on the firm's optimal prices and profits may be more enduring than previous models predict.