Dynamic Pricing with Loss Averse Consumers and Peak-End Anchoring

Abstract

We study the dynamic pricing implications of a new, behaviorally motivated reference price mechanism based on the peak-end memory mode. This model suggests that consumers anchor on a reference price that is a weighted average of the lowest and most recent prices. Loss-averse consumers are more sensitive to perceived losses than gains relative to this reference price. We find that a range of constant pricing policies is optimal for the corresponding dynamic pricing problem. This range is wider the more consumers anchor on lowest prices, and it persists when buyers are loss neutral, in contrast with previous literature. In a transient regime, the optimal pricing policy is monotone and converges to a steady-state price, which is lower the more extreme and salient the low-price anchor is. Our results suggest that behavioral regularities, such as peak-end anchoring and loss aversion, limit the benefits of varying prices, and caution that the adverse effects of deep discounts on the firm's optimal prices and profits might be more enduring than previous models predict.