Consumer-Driven Class Pricing

Class pricing describes a widespread practice of assigning a few price points to a large set of differentiated products. While Wernerfelt (2008) proposes firms' costly price setting activities as a friction-based explanation, we offer a consumer-driven rationale rooted in reference-dependent and lossaverse consumer behaviors. We develop a model incorporating a monopolistic firm selling multiple products to a continuum of consumers with heterogeneous tastes and employ Kőszegi and Rabin's (2006) expectations-based prospect theory to depict customers' reference points as endogenously determined via aligning their optimal choices to their rational expectations about consumption outcomes. We find that while product cost variations motivate unequal prices to stimulate demand for lower-cost products, loss aversion constrains this practice: the resulting demand shift asymmetrically diminishes consumers' willingness to pay (WTP) for lower-cost products more significantly than it can elevate WTP for highercost alternatives. This asymmetry reduces the firm's total profit from multiple products and drives the adoption of class pricing. Our research contributes to a better understanding of class pricing for both academic and managerial practice, and provides insights on when more prices are not necessarily advantageous in an era of information and emerging AI technologies.