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Dynamic pricing with loss averse consumers and peak-end anchoring

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We analyze a dynamic pricing problem where consumers’ purchase decisions are affected by representative past prices, summarized in a reference price. We propose a new, behaviorally motivated reference price mechanism, based on the peak-end memory model proposed by Fredrickson and Kahneman (1993). Specifically, we assume that the consumers’ reference price is a weighted average of the lowest and last price. Gain or loss perceptions with respect to this reference price affect consumer purchase decisions in the spirit of prospect theory, resulting in a non-smooth demand function. We investigate how these behavioral patterns in consumer anchoring and decision processes affect the optimal dynamic pricing policy of the firm. In contrast with previous literature, we show that peak-end anchoring leads to a range of optimal constant pricing policies even with loss neutral buyers. This range becomes wider if consumers are loss averse. In general, we show that skimming or penetration strategies are optimal, i.e., the transient pricing policy is monotone and converges to a steady state, which depends on the initial price perception. The more the value of the steady state price decreases, the more consumers are sensitive to price changes, and the more they anchor on the lowest price.

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