Essays On Marketing Strategies With Endogenous Reference-Dependent Preferences

Abstract

Essay 1: Class Pricing with Reference-Dependent Consumers Essay 1 investigates the origin of class prices, a widespread practice in which a large set of goods or services (SKUs) are first divided into a smaller number of classes and then a single price is assigned to all members of a class even when their costs and demands are self-evidently quite different (Wernerfelt, 2008). A few studies (Levy et al., 1997; Wernerfelt, 2008) rationalize the phenomenon by emphasizing a particular friction, namely, that firms incur costs to set prices (e.g., the costs of assembling and processing relevant information, printing and attaching labels, etc.). Given advances in information technology and data availability, we would expect such practices to fade away. However, there is no such discernible trend, so we look to additional drivers. I propose an explanation that stimulates consumers’ reference-dependent preferences. Consider a firm that offers multiple SKUs with different attributes to heterogeneous consumers who are ex-ante uncertain about their taste, which is resolved just prior to purchase. By applying the UPE solution concept and extending Koszegi and Rabin’s (2006) framework, these consumers formulate credible consumption plans that evaluate their consumption outcomes along all the relevant dimensions against their rational expectations about consumption outcomes. These credible plans align their optimal choices with their ex-ante plans, which carries forward the expectations-based gains and losses. My results show that firms do not set a different price for each product, even when their costs or demands are different across the products. In contrast, firms robustly use class prices as optimal prices to engage consumers in different settings (i.e., either horizontal or vertical). Intuitively, firms use class pricing because it cushions consumers against the larger, expected aversive losses that come with greater numbers of prices, particularly when a) the gaps in consumers’ tastes across products are small and/or b) the differences in the products’ marginal costs are small. Consumers’ willingness-to-pay is adversely impacted by these aversive losses. Essay 2: Opportunism and Trust in Inter-Organizational Ties: A Reference-Dependent Approach Essay 2 investigates the origin of trust in a buyer–seller setting. Trust and trustworthiness imply some shared expectations of the trustee’s appropriate behaviors, and the actions of both buyers (trustor) and sellers (trustee) depend on these expectations. This exhibits the same spirit of Koszegi and Rabin’s (2006, 2007) expectations-based prospect theory, which makes a reference-dependency approach toward modeling trust come naturally. I model a private, one-shot dyadic exchange where both the trustor and the trustee have reference-dependent preferences in the sense of Koszegi and Rabin's (2007) framework. I analyze social norms as shared belief distributions of appropriate payment for the task. Trustworthiness, then, is not a fixed trait but is rather based on the shared belief distribution of the appropriate effort to be returned for the trust. My results emphasize that equilibrium trust and opportunistic betrayal rise and fall in tandem, with high levels of trust inviting more betrayal and vice versa. These behaviors are not mirror opposites; rather, people are inclined to be opportunistic and benevolent simultaneously and thus act accordingly. Extending the analyses to trustees with heterogeneous capabilities, I show that greater variability in the competence across trustees reduces trust because those trustees with relatively lower capabilities struggle to meet the trustworthiness standards. This reference-dependence approach of modeling trust closes several gaps in extant trust literature: (1) this theory of trust meets the endogeneity challenges surrounding trustworthiness beliefs vis-à-vis trust acts; and (2) it overcomes Williamson’s (1993) twin requirements of unconfounding trust acts with risky acts and unconfounding trust acts with self-interested reputation effect.