Academic journal article International Journal of Business

Economics of Deals and Optimal Pricing Policy

Academic journal article International Journal of Business

Economics of Deals and Optimal Pricing Policy

Article excerpt

I. INTRODUCTION

The literature concerning behavioral economics dates back almost thirty years with the publication of the ground breaking research of Kahneman and Tversky (1979). They showed that individuals tend to be swayed by psychological factors when deciding on a purchase of a good or service. In the intervening years much further research has been undertaken. Today we use the term "Framing Effect" (see also Tversky and Kahneman (1981)) to describe the fact that individuals' purchasing decisions are often sharply influenced by the wording of the seller's offer although the different formulations of the offer are in effect completely identical. In other words, re-wording the exact same offer or deal could change the decision as to a purchase or as to accepting a certain level of risk in undertaking a project or an investment.

Another aspect of this interesting phenomenon was brought to light in papers by Simonson et al. (1994) and Raghnbir (1998) [followed by similar papers by her (2004)] in which give-aways are studied. The idea of the give-away is that when you purchase a unit of product A, a unit of product B is given to you free of charge. Raghnbir's results show that being exposed to this give-away brings about a decline in the price that customers are willing to pay for good B when good B is being sold under normal (non give-away) market conditions. Clearly having become aware that good B was involved in a give-away cheapens it in the eyes of the potential consumer. He internalizes (perhaps only subconsciously) that the good is probably cheap to produce, is of low quality, etc. Giving away product B with a price tag attached listing its full price reduces this image problem but does not eliminate it.

We utilize these results but in the opposite direction, and thus add another dimension to these behavioral economics discussions. Our analysis is based on the empirical observation that many large (and small for that matter) department stores advertise large price reductions (on clothing, shoes, household items, etc.) immediately after major holidays or with the approaching change of seasons. Often these reduced prices are reduced even further in the following weeks, and eventually some of those items might altogether disappear from the shelves. Frequently however a unique method of promoting the price reduction is undertaken. The original price is attached to the discounted price with a big X drawn across it to show the less informed customer just how dramatic a price reduction he is being offered. The empirical evidence indicates that sellers consider this tool to be effective, since the deal-prone customers are not only affected by a low price, but they also compare the low price to the original price. A larger gap between the original price and the sale price motivates the deal-prone to buy more. This is probably the result of customers taking the high reference price as an indicator of high quality, and therefore the new lower price is considered a better deal than would be the case had the initial price opened low and continued to remain low. Of course, the less independent information a customer has about a given product, the more likely he is to use price as a predictor of quality. The purpose of this paper is to investigate this popular pricing policy and to develop the optimal price trajectory based on the interdependency between current purchases and previous and current prices.

An intentional policy of making the product expensive and/or hard to get in the initial period can in an inter-temporal framework result in higher income and profits for the seller. Often firms introduce a new product at a sharply reduced price in order to get the public to try it and develop a taste for it. Once the product has made its desired market inroad the price is raised to the desired level. We argue that instead of introducing a new good to the public by setting a very low introductory price (which could have negative image implications), it might be appropriate to do just the opposite, i. …

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