Category Pricing with State Dependent Utility

Abstract

There is a substantial literature that documents the presence of state dependent utility with packaged goods data. Typically, a form of brand loyalty is detected whereby there is a higher probability of purchasing the same brand as has been purchased in the recent past. The economic significance of the measured loyalty remains an open question. We consider the category pricing problem in the presence of loyalty and demonstrate that a retailer has an incentive to invest in building brand loyalty to maximize the present value of category profits and that this materially affects optimal pricing. Given the well-known problems with the confounding of state dependence and consumer heterogeneity, loyalty must be measured in a model which allows for an unknown and possibly highly non-normal distribution of heterogeneity. We implement a highly flexible model of heterogeneity using multivariate mixtures of normals in a hierarchical choice model. We find important deviations from the standard one component normal mixture.