THE IMPACT OF REFERENCE PRICE EFFECTS ON THE PROFITABILITY OF PRICE PROMOTIONS

This paper investigates the impact of reference price effects on retai ler price promotions and describes why these effects can make promotin g profitable. First, we analyze the profit impact of reference price e ffects generated by a single period of promotion. The promotion can in crease profit if the gain that these effects create in the promotion p eriod outweighs the loss they create in future periods. We then descri be how retailers can estimate the optimal strategy of recurring promot ions that maximizes profits from reference price effects over a time h orizon. Examples of such strategies are presented for a retailer selli ng a national brand of peanut butter. We obtain insights into how prom otion prices, timing and profits are affected by changes in costs, int erest rates, consumers' reactions to reference price effects, and erro r in estimates used in the model. The retailer's optimal reaction to a trade deal is also examined. This strategy involves a phase of increa sed promotion activity sandwiched between phases of decreased activity . We explain these results using the effects described in the single-p eriod model.