When Prospect Theory Meets Consumer Choice Models: Assortment and Pricing Management with Reference Prices

Problem definition: Reference prices arise as price expectations against which consumers evaluate products in their purchase scenarios. We investigate what will happen when prospect theory (e.g., reference prices) meets consumer choice models from the perspectives of both the consumers and the firm. Academic/practical relevance: Consumers see multiple relevant products on a particular purchase occasion and often compare their prices to form the willingness to pay when considering whether to purchase a particular product. Reference prices, which are not included in many choice models, may impact consumer choice behavior, so we incorporate reference prices into consumer choice models and investigate the operations management problems. Methodology: We take the widely used multinomial logit model as a showcase to examine the effects of reference prices through analytical and empirical study. We consider the optimization problems on assortment planning and pricing under consumer choice models with a variety of reference prices, including the lowest price and the assortment variety. Results: Our empirical study on a real data set demonstrates that incorporating reference prices into choice models can significantly improve goodness of fit and prediction accuracy of consumer choice behavior. Moreover, we characterize the optimal policies for the assortment planning and pricing problems under the consumer choice models with various reference prices. In particular, for the pricing problems under the reference prices defined by either the lowest price or assortment variety, we show that the optimal pricing policy has the following structure: products can be divided into several groups based on their costs; the products in the same group charge either the same markup or the same price. Managerial implications: In practice, reference prices should be taken into account in model estimation and operations management. Ignoring reference prices may lead to substantial losses. The online appendix is available at https://doi.org/10.1287/msom.2017.0688 .