Price dispersion and optimal price categories with limited memory consumers

Abstract

JEL Classification: L11; L13; L20In this paper, we study consumers with limited memory and examine the effects of their price categorization on the pricing strategies of competing firms. The valuations of consumers are assumed to be heterogeneous. We find that it is possible to observe price dispersion even when each firm charges a single price if the consumers categorize prices non-optimally. Moreover, we demonstrate that the likelihood of a price dispersion outcome is reduced when consumers with limited memory set up the price categories optimally. These findings suggest that the consumers' limited memory and their sub-optimal behavior, that is, their inability to choose price categories optimally can be a reason for observed price dispersion. | INTRODUCTIONConsumers are not endowed with perfect information. Thus, they are not able to recall all prices every time. Often, some consumers do not recall the prices of the products they just bought (Wakefield & Inman, 1993). One way consumers deal with their cognitive limitations is by categorizing prices according to their perceived similarities, for example, when prices are close to each other. These categories serve as imperfect but practical approximations for consumers. According to the terminology of the bounded rationality literature, satisficing is a cognitive heuristic that can explain consumers' behavior to stop optimizing when they get a near-satisfactory result (Simon, 1956).Price categorization is in line with this concept. In this paper, we demonstrate that a likely outcome of this categorization process is the practice of firms charging different prices for the same product: a case known as price dispersion. Chen, Iyer, and Pazgal (2010) consider a market mixed with informed consumers, who have limited memory to recall exact prices, and uninformed consumers and find that firms randomize their pricing strategies to generate guaranteed profits from their uninformed consumers. In their setting, consumers have homogeneous valuations and this process leads to price dispersion as a mixed strategy equilibrium. In a similar yet different framework, Kutlu (2015) assumes consumers to have heterogeneous valuations and explains that firms charge different prices at the unique pure strategy Nash equilibrium.Following an analogous duopoly framework, consumers in our model have heterogeneous valuations as in Kutlu (2015). Further, we introduce price categorization. Consumers recall the categories but not the exact prices. We find that it is possible to observe price dispersion in a pure strategy equilibrium, even when each firm charges a single price, when consumers choose price categories non-optimally.Conversely, price dispersion tends to disappear if the consumers optimally set their categorization scheme. These results confirm that observed price dispersion in some markets may exist due to consumers' memory limitations. In addition, we find that an additional contributing factor is their inability to optimally allocate their memory, that is, non-optimal price ca...

Retailers' Differentiation Strategy and Pricing in the Rental Market of Digital Content: A Case of E-Textbooks

“…Market friction refers to the conditions under which the market is not perfectly competitive. For example, retailers may provide incomplete information and increase search cost [24] or take advantage of consumers' limited memory [3]. However, strategies related to market friction such as increasing search cost and setting up high entry barriers don't fit the etextbook rental market.…”