Reference Price Formation Model for Heterogeneous Consumers

Wirawan Dony Dahana, Nobuhiko Terui

We propose a hierarchical Bayesian model that accounts for consumer heterogeneity ofreference price formation. Two types of reference prices, internal and external, are considered ascomponents of the formation. We model a reference price as a weighted average of these types ofreference price. The weight parameter, which indicates the relative importance of one type ofreference price, is assumed to vary among consumers and across brands. We apply a hierarchical
Bayesian framework that links the weights to some consumers’ characteristics to explain thevariation. The proposed model is calibrated on a scanner panel data of curry roux and instant coffee
category using MCMC method. We observed that more than 50 percent of consumers form theirreference prices based either on an internal or external reference price.

1. Introduction
Reference prices are a well established concept in consumer behavior and marketing research.
Numerous theoretical and empirical studies have examined this area. An empirical generalization by
Kalyanaram and Winer (1995) summarized the effects of reference prices on consumers’ demand.
They highlighted some theories on which the existence of reference price is based, empirical studies
supporting its effects, and how consumers react to price changes relative to reference prices.
Although it is a widely recognized concept, no consensus exists among researchers of how
consumers form reference prices. Some researchers argue that a reference price is determined by past
prices (Lattin and Bucklin 1989, Kalyanaram and Little 1992, Greenleaf 1995). This type ofreference price is called an internal reference price (IRP). This finding is based on Helson’s
Adaptation-Level Theory that assumes that consumers judge stimuli with respect to past and present

1stimulation. Therefore, past prices can be considered to serve as an adaptation level, or a reference
point relative to an actual price. In addition, consumers’ use of past prices as a reference point has
been justified in laboratory studies in consumers’ price judgments (Della Bitta and Monroe 1974,
Kalwani and Yim 1992). An empirical study by Winer (1986) of past prices’ effects using coffee
scanner panel data showed that a brand choice model fit the data better when the effects wereincorporated.
However, some doubt remains about consumers’ recall of past price knowledge. A study byDickson and Sawyer (1990) showed that almost half of consumers demonstrated a limited ability torecall prices they paid for goods (only 47% to 55% of the respondents could accurately recall the
prices they had just paid). These facts therefore raised the issue of whether reference price models
based on past prices can predict consumer behavior (e.g. brand choice) adequately (Urbany andDickson 1991). Some researchers have proposed alternative formulations of reference prices basedon current prices of some reference brands (Hardie et al. 1993, Mazumdar and Papatla 1995). This
type of reference price is called the external reference price (ERP). The underlying arguments are,first, that the most recent prices are more salient in a consumer’s memory than past prices(Rajendran and Tellis 1994). Secondly, the most recent brand purchased seems likely to serve as areference brand; its price is used as reference point (Hardie et al. 1993). In an empirical study
applied to refrigerated orange juice data, Hardie et al. (1993) found that the ERP (current price of thelast purchased brand) choice model fitted in-sample and holdout data better than an internalreference price (IRP) (exponentially smoothed prices) choice model.
The evidence indicates that both IRP and ERP effects are supported theoretically and empirically.
Whereas other formulations of reference price exist such as the reservation price (Hauser andWernerfelt 1988, Srivastava et al. 2000) and expected future price (Khirsna 1992, Kalwani et al.
1990, Jacobson and Obermiller 1990), IRP and ERP can be conceptualized as encompassing themost relevant prices that consumers use (Rajendran and Tellis 1994). Therefore, it is natural to infer2that several types of consumer exist in the market. They form their reference prices based either on
IRP or ERP, or both IRP and ERP combined. A study by Mazumdar and Papatla (2000) found that
more than 50 percent of the consumers in the liquid detergent and ketchup markets belong to the IRPor ERP segment. That consumers do have multiple reference prices has also been asserted by
Mayhew and Winer (1992), who found that both IRP and ERP have considerable effects on purchaseprobability.
Understanding how reference prices are formed is important because that process determines the
optimal pricing policy that should be taken by marketing manager to maximize profits (Kopalle et al.
1996). For example, given some conditions, cyclical (Hi-lo) pricing is the optimal policy for a
duopolist when consumers use past prices as reference prices in contrast to constant pricing (e.g.
EDLP) when consumers’ reference prices are based on the current price of reference brand.
Consequently, marketing managers would have an interest in acquiring information of how
customers form their reference prices.
Rajendran and Tellis (1994) propose a reference price formation model that incorporates both
IRP and ERP to answer the dualism of reference price conceptualizations. They argue that reference
prices of target brands are formed as a weighted average of IRP and ERP. The weight parameter isbounded by 0 and 1 and is homogeneous among consumers. Mazumdar and Papatla (2000) extended
this specification by assuming that the weight parameters might vary across segments in the market.
They apply a finite mixture model to account for weight parameter heterogeneity and estimatedparameters at the segment level.
Our study extends the specification of reference prices proposed by Mazumdar and Papatla(2000) by assuming that the weight parameters are heterogeneous among consumers (i.e. eachconsumer has a different weight). Furthermore, following the work by Briesch and colleagues (1997),
which showed that the “best” reference price is the brand specific one, we also assume that theweight parameters vary across brands. This is of particular interest for manufacturers who wish to3

know the price competitiveness of their brands.
We use a continuous mixture model, instead of a finite mixture model, to capture parameter
heterogeneity at the consumer level. This model has several advantages compared to its finite
mixture counterpart, which will be mentioned in a subsequent section. We adopt a hierarchical
Bayesian model and regress the weight parameters to some consumer characteristics to explain what
factors that produce different parameters among consumers.
The remaining sections are organized as follows. In section 2, we describe the basic concepts ofthe proposed model. The model itself is discussed in section 3. Section 4 summarizes data andvariables’ operationalization. Empirical results and discussion are presented in section 5. Section 6
concludes this paper.

2. Basic concepts
Some terms are used in the literature to describe IRP and ERP. The IRP and ERP have beencalled a temporal reference price and a contextual reference price (Rajendran and Tellis 1994), which
are memory-based and stimulus-based reference prices Briesch et al. (1997). In this section, we will
discuss the process of reference price formation based on these two types of reference price andfactors that might influence their relative importance.
How consumers form their reference prices depends on the accessibility of a price in memory(e.g. Biehal and Chakravarti 1983). Consumers who have a better memory of previous prices paid
will use that information to construct a reference price. Then IRP will dominate the formationreference price of such a consumer in making price judgment. On the other hand, consumers who
have limited ability to access past prices stored in memory will rely greatly on ERP in making such a
judgment. Which type of reference price dominates consumer judgment is of particular interest for aretailer and manufacturer who want to identify their customers as belonging to an IRP or ERP
segment so that they can make a decision about the best promotion strategy. For example, if the4market is dominated by IRP consumers, a frequent price promotion will result in a sales trough after
the deal (Blattberg et al. 1981, Neslin et al. 1985, Jain and Vilcassim 1991) because of the change ofreference prices (Lattin and Bucklin 1989, Kalwani et al. 1990, Kalwani and Yim 1992).
However, it is well documented that the ability to recall past prices varies among consumers(Dickson and Sawyer 1990, Urbany and Dickson 1991, Vanhuele and Dreze 2002). Some
researchers have investigated the extent to which this ability varies and the factors that can be used
to explain the variation. According to the studies, variation of consumers’ ability to recall past prices
arises from the distinction in consumer characteristics (Rajendran and Tellis 1994, Vanhuele andDreze 2002, Mazumdar and Papatla 2000), brand characteristics (Mazumdar and Papatla 2000), andhousehold inventory position (Kumar, Karande, and Reinartz 1988). We will restrict our discussion
on the relation between consumer characteristics and the ability to recall past prices (a summary
relating this issue is apparent in Mazumdar, Raj, and Sinha 2005). Characteristics are purchasefrequency, interpurchase times, the number of brands sampled, deal proneness, purchase quantity,
price volatility, and brand preference. We summarize the relation as follows.
1. Purchase Frequency. Consumers who purchase particular brands in the category more
frequently are likely to have better memory concerning the past price of those brands.
Therefore, we can expect that such consumers tend to use IRP than ERP (Rajendran and Tellis
1994).
2. Interpurchase times. A second characteristic that can influence the relative use of IRP and
ERP is the interpurchase time (Mazumdar and Papatla 2000). Consumers who leave themarket for a long time, i.e. who have longer interpurchase times, are likely to have difficulty
recalling past prices. Such consumers would therefore use ERP rather than IRP to evaluate
brands’ prices.
3. Brand sampled. Consumers who tend to switch across numerous different brands in the
category will encounter various prices (Rajendran and Tellis 1994, Mazumdar and Papatla

52000). It would be difficult for consumers to recall those prices if the prices of the brands thatwere purchased varied with a large range.
4. Deal Proneness. If a consumer purchases the category mostly when it is on promotion, then
ERP will be stronger than IRP (Mazumdar and Papatla 2000). Promotion-sensitive consumers
are more likely to notice in-store price information and related cues and instead form areference price at the point of purchase.
5. Purchase quantity. Vanhuele and Dreze (2002) posit that the consumer’s budget for the
category can improve consumer attention toward prices. Therefore, a consumer who buys alarger size is likely to have better ability to recall past prices and therefore to be an IRP
shopper.
6. Price volatility. Price volatility is also a potential factor of a consumer’s ability to recall past
prices (Vanhuele and Dreze 2002). It would be easier for a consumer to recall if a price wererelatively stable. On the contrary, if prices fluctuate intensely with a large range, consumers
would find it harder to recall past prices. Consequently, ERP is expected to be more important
relative to IRP for a consumer who encountered volatile prices.
7. Brand preference. The last factor that might engender a greater use of one type of reference
price is brand preference (Mazumdar and Papatla 1995). A consumer who has a higher
preference to a specific brand would have higher probability to purchase the brand. In turn,that consumer would have better knowledge of the brand characteristics, including price. Sucha consumer is more likely to rely on IRP than on ERP.
In the subsequent sections, we will investigate the robustness of the characteristics mentioned
above in explaining the heterogeneity of reference price formation. We adopted a hierarchical Bayes
structure proposed by Rossi, McCulloch and Allenby (1996) to model the effects of consumer
characteristics on weight parameters that represent the domination of IRP toward ERP.

6

3. The Model
Brand Choice Model. Most studies concerning reference prices have been devoted toinvestigating its effects on consumers’ brand choice behavior (Kalyanaram and Little 1989, Winer
1989, Lattin and Bucklin 1989, Mayhew and Winer 1992). Specifically, the effect is often modeled
as a discrepancy of the reference price from the actual price. It is called a “gain effect” if thereference price is greater than the actual price, and a “loss effect” if otherwise. We follow such amanner of modeling reference price effects in our study.
To begin, we first define a random utility function that incorporates reference price effects.
Consumer h’s utility to brand j at time t is a linear function of the discrepancy of reference pricefrom actual price, marketing mix variables and brand loyalty.

U jht = α jh + β Gh I Gjht ( RPjht − Pjht ) + β Lh I Gjht ( Pjht − RPjht )+ β1h X (1)+ L + β dh X (jhtd ) + ε jht ,jht

ε jht ~ N ( 0, σ 2 ) ,j = 1, K , J ,h = 1, K , H ,(1)
t = 1, K , Th .

In those equations, RPjht and Pjht are the reference price and the actual price of brand j for consumer(d )h at time t. Also, I Gjht ( I Ljht ) equals 1 if RPjht > Pjht (Pjht > RPjht), and 0 otherwise. X (1)arejht , K , X jht

covariates including the marketing mix variables and brand loyalty. In addition, αjh represents
 Lhβ
 1h,…βdh denote consumer h’s sensitivity toconsumer h’s intrinsic preference for brand j; βGhβreference price effects and the covariates. Finally, εjht is an error term.
To model consumers’ brand choices based on (1), we employ a multinomial probit model. Using
this model, a consumer chooses a brand that has the greatest utility. However, we do not observe theutility Ujht directly; instead, we observe the index Ijht such that I jht = 1 if brand j were chosen by
consumer h at time t, and 0 otherwise. The consequence of using the probit model is that the model
specified by (1) suffers from identification problems: location invariance and scale invariance. The

7

former can be removed by subtracting the utility function of each brand (i.e. Ujht) with respect to theJ-th brand. The latter will be examined in the appendix. Thereby, we have a new system:u jht = U jht − U Jht
G= α ′jh + βGh  I Gjht ( RPjht − Pjht ) − I Jht( RPJht − PJht )

(2)

L+ β Lh  I Ljht ( Pjht − RPjht ) − I Jht( PJht − RPJht ) + β1h X 1′ + K + β dh X d′ + ε ′jht ,where α ′jh = α jh − α Jh , X ih′ = X jht − X Jht (i = 1, K , d ) , and ε ′jht = ε jht − ε Jht . It suffices to
(i )

(i )

consider M = J−1 brands’ utility functions that we have just defined in (2).
Reference Price Model. We model the reference price as a weighted average of IRP and ERP.

We assume that each consumer has their own weight, which might differ among consumers, thereby
allowing for heterogeneity. Furthermore, the weights are also assumed to vary across brands because
consumers might have different preferences, purchase experiences, etc. against the brands in the
category. Consequently, the reference price (RP) of brand j at time t for consumer h is definable as

RPjht = λ jh IRPjht + (1 − λ jh ) ERPjht .

(3)

The weight parameter λjh is restricted to take a value in the interval [0, 1]; if λjh is greater than 0.5,
we expect that the consumer is likely to use IRP rather than ERP. We call it the “memory parameter”
because it represents a consumer’s ability to recall past prices1.
The model that includes both IRP and ERP as components of reference price formation was
introduced for the first time by Rajendran and Tellis (1994). The model is based on the assumptionthat memory parameter λ is common for all consumers; hence, it does not account for consumer
heterogeneity. Rajendran and Tellis (1994) attempted to explain the variation of how IRP consumers
might be different from ERP consumers by grouping data based on consumers’ characteristics.
However, the study addresses limited consumer characteristics. We are not able to test the statisticalsignificance of between-group parameter correlations.

1

Kopalle et al. (1996) used this term to denote the weight of exponentially weighted past prices.

8

Mazumdar and Papatla (2000) extended this specification by introducing consumer
heterogeneity into the model. They employed the latent class model (finite mixture model) proposedby Kamakura and Russell (1989) and modeled reference prices as did Rajendran and Tellis (1994),
but with segment-specific memory parameters. Consumers and brands’ characteristics are used to
explain the parametric variation across segments.
Finite mixture models have been used frequently by marketing researchers to model consumer
heterogeneity because they are estimated easily and generally yield few segments. However, in spiteof their attractive features, these models might not be appropriate in our context for at least two
reasons. First, variables such as brand preference, price, and brand loyalty have the greatest impact
on segmentation because they explain the greatest variance in brand choices (Keane 1997).
Generally, reference price effects are smaller than these variables. Consequently, the resultant
segments will be characterized well by parameters of such variables rather than by memory
parameters. Secondly, as pointed out by DeSarbo et al. (1997), the derived groups or segments
typically relate weakly to consumers’ demographic or psychographic data. Furthermore, from amethodological point view, finite mixture models provide worse performance in fitting data than acontinuous mixture model (Allenby and Rossi 1999). Therefore, as an alternative in this paper, we
adopt a continuous mixture model to capture consumer heterogeneity of relative importance of IRP
and ERP.
To account for heterogeneity of the memory parameter λ h = (λ1h , K , λMh )′ , we adopt a flexible
hierarchical Bayesian model proposed by Rossi, McCulloch and Allenby (1996). This model is arandom coefficient model that regresses memory parameters on some covariates. In our case, we use
consumers’ characteristics discussed in section 2 as covariates. Because memory parameters arebounded by 0 and 1, it would be tractable to work with their logistic transformation. Therefore, thehierarchical Bayesian model for memory parameters is

9λ *h = Θδ h + ω h ,ω h ~ N ( 0, Ω ) ,

(4)

where

(

)

*
′,
λ *h = λ1*h , λ2*h , K , λMh λ jh 
λ *jh = ln  .
 1 − λ jh 

In those equations: δ h is a vector of length m of consumer h’s characteristics; Θ is the

M ×mcoefficient matrix; ω h is a vector of length M of error terms whose elements are allowed tocorrelate across brands, but is independent across consumers.
Extension to include no reference price shoppers. To this point, we have assumed in our modelthat all consumers respond to a reference price effect. However, as pointed out by Erdem, Mayhew,
and Sun (2001), the responsiveness to reference price is heterogeneous across consumers, indicating
the possible existence of consumers who do not respond to reference prices. Such no-reference priceshoppers respond to observed prices without going through any subjective encoding prices when
making purchase decisions (Moon, Russell, and Duvvuri 2006). We extend the reference price model(3) by adding the observed price in the third term to include the existence of no-reference priceshoppers in our model. Therefore, the reference price and random utility function are defined as′ = λ1 jh IRPjht + λ2 jh ERPjht + λ3 jh Pjht
RPjht
U jht = α jh + β Gh I Gjht ( RPjht′ − Pjht ) + β Lh I Gjht ( Pjht − RPjht′ )+ β1h X (1)+ L + β dh X (jhtd ) + ε jht ,
jht

(5)

(6)

where we impose a restriction on λ1jh, λ2jh and λ3jh such that they are bounded respectively by 0 and
1 and sum to 1. In addition, λ1jh and λ2jh respectively indicate the relative importance of IRP and
ERP; λ3jh is a parameter denoting whether or not a consumer responds to reference price. Therefore,
if λ3jh = 1, then the second and third term of utility function are cancelled out. The utility function
reduces to a standard utility function (e.g. Guadagni and Little 1983), which implies that such a
consumer does not respond to a reference price.

10

4. Model Application
Data and Variable Operationalization. We calibrate the proposed model on scanner panel datafrom two categories in the Japanese market: curry roux and instant coffee. Curry roux data are drawn
from the Nihon Keizai Shimbun and coffee data are drawn from Video Research Co. Ltd.
Curry Roux. The data are scanner panel records from January 1998 to December 1999. We

considered eight brands that account for 86.1% of the purchases of this category. The brand packages
are of different sizes. For that reason, we rescaled their prices to prices per 100 g to make themcomparable. Households included in these analyses are those that have made at least 10 purchases ofthe brands. We have 331 qualified households and 4999 observations.
Instant Coffee. The data are scanner panel records from October 1993 to September 1996. Fivebrands were selected for calibration. They account for 75.6% of the purchases of the category during
the calibration period. Their prices are rescaled to prices per 100 g to facilitate their comparison. As
in the case of curry roux, we selected households that had made at least 10 purchases of the brands,
resulting in 154 qualified households and 2788 observations. Table 1 shows a description of the data.
Insert Table 1 about here

Marketing mix and Brand Loyalty. In model (1), we expressed the latent utility as a linear

function of the reference price effect, marketing mix variables, and brand loyalty. We use a log priceand promo for marketing mix variables. The promo is a dummy variable that is 1 if the price isdiscounted and 0 otherwise. For brand loyalty, we use the specification proposed by Guadagni and
Little (1983).
Internal and External Reference Price. We use the respective brands’ prices on the lastpurchase occasion (Mayhew and Winer 1992, Krisnamurthi et al. 1992) for IRP. We use the current
price of the brand chosen on the last purchase occasion (Hardie et al. 1993) for ERP.

11

Consumer Characteristics. As mentioned previously, we model the reference price as aweighted average of IRP and ERP, where the weight or memory parameter is assumed to behousehold-specific and brand-specific. To explain the variation of the memory parameter acrosshouseholds, we set a prior on the memory parameter where the hyper parameter is a function of theconsumer characteristics described in section 2. That is, average purchase frequency, averageinterpurchase times, the number of brands sampled, percentage of purchases at promotion, averagepurchase quantity, price volatility, and brand preference. However, to avoid a multicollinearity, we
dropped purchase frequency from the analyses because it is strongly correlated with interpurchasetimes (-0.81 in curry roux and -0.87 in instant coffee). Price volatility is the standard deviation ofprices paid by household. Brand preference is the maximum value of the average brand loyalty
assigned to each brand (Kalyanaram and Little 1994).

5. Empirical Results and Discussion
Model Comparison. In addition to the proposed model, we calibrate six benchmark models forvalidation: the reference price model that contains IRP only (IRP model), ERP only (ERP model),both IRP and ERP with homogeneous memory parameter (HMP model), the Finite Mixture Model(FM Model) used by Mazumdar and Papatla (2000), the Continuous Mixture Model with constantprior on λ h , and the extended model. We include the Continuous Mixture Model with constantprior on λ h to allow comparison of the performance of the finite and continuous model under thesame set of information. To test the goodness of fit of the proposed model and its benchmarks, we
compute the log of marginal likelihoods (Newton and Raftery 1994) and summarize the results inTable 2.
In both categories, the ERP model fit the data better than the IRP model. This result occurredperhaps because ERP households form a larger segment in the markets. Model fitness was improved
when the reference price was modeled as a weighted average of IRP and ERP with a common

12memory parameter (HMP model). The results suggest that modeling the reference price as IRP or
ERP alone will fail to portray the fact that consumers might have multiple reference prices.
Furthermore, the performance was improved when heterogeneity was imposed on the memory
parameter through the finite mixture model. This fact suggests that, although consumers might use
both IRP and ERP, their relative importance might vary among individuals. The FM model therefore
captures this heterogeneity at the segment level. Under the same set of information, however, theability to fit data of FM model is inferior to that of the Continuous Mixture Model with constantprior on λ h , which accounts for heterogeneity at the individual level. Finally, as the table shows,the proposed model improved the previous models’ performance of fitting the data closely. That
improvement might have arisen from two sources of heterogeneity imposed on memory parameters.
That is, the heterogeneity of memory parameters across individual households and across brands was
not considered in previous models. For the extended model, we found no improvement of goodnessof fit, even after introducing no-reference price shoppers. Instead, we observed that its log of
marginal likelihood is slightly worse than that of the proposed model.
Insert Table 2 about here

Heterogeneous Distribution of Memory Parameters. The estimates of memory parameters areshown in Table 3, which also shows the mean of memory parameters of all consumers in therespective markets. We observed that the mean memory parameters vary across brands. In the curryroux category, the mean memory parameters for brands A, B, C, and E is less than 0.5, indicatingthat their typical consumers are likely to use ERP when purchasing them. In contrast, the respective
mean memory parameters for brand F and brand G are greater than 0.5, indicating that IRP is
important when consumers consider purchasing these brands. The variation of mean memory
parameter in the instant coffee category is less noticeable than in curry roux. However, we can seethat for brands A, B, and D, the values are less than 0.5, whereas for brand C, the values are greater

13than 0.5, which implies that the relative importance of memory in the purchase of those brands isdifferent.
Insert Table 3 about here

Information summarized in Table 3 reveals nothing about the distribution of memory parameters.
Therefore, we discuss how memory parameters are distributed across consumers. Figure 1.a presents
a histogram of memory parameters for curry roux. It is immediately apparent that the distributions ofmemory parameters are U-shaped or J-shaped (rather than bell-shaped), where the modes are within
the interval of either [0, 0.1] or [0.9, 1]. Households that use both IRP and ERP moderately (i.e.
whose memory parameters are between 0.4 and 0.6) account for only 11% to 15% of the market. The
results reveal that most households have great probability to use either IRP or ERP, but not both.
Furthermore, as the figure shows, memory parameters vary not only across households, but also
across brands. Households are more likely to use ERP when they evaluate brand A, B, C, D and E. In
contrast, when brand F and brand G are considered, ERP is important for most households. Thus, theassumption that a consumer assigns a common weight for all brands will fail to capture thisheterogeneity.
The distribution of memory parameters in the instant coffee category is presented in Table 1.b.
The results resemble those of curry roux. That is, the market is dominated by households that use
IRP or ERP alone. As for curry roux, the distributions vary across brands. Internal reference pricehouseholds (i.e. whose memory parameters are between 0.9 and 1) account for more than 29% of thetotal market when they evaluate brand A. On the other hand, households have great probability touse ERP for other brands.
Insert Figure 1.a about here
Insert Figure 1.b about here

14

Although we observed that the distributions of memory parameters are U-shaped or J-shaped,
we found that such is not the case when we used FM model. We present the distributions of memory
parameters generated by the FM model in Fig. 2. The figures plot estimates of memory parametersof each segment on the horizontal axis and segment sizes or membership probabilities on the verticalaxis. We can see that the distributions are not U-shaped or J-shaped as observed in the proposedmodel. Similar results of FM model-induced memory parameter distribution have also been
observed in a study by Mazumdar and Papatla (2001) using liquid detergent and Yogurt data.
Insert Figure 2 about here

The question now is why the two models can suggest different distributions of memory
parameters. As noted by Keane (1997), marketing mix variables such as price and promotion morestrongly affect brand choice probability than reference price. Therefore, in the FM model, thederived segments do not represent a group of households having similar memory parameters because
they are characterized mostly by marketing responses rather than by reference price responses.
On the other hand, unlike the FM model, our model allows the estimation of memory parametersat a household level. Therefore, we can use these household level estimates to infer their distribution
without having to risk misclassifying the distributions. For this reason, we suggest that the FMmodel might be inappropriate in this analysis: the model incorrectly describes the distribution ofmemory parameters.
Choice Model Parameters. Table 4 presents the average of estimates of β. Estimates should beinterpreted as relative to the last brand. That is, if the sign of any brand constant is positive, it
implies that the brand is preferred to the last brand. Marketing responses (price and promo) andbrand loyalty have the expected signs. The sign is positive for gain and negative for loss, as expected.
For both categories, the loss effect is greater than the gain effect (i.e. | β L | > | β G | ), indicating thatloss aversion was observed in our data. However, this result does not mean that all households

15exhibit loss aversion.
Insert Table 3 about here
Hierarchical Structure for Memory Parameters. Now we discuss the robustness of consumer

characteristics in explaining the variation of memory parameters. Table 5.a provides estimates of Θin the curry roux category. Average interpurchase times have negative signs for all brands, as
expected, indicating a negative relation between interpurchase times and memory parameters, whichis consistent with previous works. The number of sampled brands has significant negative signs forbrand A, D, F and G. Therefore, the result partially supported our hypothesis that consumers who
sampled a larger number of brands will have higher probability to use ERP. Except for brand E, deal
proneness has negative signs and is significant for brands A, B, D, and F, indicating that consumers
with higher propensity to purchase on deal will tend to use ERP. For purchase quantity, the relation
is mixed and not significant, except for brand B and brand F. Price volatility exhibits negative signs
and is significant for all brands except brand C, which implies that households that confront volatile
prices are likely to use ERP instead of IRP. Brand preference has significant positive signs for brands
B, D, F and G, which supports our hypothesis, but such is not the case for the other brands.
Results for Instant Coffee are reported in Table 5.b. As in the case of curry roux, the results are
consistent with previous works for interpurchase times, brand sampled, deal proneness and pricevolatility. However, in the case of purchase quantity and brand preference, the results are mixed or
not significant otherwise.
Insert Table 5.a about here

Insert Table 5.b about here
Results of the extended model. Although the extended model is inferior to the proposed modelin terms of the log of marginal likelihood, it is useful to see the distribution of λ when no reference
price shoppers are included in the model. In Figs. 3.a and 3.b, we present joint distributions of λ1jh,

16

λ2jh and λ3jh. Interestingly, the conditional distributions of λmjh given λnjh and λojh (m ≠ n ≠ o)reveal U-shaped distributions, even after no reference price shoppers are included. This factindicates that consumers who use solely IRP and ERP, and those who do not respond to reference
price, account for a large fraction of the market.
The fact that no-reference price shoppers account for a large fraction of the whole market isimportant from a managerial perspective. Their existence is useful to explain why post promotion
sales are not zero. This kind of consumer would not regard a reversion to a normal price as a priceincrease because they do not compare past prices as IRP consumers do. Therefore, targeted coupon
distribution to this segment will not cause a trough after the deal.
Insert Figure 3.a about here

Insert Figure 3.b about here
Beside the existence of no-reference price shoppers, a retailer also has to consider pricesensitivity of targeted segment to conduct a successful pricing strategy. Therefore it is necessary to
make a comparison about price sensitivity between IRP, ERP, and no-reference price consumers. In asimulation by Moon, Russell, and Duvvuri (2006), it is reported that IRP consumers are more pricesensitive than other consumers. In our study, however, the results are inconclusive. Figure 4.a and4.b show the scatter plots of the estimates of weight parameters and price responses for curry rouxand instant coffee respectively. In the case of curry roux, the results are consistent with those ofMoon, Russell, and Duvvuri (2006). The average of the estimates of price responses of IRP
consumers (those whose λ1 jh ∈ [0.9,1] ) is equal to -3.310 which is greater in absolute value thanthose of ERP and no-reference price consumers (those whose λ2 jh , λ3 jh ∈ [0.9,1] ) which are-3.204 and -3.253. On the other hand, the results in instant coffee reveal that ERP consumers are
more price sensitive than other consumers. The average of the estimates of price responses of IRP,
ERP, and no-reference price consumers are -1.272, -1.444 and -0.428 respectively.
17

Insert Figure 4.a about here

Insert Figure 4.b about here

6. Concluding Remarks
A recent popular issue in marketing studies is how to build models that can capture consumer
heterogeneity. Consumers have different preferences and sensitivity to marketing variables.
Modeling consumer behavior at an aggregate level merely provides summary statistics of the entire
market. Representation of parameters in the aggregate model is limited to an average group of
consumers. For that reason, the information contained would not be adequate for firms wishing topursue their marketing activities because there might be numerous consumers who are not well
represented. An effective marketing strategy can be attained only if a firm offers a product that is
priced, promoted, and placed in a manner such that they meet the targeted group’s needs. Therefore,
models that provide individual level estimates are required for it to be possible.
Our proposed model of reference price formation allows weight parameters to vary acrossconsumers and brands. Application of Bayesian analyses of MCMC method made it feasible to infer
individual level parameters. The model provides information related to how individual consumers
form their reference prices, which might be useful for a manufacturer and retailer who want to
identify their customers. For example, a retailer wishing to remove a post-promotion dip in sales
might target coupons to ERP consumers because they are likely to be unaffected by past prices.
The hierarchical Bayesian model of memory parameters also provided theoretical insights forresearchers interested in investigating the process of reference price formation. Our study only
investigated effects of consumer characteristics on the memory parameter. However, as noted by18

Dickson and Sawyer (1990), variables such as product characteristics might influence consumers’ability to recall past prices. In addition, consumer demographics can also be considered to influence
the process. Incorporating the effects of such variables on reference price formation has now becomestraightforward because we can treat them as explanatory variables in the proposed hierarchicalframework.
However, the proposed reference price model leaves room for improvement. For example, if
forward-looking consumers account for a large share of the market, we should consider expected
future prices as a component of reference prices in addition to IRP and ERP. It would therefore beappropriate to model reference prices as a function of past, present, and expected future price. This
would be particularly important in consumer durable markets such as that for automobiles, in which
consumers tend to predict future prices when considering purchases.

Appendix (Estimation of the Model)
Posterior Distribution on Memory Parameter. First, for convenience, we denote the utility

system (2) in matrix notation. Thus we haveU ht = X ht β h + ε ht ,ε ht ~ N ( 0, Λ ) ,(A.1)

where U ht = (u1ht ,K , u Mht )′ , β h = (α1′h ,K,α Mh′ )′ . In that′ , βGh , β Lh , β1h ,K, β dh )′ , ε ht = (ε1′ht ,K, ε Mht(d )equation, Xht = ( I M , G ht , L ht , X(1)is a matrix including an intercept term of the M
ht ,K, X ht )brands and covariates, where I M is an M -dimensional identity matrix, G ht and L ht are(d )are covariate vectors of length
vectors of length M of gain and loss effects, and X (1)ht , K , X ht

M , including marketing mix variables and brand loyalty.
In our model, the set of parameters to be estimated is ({β h }, Λ , Θ , Ω ,{λ h }) . The parameters
are estimated using MCMC method. We generate random draws using the Gibbs sampler from a setof full conditional distributions. To proceed, we must define the conditional posterior distribution of

λ *h from which the sample of logistic transformed memory parameters are drawn. The distribution19

is defined as follows.

π ( λ *h | U ht , X ht , β h , Λ, δ h , Ω ) ∝ l ( λ *h | U ht , X ht , β h , Λ ) P ( λ *h | δ h , Ω )T∝ exp  −0.5  ∑ t =h 1 ( U ht - X ht β h )′ Λ −1 ( U ht - X ht β h )  (A.2)





+ ( λ *h - Θδ h )′ Ω −1 ( λ *h - Θδ h )  This distribution contains information of each consumer along with market level information
summarized in the prior. The likelihood implies the probability that consumers achieve utility Uht
given λ *h , which is expressed implicitly in Xht. We set a conjugate prior on λ *h based on
consumers’ characteristics so that it will be determined not only by the individual utility function but
also by consumers’ characteristics. However, the distribution is not proper (i.e. its integral does notequal 1); it has no closed form. Therefore, we use the Metropolis-Hastings algorithm to determine
the distribution.
The Priors. We set four priors for the hierarchical model: (1) the prior on the error variances in

random utility model Λ , (2) the prior on the coefficient of random utility model β h , (3) the prioron Ω , the covariance matrix of λ *h , and (4) the prior on the matrix of regression coefficients in thememory-parameter model of heterogeneity Θ .
(1) Prior on ΛΛ −1 ~ Wishart (ν 0 ,V0 ) , where ν 0 = M + 2, V0 = ν 0 I M(2) Prior on β h
β h ~ N( 0, Vβ ) , where Vβ = 0.1 I rank ( Xh )(3) Prior on Ω
Ω β−1 ~ Wishart( p 0 , P0 ), p 0 = M + 2, P0 = p 0 I M(4) Prior on Θ

( (vec( Θ ) ~ N d, Ω ⊗ C −1

20) ) , d = 0, C = 0.1I

MGibbs Sampler.

(1) U ht | I ht , X ht , β h , Λ, λ hGenerate U ht from truncated N( X ht β h , Λ ) .
(2) β h | U ht , X ht , Λ, Vβ , λ hGenerate β h from N(β h , ( X′h X h + Vβ−1 ) −1 ) where β h = ( X′h X h + Vβ−1 )−1 X′h U h .
(3) Λ −1 |{U ht },{X ht },{β h },{λ h }Generate Λ −1 from Wishart(ν 0 + HTh , V0 + S1 ) ,where S1 = ∑ (Uht − Xht βh )(Uht − Xht βh )′ . Note that, for identification, the M × M-thh ,telement of Λ is fixed to 1.
*(4) λ h | U ht , X ht , β h , Λ, Θ, Ω, δ h

(

*

)

First, generate λ h from its conditional posterior distribution π λ *h | U ht , X ht , β h , Λ, δ h , Ω .
However, it does not constitute a conjugate family, so we use Metropolis-Hastings with a random
walk algorithm. The procedure is described as follows.
For j = 1, K , M
Set the starting point λ *(0) .
jhGenerate γ jh from N ( 0,1) and renew λ *(jh k ) = λ *(jh k −1) + γ jh at the k-th iteration.
Generate u jh from U ( 0,1) .

()

k −1) otherwise.
Set λ *jh = λ *(jhk ) if u jh ≤ α λ *(jh k ) , λ *(jh k −1) | U h , β h , Λ, δ h , Ω , and λ*jh = λ *(jhα ( λ *(jhk ) , λ *(jh k −1) | U h , β h , Λ, δ h , Ω ) is the acceptance probability defined asα (λ*( k )jh ,λ*( k −1)| U h , β h , Λ, δ h , Ωjh π kjh ( λ *h | U h , β h , Λ, δ h , Ω ) ) = min  π ( k −1) λ* | U , β , Λ, δ , Ω ,1 ,) h jh ( h h hwhere π jh is posterior density of λ h evaluated at λ jh = λ jh .
k

*

*

21

*( k )

Finally, substitute λ jh to obtain λ jh .
*(5) Θ | Ω,{δh }, {λ h }(Generate vec( Θ ) from N d% , ( Ω ⊗ δ′δ + C )

−1

),

)
)
−1
−1
−1
where d% = vec D% , D% = ( δ′δ + C ) δ′δD + CD , and D = ( δ′δ ) δ′λ ** .

( )

(

)

′
λ ** is the H × M matrix with each ( λ **h ) as a row.
δ is the H × m matrix with each δ′h as a row.

D = stack (d ) , the m × M matrix formed column by column from the elements of d .
(6) Ω −1 | {λ h } , Θ
Generate Ω −1 from Wishart( p 0 + H , P0 + S 2 ) , where S2 = ∑ (λ*h − Θδh )(λ*h − Θδh )′ .
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25

Table 1. Description of the Data
Brand

Choice Share

Average Price

Percentage ofPurchases on
Discount

Curry Roux
Brand A
Brand B
Brand C
Brand D
Brand E
Brand F
Brand G
Brand H

0.191
0.255
0.253
0.106
0.060
0.057
0.049
0.029

73.67479.42579.86990.457108.712159.226
188.380
57.202

11.082
11.08413.33812.56011.775
11.52212.7177.233

Instant Coffee
Brand A
Brand B
Brand C
Brand D
Brand E

0.480
0.099
0.225
0.057
0.138

473.628
412.663477.061
419.477
398.495

8.967
10.133
4.874
11.1107.250

Table 2. Log of Marginal Likelihood
IRP Model
ERP Model
HMP Model
FM ModelCM Model 1*
Proposed Model
Extended Model

Curry Roux
-166,354.201-166,281.449-165,992.520-165,169.397-163,273.013-161,257.878-161,636.7793

Instant Coffee-37,629.538-37,540.172-37,284.931-36,571.210-36,296.178-36,029.202-361,33.272* Continuous Mixture Model with constant prior on λ hTable 3. HB Estimates of Memory Parameter
Variable
Brand A
Brand B
Brand C
Brand D
Brand E
Brand F
Brand G

Curry Roux
Post Mean
Post STD
0.481
0.124
0.354
0.105
0.487
0.124
0.519
0.128
0.437
0.119
0.658
0.138
0.720
0.142

26

Instant Coffee
Post Mean
Post STD
0.474
0.132
0.446
0.129
0.513
0.132
0.368
0.124
―
―
―
―
―
―

Table 4. HB Estimates of βCurry Roux
Post Mean
Post STD

Variable

Instant Coffee
Post Mean
Post STD

Brand Constants
Brand A
Brand B
Brand C
Brand D
Brand E
Brand F
Brand G

-0.0820.245
0.172-0.087-0.121-0.244-0.300

0.065
0.108
0.076
0.134
0.097
0.092
0.112

1.134
-0.5450.506-0.465
―
―
―

0.223
0.195
0.206
0.209
―
―
―

Responses Parameters
Price
Promo
Loyalty-1.216
3.617
0.783

0.226
0.189
0.204

-3.288
1.693
0.976

0.346
0.268
0.244

Reference Price Parameters
Gain
0.232
Loss
-0.275

0.107
0.116

0.208
-0.224

0.102
0.106

Table 5.a. HB Estimates of Θ (Curry Roux)

Constant
Interpurchase
times
Brand Sampled
Deal Proneness
Purchase
Quantity
Price Volatility
Brand
Preference

Brand A

Brand B

Brand C

Brand D

Brand E

Brand F

Brand G

3.774
(3.194)-0.166(-4.536)-0.122(-2.055)-1.864(-2.505)-0.411(-0.816)-1.946(-2.929)0.330(0.531)2.257(2.082)-0.145(-3.993)-0.078(-0.923)-5.390(-7.252)-1.385(-2.388)-1.422(-2.177)
4.348(7.151)

0.031(0.017)-0.004(-0.109)
0.033(0.388)-0.422(-0.560)
0.729(1.249)-0.299(-0.493)-0.058(-0.089)-0.862(-0.483)-0.099(-2.705)-0.770(-9.060)-1.737(-2.345)-0.109(-0.188)-7.193(-10.981)
1.398(2.357)-1.074(-0.573)-0.035(-0.905)-0.042(-0.493)
1.923(2.551)1.010(1.905)-1.481(-2.263)-1.526(-2.302)-1.603(-0.960)-0.229(-6.440)-0.214(-2.543)-2.393(-3.251)
1.273(2.132)-2.502(-4.536)1.272(2.088)7.096(5.507)-0.175(-5.096)-0.446(-5.304)
0.834(1.135)-0.827(-1.405)-2.996(-5.624)
2.642(5.407)t-value in parentheses. Bold indicates significance at 0.05 level.

27

Table 5.b. HB Estimates of Θ (Instant Coffee)

Constant
Interpurchase
times
Brand Sampled
Deal Proneness
Purchase
Quantity
Price Volatility
Brand
Preference

Brand A

Brand B

Brand C

Brand D

4.294
(2.297)-0.112(-2.071)-0.192(-2.962)-0.405(-2.009)
1.717(4.149)0.793(0.812)-0.048(-0.040)1.282(0.683)0.006(0.085)-0.343(-3.294)-0.610(-2.541)-0.795(-1.620)-2.535(-2.423)
2.541(2.161)-1.517(-0.767)-0.122(-2.026)-0.410(-3.474)-0.038(-0.300)
0.038(0.173)-5.678(-5.477)-1.027(-0.806)-3.977(-2.139)-0.159(-2.256)-0.307(-2.948)-0.588(-2.712)-0.386(-0.937)-1.617(-1.989)
2.811(2.248)t-value in parentheses. Bold indicates significance at 0.05 level.

28

Figure 1.a Distribution of memory parameters (Curry Roux)
Brand B

40%

Relative Frequency

Relative Frequency

Brand A

30%
20%
10%
0%

50%
40%
30%
20%
10%
0%
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Brand D40%

Relative Frequency

Relative Frequency

Brand C

30%
20%
10%
0%

35%
30%
25%
20%
15%
10%
5%
0%
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Brand F40%

Relative Frequency

Relative Frequency

Brand E

30%
20%
10%
0%

40%
30%
20%
10%
0%
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Brand G
Relative Frequency

50%

50%
40%
30%
20%
10%
0%
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

29

Figure 1.b Distribution of memory parameters (Instant Coffee)
Brand B

40%

Relative Frequency

Relative Frequency

Brand A

30%
20%
10%
0%

40%
30%
20%
10%
0%

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Brand D40%

Relative frequency

Relative Frequency

Brand C

30%
20%
10%
0%

50%
40%
30%
20%
10%
0%
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Figure 2 Distribution of Memory Parameters of Finite Mixture Model
Curry powder

Instant coffee

0.60
Segment size

Segment size

0.50
0.40
0.30
0.20
0.10
0.00
0.138

0.448

0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
0.432

0.506

30

0.560

0.742

0.890

Figure 3.a Joint Distribution of lambda λ (Curry Roux)
BrandA8070
frequency

60
50
40
30
20

0.9

10
0

lambda1

0.1
0.9

0.7

0.5

0.3

0.1

0.5

lambda2

Brand A8070

frequency

60
50
40
30
20

0.9

10

0.5
0.9

0.7

0.5

0.3

0.1

0

lambda1

0.1

lambda3

Brand A

80
70
50
40
30
20
10
0

0.9

lambda3

31

0.9

0.7

0.5

0.3

0.5
0.1

frequency

60

0.1

lambda2

Figure 3.b Joint Distribution of λ (Instant Coffee)
Brand A25

frequency

20
15
10
5

0.9

0.7

0.5

0.3

0.1

0

0.9
0.5

lambda1

0.1

lambda2

Brand A25

frequency

20
15
10
5

0.9

0.7

0.5

0.3

0.1

0

0.9
0.5

lambda1

0.1

lambda3

Brand A

30

20
15
10
5

lambda3

32

0.9

0.7

0.5

0.3

0

0.9
0.5
0.1

frequency

25

0.1

lambda2

Figure 4.a Relation between lambda and price sensitivity (Curry Roux)
brand A
2

price

0
-2
-4
-6
-8
0.0

0.2

0.4

0.6

0.8

1.0

0.8

1.0

0.8

1.0

lambda1

brand A
2

price

0
-2
-4
-6
-8
0.0

0.2

0.4

0.6

lambda 2

brand A
2

price

0
-2
-4
-6
-8
0.0

0.2

0.4

0.6

lambda 3

33

Figure 4.b Relation between lambda and price sensitivity (Instant Coffee)

Brand A
4

price

2
0
-2
-4
-6
0

0.2

0.4

0.6

0.8

1

0.8

1

0.8

1

lambda 1

Brand A
4

price

2
0
-2
-4
-6
0

0.2

0.4

0.6

lambda 2

Brand A
4

price

2
0
-2
-4
-6
0

0.2

0.4

0.6

lambda 334