Essays on the effects of the consumer price-perceived quality heuristic : theoretical and empirical perspectives

The study of consumer behavior and the study of firm strategy using quantitative modeling are among the many successful research streams in marketing. While both traditions have proved fruitful, there exists an obvious "gap" between them. In particular, relatively few of the significant findings in the behavioral research stream have been incorporated into the modeling framework to study firm strategies. For example, while numerous behavioral studies suggest that consumers may not have perfect information and may employ judgmental heuristics when they make purchase decisions, most of the quantitative studies on product positioning have assumed, among other things, that consumers have perfect information about true product quality. The research "gap" between behavioral studies and quantitative research needs to be filled, since to derive practically useful managerial implications, a modeling framework needs to reflect market realities to the possible extent. The rich findings in consumer behavior thus provide a great opportunity to incorporate them into models of firm strategy, and examine how the optimal outcome is changed. Feinberg, Krishna and Zhang (2002) and Krishna (1994) are some examples of work done with this focus. This is especially important for the studies of product positioning, since consumer perception about product offerings is often the consequence of both economic and psychological factors. This thesis examines one aspect of consumer behavior that has received consistent recognition in the behavioral literature but has not been considered in a modeling framework. In particular, we examine the effect of the price-perceived quality heuristic on a monopolist's quality and price strategies. The thesis will comprise 7 chapters. For the first chapter, the research problem is defined and a literature review of the existing work done on price as a signal of objective quality and the relevance of the price-perceived quality heuristic is presented. In the second chapter, we introduce and define the price-perceived quality heuristic formulation. In the third chapter, in the context of a monopolist deciding on price and quality strategies, we propose that consumers in reality may not have perfect information about the quality of a product. Instead, the "perceived" quality depends upon both true quality, which can be communicated to the market through non-price advertising, and the price level, which serves as an index of quality in addition to the indication of monetary sacrifice. As the behavioral literature suggests, this is particularly true for products that are difficult to evaluate, at least initially. We are able to derive analytical results that provide a valuable addition to existing studies where a perfect information world is assumed (i.e., consumers know the exact quality level and do not use the price-perceived quality heuristic). Some results are highlighted here. First, the degree of sub-optimality of inappropriately assuming only true quality information is shown to critically depend on both the significance of the price-perceived quality heuristic, and its interaction with the amount of true quality information available to consumers. Second, and perhaps more importantly, the firm can improve its optimal profits by enhancing the relative availability of the true quality information as compared to perceived quality through advertising. However, such an improvement is constrained by the magnitude of the price-perceived quality heuristic and occurs in the model when there does not exist a strong correlation between the magnitude of price-perceived quality heuristic and the availability of true quality information. In other words, this occurs when the use of the price-perceived quality heuristic is primarily a behavioral primitive, as most of the existing studies suggest. If a strong dependence between the magnitude of price-perceived quality heuristic and the availability of true quality information is assumed in the model, the pattern of results reverses. A few welfare implications are also obtained. For instance, the greater dependence on price to judge perceived quality in an efficient solution and the greater availability of true quality information in a monopoly solution may actually hurt consumers. In the fourth chapter, an empirical study was designed to test our conclusions that for markets where the consumers rely more heavily on the price-perceived quality heuristic, a higher level of non-price advertising will lead to greater profits. Despite the limitations of the study, the results are consistent enough with our expectations. Thus our conjecture that the parameters for the price-perceived quality and true quality information are independent or, at most, mildly dependent is supported and the theoretical results obtained are significant and have relevant managerial implications. In the model extensions, the thesis investigated product and price strategies for a monopolist in a dynamic setting as well as with a product line. In the dynamic setup with two periods, we incorporate the main findings of prospect theory when modeling how consumers respond to the differences between anticipated (perceived) quality and actual (true) quality. Our analysis indicates that it is optimal for the monopolist to adopt a price skimming strategy when both the price-perceived quality heuristic is important and the true quality information is readily available. Otherwise it is actually optimal for the firm to provide a quality level that matches or exceeds the level necessary for purchase, adopting a pricing strategy dependent on the heterogeneity of the consumers. The inclusion of the prospect theory also provides a more accurate guideline for managers when they need to adopt the correct quality and price strategies under different market conditions. In the next extension, optimal product and price strategies for the monopolist with a product line are obtained. The results are analyzed for various different market conditions for the two products as well as against the monopolist single product solution. The monopolist is better off having a product line for most market conditions as the market coverage is bigger and the higher product can be used to extract surplus from the consumers. However, when both the strength of the price-perceived quality and the availability of true quality information are high, the single product solution is more optimal as the monopolist can charge a very high price for a high quality product to a small customer segment that is willing to pay high for quality. In the 6th chapter, we incorporate competitive effects and investigate the product and price strategies when firms in a duopoly correctly believe or incorrectly not believe that consumers adopt the price-perceived quality heuristic prior to purchase. A comparison between the equilibrium solution, the efficient solution and the monopoly solution reveals that generally the equilibrium products are not efficiently positioned and the firm that is more profitable has a product closer to the monopoly product. Finally, we conclude and present directions for future research.Business, Sauder School ofGraduat