Impact of Reference Prices on Positioning and Advertising in Non-Durable Goods Markets

The existence of reference price effects in consumer decision making is well documented in prior research, but few studies focus on its implications for firms' strategic behavior. Using a competitive model, we address this gap by examining how firms' product positioning and advertising strategies in a non-durable goods market (where consumers repeatedly purchase products from the category) are affected compared with a benchmark situation in which reference price effects are not pertinent. We find that as the salience of reference price effect increases, (a) initially prices are higher than, but eventually they fall below, the benchmark prices; (b) product differentiation first decreases and then increases compared with the benchmark; and (c) firm profits first decrease and then increase, but always remain less than, the benchmark profits. Using price advertising as a way to increase the reference price, this study shows that such an intervention potentially improves firms' profits above the benchmark profits. The underlying reason is that the reference price effect influences price competition, which incentivizes firms to change their product positions, which then again impacts firms' prices.