Journal of Emerging Trends in Economics and Management Sciences: Home

Abstract:
This paper studies the integrative impact of reference effect and substitution effect on the price decision of firms. We start with a monopolist selling the product in two sequential selling periods. An internal reference effect as an additional component of the base demand occurs in the second period. Analytically, such effect can encourage the firm to set a higher price firstly to better establish a higher reference effect which exaggerates the demand in a near future. We explicitly illustrate the price distortion between the scenario with and without reference effect and an upper bound of discount percentage within the two periods. Next, we study the duopoly scenario in which substitution effect among multiple firms coexists with reference effect. Interestingly, we find that the two effects have distinct impacts on the price of the product. Concisely, competition effect affects the price in a vertical way, where the price base (traditional price without reference effect) is decreasing in competition intensity, and reference effect affects the price in a lateral way, where the additive component of the price is increasing (decreasing) in reference intensity in the first (second) period. Overall, the competition will reduce a firm?s profit. However, the reference effect will increase a firm's profit.

Keywords: reference effect; competitive intensity; dynamic pricing; two periods; discount percentage.

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