A simple test for distinguishing between internal

Authors: Tülin Erdem Michael L Katz Baohong Sun

Publish Date: 2010/04/28

Volume: 8, Issue: 3, Pages: 303-332

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Abstract

A large literature demonstrates the empirical importance of internal reference price effects There are several theories regarding how and why these effects arise We offer a simple test that distinguishes between the two leading theories based on economically rational behavior price as a signal of quality and price as a predictor of future prices Our test builds on differences in how past consumer purchases interact with internal reference prices We first validate the reliability of our test by applying it to synthetic data We then apply our test to purchases of ketchup and diapers and find 1 quality signaling is the dominant mechanism behind reference price effects in both categories 2 consistent with the qualitysignaling theory reference price effects diminish as various measures of consumer experience increase but 3 in both categories there are many individuals for whom priceprediction effects dominate qualitysignaling effectsWe are grateful to Sue Chang for expert research assistance Michael Keane for extremely helpful advice and two referees and seminar audiences at Columbia University Duke University the 4School Colloquium Columbia NYU Wharton and Yale New York University and University of California Riverside for useful comments and suggestionsWe aggregated each brand’s diaper sizes into five categories a 0 and 1 b 2 c 3 d 4 and e 5 and 6 We lumped sizes 0 and 1 as well as 5 and 6 together because the size differences between 0 and 1 and 5 and 6 are very small and there were fewer purchases of these sizes individually compared to other sizes We then created a distinct price index for each brand × size category × week × store Where data were available we took a quantityweighted average of the prices paid at that store that week for that brand and size category We calculated the sampleperiod weights by city Where no data were available for a given store/week for that diaper size/brand we constructed a price index based on the relevant data for all stores in the same city that week If no data were available at any store in a given week then we used the process described earlier in the text to interpolate data from other weeksConsider a household with purchase dates t 1 t 2t N and let x t 1x t 2x t N denote the corresponding purchase quantities on those dates Notice that the purchase quantities are 0 in weeks that are in our sample period but not on these dates that is X t=0 for t notin left t 1t 2t N right

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