Price Reference Effects and Vertical Contracts in the Book Retail Market

Abstract

In many settings, behavioral economists have documented a price reference effect: the fact that a consumer's willingness to pay for a good is affected by difference between the observed price and the reference price they rationally expect. In this paper, we show that such preferences interact with vertical contracting in a way that can overturn standard textbook intuition. In particular, we show that if this price reference effect is sufficiently large, vertical integration between an upstream producer and a downstream retailer can decrease joint profits, unlike in the textbook case where vertical integration improves profits. The key intuition is that the increase in quantity is smaller when consumers expect lower prices in the new equilibrium. To test whether this force is large in a real-world setting, we develop a model of a downstream retailer who faces behavioral consumers and bargains with an upstream producer. We estimate this model using a novel dataset from a large online book retailer, where we observed retail prices, quantities sold and wholesale prices. Counterfactual simulations show that vertical integration would reduce joint profits by 11%. These findings highlight the importance of incorporating consumer expectations in the analysis of optimal pricing and firm profits.