The Effects of Consumers' Price Expectations on Sellers' Dynamic Pricing Strategies

Hong Yuan and Song Han
Journal of Marketing Research (JMR)
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Executive Summary
The main purpose of this study is to examine the effect of price expectations on consumers’ adaptive search behavior and sellers’ pricing strategies. On the basis of the price expectation literature in marketing, we propose and show that price information collected throughout the entire purchase history (not just the prices paid in the last period) has an important role in price expectation formations. In turn, these expected prices affect search behavior because consumers decide whether to continue searching by comparing their price expectations and observed current period prices. The authors derive perfect Bayesian Nash equilibrium and show that consumers search less when prices are lower than the last period. Therefore, when anticipating consumers’ adaptive search behavior, sellers may have incentives to lower prices just enough to prevent consumer search when costs fall, which causes the prices to be less responsive downward and inefficiency in the market. This proposition offers an alternative explanation for the well-documented “Rockets and Feathers” phenomenon. Although researchers in economics and marketing have devised several explanations for asymmetric price adjustment from the sellers’ perspective, the authors show how adaptive consumer search, by itself, could also lead to the same phenomenon.

They then test their model implications in an experimental setting in which they can control for other theoretically relevant factors (e.g., industry capacity, inventory, market size, concentration) while manipulating external cost shocks. Their experimental approach is different from most experimental research on this topic, which focuses on one side of the market. They simulate market experiments as buyers and sellers might interact with each other. These experiments enable the authors to examine changes in prices (which can be documented using secondary data) and search (which is much harder to observe in the marketplace). Results from two experiments provide strong support for both directional and point predictions of the model.

The authors’ findings suggest that it is important for researchers and practitioners to understand the effects of adaptive consumer search on pricing and market behavior. Policy makers should also be aware of the possibility of sellers exploiting their understanding of the adaptive search process by dynamically adjusting prices to maximize profits. Because consumers may have incomplete information about marginal costs, they may not be able to recognize whether the price adjustment is due to cost change. By making the markets (especially cost information) more transparent to the consumers, the market can be much more efficient. Further research could attempt to manipulate market transparency and show that the effect dwindles as consumers glean information about sellers’ costs.

Biography
Hong Yuan is Assistant Professor of Marketing in the College of Business at the University of Illinois at Urbana-Champaign. She has a Master’s degree in Applied Economics and a PhD in Marketing from the University of Michigan. She uses analytical models and market experiments to study buyer–seller interactions in the context of pricing.

Song Han is Associate Professor in Economics School at Renmin University of China. She has a PhD in Economics from Renmin University of China. Her research interests are in the areas of game theory and industrial organization.

Journal of Marketing Research, Volume 48, Number 1, February 2011
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Hong Yuan and Song Han
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