A Model For The Effects of Psychological Pricing in Gabor-Granger Price Studies

A model for the eects of psychological pricing in
GaborGranger price studies

Michel Wedel
*
, Peter S.H. Leeang
Department of Economics, University of Groningen, Groningen, The Netherlands
Received 7 March 1996; received in revised form 7 July 1997; accepted 10 September 1997
Abstract
We present a model of consumers' price sensitivity that explicitly deals with the existence
of so-called psychological price levels or odd prices, i.e. prices ending in an odd number. The
model is formulated in a latent class framework, in which splines are used to model utility as
a function of prices in consumer segments. The knots in the splines represent psychological
prices. Additionally, the model allows for inferences on price expectations and the role of
price as an indicator of quality. The model is tailored to the analysis of so-called Gabor
Granger price experiments. We provide an empirical application to the analysis of a
GaborGranger study, and investigate the performance of our model relative to a competing
model. 1998 Elsevier Science B.V. All rights reserved.
PsycINFO classication: 2240; 3920
JEL classication: C25
Keywords: Pricing; Mixture model; Splines; GaborGranger price experiment
Journal of Economic Psychology 19 (1998) 237260
*
Corresponding author. Address: Department of Marketing and Marketing Research, Faculty of
Economics, University of Groningen, P.O. Box 800, 9700 AV Groningen, The Netherlands. Tel.: +31 50
3633735; fax: +31 50 3633720.
0167-4870/98/$19.00 1998 Elsevier Science B.V. All rights reserved.
PII S 0 1 6 7 - 4 8 7 0 ( 9 8 ) 0 0 0 0 6 - 3
1. Introduction
The practice of setting prices just below the nearest round gure is pop-
ular among manufacturers and retailers. Such pricing practices are usually
referred to as psychological or odd-pricing (see Monroe, 1973; Blattberg
and Neslin, 1990, p. 349). Examples of these prices are $4.99 instead of
$5.00 or $99.95 rather than $100. The origin of this practice can only be
conjectured, but it may for example have arisen as a quantity-discount
when fresh products were only oered by the pound, and the consumers'
temptation to buy half the oered quantity was reduced when products
are oered at such odd prices (see Friedman, 1968). Many retailers believe
psychological pricing to be eective. In a survey of newspaper advertise-
ments Friedman (1968) found prices ending in ``9'' to be by far the most
popular among food retailers. The reason for the use of these price settings
is that a higher price elasticity is expected at the psychological price, as
compared to those within the surrounding price-interval. The increase in
sales that results from a price cut from e.g. $1.00 to $0.99 is expected to
be much larger than that from decreasing $0.99 to $0.98 or from $1.01
to $1.00 (see Gabor and Granger, 1961, 1966). Monroe (1973) indicated
that empirical evidence for the existence of discontinuities in demand at
psychological prices is limited, and since then only the work of Blattberg
and Wisniewski (1987) has addressed this issue. These authors used retail
scanner data to demonstrate that for fast moving consumer goods, the per-
centage of increase in sales obtained at psychological price levels was 10%
above the eect simply due to the price decrease. To this end they devel-
oped several alternative models describing the shape of deal-discounts.
These models are aggregate-level models.
The purpose of this paper is to develop a stochastic disaggregate-level
choice model, which may serve to investigate the eects of psychological pric-
ing within the context of GaborGranger price studies (Gabor and Granger,
1966). It is a logit model of binary choices of individual consumers, and al-
lows for a more detailed representation of the form of price-response func-
tions than has been possible until now. Splines are used to model
consumers' utility as a function of prices. The model is formulated in a latent
class framework and allows for the identication of market segments with
dierent price-response functions. First we will provide a possible explaining
hypothesis for the eects of psychological price-settings, using consumer be-
havior and economic theories. Then, we will provide a review of additional
issues in the pricing literature, that will be accommodated in the model.
238 M. Wedel, P.S.H. Leeang / Journal of Economic Psychology 19 (1998) 237260
Section 4 describes the GaborGranger procedure, our model and the es-
timation procedure. Section 5 provides the results of a study into consumer's
price sensitivity, where the results are analyzed with the proposed model. In
Section 6 our model is compared to an alternative model with respect to pre-
dictive validity. An investigation of the external validity is provided as well.
Section 7 contains a discussion of the results.
2. Psychological prices
The explaining hypothesis of the eect of psychological prices that we will
use, is based upon adaptation level theory (Helson, 1964) and transaction
utility theory (Thaler, 1985).
Adaptation level theory states that perceptions of new stimuli are
formed relative to a standard or adaptation level. The adaptation level
is determined by previous and current stimuli to which a person has been
exposed. A possible hypothesis for the occurrence of discontinuities in
consumer demand at psychological prices is related to how consumers per-
ceive psychological prices, relative to prices perceived as `fair' (see Fried-
man, 1968; Schindler, 1991). Consumers may very well evaluate prices
according to round monetary units, such as one dollar, pound, franc,
mark, etc. Consumers perceive odd prices as being substantially lower
than even-priced items, even though the real dierence is perceptually very
small. Thus, an item priced at $1.99 is thought of as costing about $1
rather than $2 (Hanna and Dodge, 1995, p. 28). We conjecture, that a
consumer's reaction to the oered psychological price of $1.99 is that
(s)he perceives the nearest integer price, e.g. $2.00, to be a `fair' price,
and that (s)he perceives that a discount is obtained relative to the `fair'
price (see Friedman, 1968).
Brenner and Brenner (1982) suggest that this phenomenon results from
consumers' limited capacity for storing directly accessible information. Con-
sumers exposed to price information store only the more valuable parts of the
message they receive and these are the rst digits of a number. When a price
is $1.99, the digit is more important as information than the rst and second
`9'. Rounding up involves an additional decision compared with storing the
integer part of the number.
Psychological pricing can be seen as implicitly presenting a fair price to
consumers, to enhance their notion of a price cut involved in the transaction.
Such implicit presentation of a fair price may even lead to higher price
M. Wedel, P.S.H. Leeang / Journal of Economic Psychology 19 (1998) 237260 239
savings being perceived than in the instance of an explicit presentation of a
price discount (see Liefeld and Heslop, 1985).
Transaction utility theory provides an explanation for the increase in de-
mand at the psychological price level. Thaler (1985) proposes that the total
utility of a transaction to a consumer is the sum of the acquisition utility
and the transaction utility. The acquisition utility is derived from the value
of the item to the consumer; it increases monotonically with price across
the entire price-range. The transaction utility results from comparing the
price paid to the fair price. We hypothesize that the perceived price cut at
a price of, say, $1.99, relative to a perceived fair price of $2.00, increases
the transaction utility (at $1.99), and results in a discontinuous increase in to-
tal utility, and thereby in consumer demand.
A large body of literature supports the hypothesis that the sensitivity to
perceived price reductions varies across consumers (see Blattberg et al.,
1978; Blattberg and Neslin, 1990, pp. 7781; Go nu l and Srinivasan, 1993).
Thereby, the relative importance of transaction utility, and consequently
the eect of psychological prices, may dier between consumers. It may
therefore be hypothesized that psychological price eects occur in some con-
sumer segments (market segments) but not in others.
3. Pricing literature review
The purpose of this study is to develop a behavioral pricing model for the
investigation of consumers' sensitivity to psychological pricing. Such a model
should not only account for the eect of odd prices on consumer demand but
also for a number of other issues that have previously been included in be-
havioral pricing models. In this respect the following issues are relevant
(see Rao, 1993, pp. 538543):
1. the formation of price expectations by consumers;
2. the role of price as an indicator of quality;
3. heterogeneity of consumers with respect to price sensitivity.
(1) Price expectations (the role of reference prices): Consumers have ex-
pectations about prices. These expectations are product and individual spe-
cic; they are known as reference prices. Support for consumers' use of
reference price levels is based on prospect theory and is supported on a large
number of studies in the pricing literature (see, e.g., Winer, 1986, Kalwani
et al., 1990).
Prospect theory of Kahneman and Tversky (1979) states that consumers
react more strongly to losses than to gains, relative to a reference; a loss/gain
meaning that the observed price is higher/lower than the reference price. The
notion of asymmetric response above and below the reference price can be
explained by price losses appearing to be larger than gains. Supporting evi-
dence for price loss-aversion comes from several studies (see, e.g., Kalwani
et al., 1990; Kalwani and Yim, 1992; Hardie et al., 1993; Bell and Lattin,
1993). The notion of reference dependence has been extended to other attri-
butes than price by Tversky and Kahneman (1991). Hardie et al. (1993) in-
vestigate loss-aversion with respect to, amongst others, quality. They
demonstrate that consumers display asymmetric response with respect to a
reference point for quality as well. Also here, quality losses appear larger
than quality gains. In the empirical studies reference price has been opera-
tionalized as the average price of similar products (see Emery, 1970), the price
last paid (see Monroe, 1973; Winer, 1986), the price most frequently paid (see
Gabor and Granger, 1961), a weighted average of past prices (see Kalwani et
al., 1990), or by direct questioning about the expected price (see Kalwani and
Yim, 1992).
(2) Price as an indicator of quality: The role of price as a determinant of
buying intentions and actual choice is complicated by its role as an indicator
of quality. Theories of imperfect information (see e.g. Monroe, 1973; Steen-
kamp, 1989, p. 37) explain that in the choice process of consumers who are
uncertain about the quality of a product, price may serve as a cue for assess-
ing that quality. In that sense, higher prices of a brand have been shown to
positively aect purchase probabilities (see, e.g., Erickson and Johansson,
1985). The associated behavior of consumers has been referred to as price-
seeking. The price-perceived quality relationship has been reported to be
highly variable across consumers and situations (see Zeithaml, 1988), and ap-
pears to be stronger for nondurable than for durable products (see Lichten-
stein and Burton, 1989).
1
Thus we conclude that we have to recognize a dual
role of price in consumers' decision-making. The classic economic eect of
price on choice behavior is modeled by the relationship between àctual price'
and `perceived monetary sacrice'. The higher the price, the more must be
sacriced to purchase the product and the lower the purchase intention.
On the other hand higher prices have a positive eect on perceived quality
1
There are a vast number of studies on the price quality relationship, which have been reviewed by e.g.
Monroe (1973) and Steenkamp (1989).
and this leads to a higher purchase intention. This trade-o is known as ``the
perceived sacriceperceived quality trade-o'' (Steenkamp, 1989, p. 195) or
the priceperceived quality trade-o.
(3) Heterogeneity: A nal complexity in the relationship of price to con-
sumer choice behavior is that consumers appear to be very heterogeneous
in their attention and reaction to price and price promotions (see Dickson
and Sawyer, 1990; Go nu l and Srinivasan, 1993; Lichtenstein et al., 1993).
Thus we may observe dierent `price segments'. There is heterogeneity be-
tween these market segments in terms of price reactions, whereas within a
price segment the consumers' reactions to price changes is homogeneous.
In the èarly' price-response models heterogeneity has been captured by using
an a priori denition of segments on the basis of socio-economic and demo-
graphic characteristics (see, e.g., Wildt and McCann, 1980). A post-hoc ap-
proach was employed rst by Elrod and Winer (1982). They grouped
consumers into segments on the basis of price-elasticities estimated at the in-
dividual level. More recently, Kamakura and Russell (1989) proposed a la-
tent class model that improves upon the previous approaches by
simultaneously estimating segments and price-response functions within each
segment. Bell and Lattin (1993) used a related model to investigate heteroge-
neity in loss aversion. Our model extends these approaches by including psy-
chological price-eects.
The theories which have been introduced briey in the two preceding sec-
tions to explain consumers' reactions to price are summarized in Table 1.
4. Model description
4.1. GaborGranger price studies
Our model is tailored to the analysis of GaborGranger studies (see Ga-
bor and Granger, 1961, 1966). The purpose of GaborGranger studies is to
establish a so-called buy-response curve, which depicts the percentages of
consumers buying a certain brand at various prices. To this end, respon-
dents are oered the brand at a number of prices, and are required to state
whether they intend to buy the brand or not, at each price. They can also
indicate not to buy the brand at all regardless of the prices. Because in Ga-
borGranger studies price-levels can be determined by the researcher, the
resulting data have the advantage over observational data of greater price
variation. In addition, these data are not confounded by simultaneous ef-
fects of e.g. competitive advertising, or the introduction of new brands. Fre-
quently, in GaborGranger price studies, a bell-shaped price-response func-
tion is observed, in which the percentage of consumers buying the brand
rises at lower prices, and declines again at higher prices. Gabor and Gran-
ger (1966) attributed this eect to consumers' use of price as an indicator of
quality. The GaborGranger procedure is still frequently used in marketing
research practice.
4.2. The model
We assume that in a GaborGranger study, a sample of n consumers is of-
fered a certain brand at, say, J dierent prices. Among these prices are K psy-
chological prices. We assume that the brand we consider is indicated by l =1,
and that the prices of the (L-2) alternative brands are xed. One alternative is
not buying. The dependent variable of our model is a 0/1 buy-response of
consumers.
Establishing the notation used in this study as follows: i = 1; . . . ; n indicate
consumers, j = 1; . . . ; J indicate the prices, k = 1; . . . ; K indicate the psycho-
logical prices, l = 1; . . . ; L indicate brands, s = 1; . . . ; S indicate segments,
y
ij
=1 if consumer i buys brand 1 at price level j, and 0 otherwise, p
ij
is
the jth price for consumer i, p
i
r
, the reference price of consumer i, and t
k
,
the kth psychological price.
Table 1
Theories explaining consumers response to price
Theory Contents Explanation for reactions to price
1. Adaptation level theory Perceptions of new prices are
formed relative to an adaptation
level: round monetary unit
Psychological prices are
compared to `fair' prices
2. Transaction utilily theory Total utility of a transaction is
the sum of the acquisition utility
and the transaction utility
Transaction utility increases
at psychological prices
3. Prospect theory Consumers react more strongly
to losses than to gains relative to
a reference: loss/gain: observed
price higher/lower than reference
price loss/gain: perceived quality
lower/higher than reference
quality
Assymmetric response to
price/quality around reference
price/quality
4. Theory of imperfect
information
Price is cue for assessing quality Higher prices lead to higher pur-
chase probabilities
We start from the assumption that there are a number of (market) seg-
ments (or latent classes), S, with relative sizes h
1
; . . . ; h
S
; h
s
= number of
consumers in segment s divided by bij n, (h
s
> 0, Rh
s
=1). Given that
(s)he comes from segment s, the conditional probability that consumer i
wishes to buy the brand at price j is equal to the probability that the utility
of buying the brand, U
ij[s
, is larger than the utility of not buying the brand,
U
iN[s
. The latter utility is dened as the maximum of the utilities of the sub-
set {N} of L-1 brands that are used implicitly as alternatives. The condi-
tional probability of buying is
P
ij[s
= ProbU
ij[s
> U
iN[s
U
iN[s
= max(U
il[s
; l = 2; . . . ; L): (1)
As usual, assume the utilities random and divide them into deterministic
parts, denoted by respectively V
ij[s
and V
iN[s
, and random parts, denoted by
respectively
ij[s
and
iN[s
.
2
The latter terms capture the eect of unobserved
background stimuli and uncertainty. It is assumed that the number of alter-
natives L-1 in the set {N} and the deterministic parts of their utilities V
iN[s
are
constant in each segment. This assumption of constancy is a rather strong
one, but is commonly made in choice models (see Ben-Akiva and Lerman,
1985).
The deterministic part of the utility V
ij[s
will depend on the product fea-
tures of the brand, its distribution, its image and among many other variables
its price. In our GaborGranger analysis price is the only variable that uc-
tuates. Thus V
ij[s
is related to the actual prices, the psychological price levels
and the respondents' reference prices. For this purpose rst order linear
splines are used, which are linear line segments of possibly dierent slopes,
joined at a number of knots (see Smith, 1979). In our model the knots are
determined a priori, corresponding to the K psychological prices. By choos-
ing the knots in such a manner, they represent the discontinuities in utility
associated with psychological prices.
In addition to the eects of the psychological prices, we model the asym-
metry in consumers' response relative to the reference price (for which we will
2
According to standard discrete choice theory (cf. e.g. Ben-Akiva and Lerman, 1985, p. 256),
U
iN[s
=

V
iN[s
ln N ln B
iN[s

iN[s
;
where

V
iN[s
= (1=L 1)
P
L
l=2
V
il[s
, is the average (i.e. `deterministic') utility of the L ) 1 implicit alterna-
tives in {N} and
B
iN[s
=
1
L 1
X
L
l=2
e
V
il[s

V
iN[s
;
is a measure of the heterogeneity of the L ) 1 alternatives in {N}.
also use a spline representation). We start from the assumption that the ref-
erence price is determined exogenous to our model.
To develop the spline representation, the total price range is partitioned
into K + 1 price ranges dened by the K psychological prices. Utility is as-
sumed to depend linearly on price, in between the K psychological prices.
The sequence of knots that forms the basis of the spline function, represent-
ing the psychological prices, is dened as t
0
; t
1
; . . . ; t
K
; t
K1
; t
0
denotes the
lowest, t
K1
the highest price oered, and t
k
(k = 1; . . . ; K) are the K psycho-
logical prices. For consumer i, the spline function contains one additional
knot at p
i
r
, his/her reference price level.
We introduce the function S
q
(.):
S
q
(Z) = Z
q
if Z > 0
= 0 if Z 60;
where the exponent q is a nonnegative integer. This function is commonly
used to formulate splines (see Smith, 1979). A simple example follows. Two
intervals of a variable x, say [), t
1
); [t
1
, ] are distinguished, where t
1
denotes a knot. Now, S
1
(x ) t
1
) =x ) t
1
, for x > t
1
. The spline function
is dened in this case as: y =b
1
x + b
2
S
1
(x ) t
1
). This function has regres-
sion coecients b
1
for x < t
1
, and b
1
+ b
2
for x > t
1
. The line segments
are connected at t
1
. In the presence of more intervals, similarly, the coe-
cients are cumulated (b
1
+ b
2
+ b
3
, etc.) across the preceding intervals, in
the calculation of the eect of x in a certain interval. We will use q =0,1,
implying linear splines. The deterministic part of the utility function for a
consumer of market segment s is written as the sum of three eects (each
comprising two terms): a linear price eect + reference price eect + psy-
chological price eect (the interpretation of the terms in the model will
be further explained below):
V
ij[s
= b
00s
b
10s
p
ij
b
2s
p
r
i
b
3s
S
1
(p
ij
p
r
i
)
X
K
k=1
b
0ks
S
0
(p
ij
t
k
)
X
K
k=1
b
1ks
S
1
(p
ij
t
k
): (2)
For an individual consumer in market segment s:, b
00s
denotes the intercept
(INTCPT), b
10s
represents the linear price eect (PRICE0), b
2s
represents
the overall eect of the reference price (REFERP), b
3s
represents the addi-
tional eect of price `losses', where a price loss is dened as the dierence
between the actual/observed price and the reference price if the actual price
is higher than the reference price (PRLOSS), b
0ks
represents the eect of
the kth psychological price level (PSYPRk), b
1ks
represents the additional
linear price eect in the kth price interval, relative to the (k ) 1)th interval
(PRICEk).
The intercept term in Eq. (2) represents that part of the deterministic part
of the utility which is not related to price. It represents the òverall' probabil-
ity of choosing the brand (l =1) by consumers in market segment s. The term
PRICE0 captures the overall linear price eect. The term PRLOSS represents
the additional eect of a price `loss', relative to price `gains' (see Kahneman
and Tversky, 1979; Tversky and Kahneman, 1991; Hardie et al., 1993). Note
that S
1
(p
ij
) p
i
r
) =0 for p
ij
< p
i
r
, and S
1
(p
ij
) p
i
r
) =(p
ij
) p
i
r
), otherwise.
For example, the partial eect of a price gain (p
ij
6p
i
r
) equals b
10s
p
ij
. The
partial eect of a price loss (p
ij
> p
i
r
), can then be represented as
(b
10s
+ b
3s
)p
ij
. Thus b
3s
represents the additional eect of price losses (on
the price p
ij
). The formulation used enables a test of loss aversion: if
b
3s
=0, price eects above and below the reference price level are symmetric.
The term REFERP represents the absolute eect of the reference price on
the choice probabilities. Compare in this respect Tversky and Simonson
(1993), who have shown that in addition to relative evaluations, absolute
evaluations play a role in consumer choice processes.
The coecients b
0ks
of the terms PSYPRk (for k = 1; . . . ; K) represent the
changes in intercept at the psychological price levels, and thus the discontinu-
ities in utility at these price levels. The coecients b
1ks
of the terms PRICEk
(k = 1; . . . ; K) represent the changes in the slope of price at the psychological
price levels, relative to the slope in the next lower price range. These coe-
cients are used to investigate the shape of the price-response function.
At this point, we formulate an expression for the conditional choice prob-
abilities P
ij[s
. We use the standard assumption of a logistic distribution of the
dierence
ij[s
)
iN[s
. The following expression for the probability that sub-
ject i, coming from market segment s, wishes to buy the brand at price level
p
ij
, is obtained:
P
ij[s
=
1
1 exp(V
iN[s
V
ij[s
)
=
1
1 exp(V
+
ij[s
)
: (3)
Since the prices of the other brands and thus V
iN[s
is assumed to be con-
stant in segment s during the experiment, this term may be absorbed in the
constant b
+
00s
in V
+
ij[s
. A given consumer i has the probability h
s
that it belongs
to segment s. The unconditional probability that subject i chooses the brand
at price j is:
P
ij
=
X
S
s=1
h
s
P
ij[s
=
X
S
s=1
h
s
1
1 exp(V
+
ij[s
)
: (4)
4.3. Estimation
The parameters of the model are estimated by the method of maximum
likelihood. Using the binomial distribution for the choice probabilities, the
likelihood can be formulated as:
l =
Y
n
i=1
X
S
s=1
h
s
Y
J
j=1
(P
ij[s
)
y
ij
(1 P
ij[s
)
(1y
ij
)
: (5)
The likelihood, or equivalently, the log-likelihood is maximized using an
EM-algorithm (see Wedel and DeSarbo, 1994) to obtain estimates of the pa-
rameters of the model. The EM algorithm has the advantages of being easy to
implement, while convergence of the iterative procedure is ensured.
Once the parameters have been estimated, the posterior probabilities that
subject i comes from segment s, h
is
, can be calculated using Bayes' rule (see
Wedel and DeSarbo, 1994). The asymptotic variances of the estimated
spline-function coecients are obtained from the Fisher information matrix.
These variances allow for signicance testing of the coecients.
In practical applications, the number of segments S is unknown. We use
the ICOMP criterion proposed by Bozdogan (1993) to determine the number
of segments, where the number of segments that yields the minimum value of
ICOMP is selected (the usual likelihood-ratio tests are invalid, because cer-
tain regularity conditions are not satised). ICOMP is an information theo-
retic measure, that improves upon the traditional Akaike (and Consistent
Akaike) Information criterion by adding a correction for model complexity,
and thus controlling for the risks of over-parameterising the model. ICOMP
is dened for our model as:
ICOMP = 2 ln l Q ln (trace(R)) det(R); (6)
where Q is the number of parameters estimated and R is the estimated co-
variance matrix of the parameters. Additionally, the percentage of variance
explained, R
2
, and the entropy E
s
, are used to evaluate the models. R
2
is
dened as 1 minus the ratio of the likelihoods of the current model and
the null-model, where the latter model includes only an intercept (V
ij
=b
0
).
E
s
is a measure that indicates the separation of classes (E
s
=1
indicates complete separation; E
s
=0 indicates complete overlap), and is
dened as:
E
s
= 1
X
n
i=1
X
S
s=1
h
is
ln h
is
ln log(S): (7)
5. Application: Parameterization
5.1. Data collection
In this section we will provide an application of our model to a Gabor
Granger study for a brand in a category of products for personal care. The
brand name cannot be revealed because of the condential nature of the study.
In the study, data were collected from a mall-intercept sample of 377 fe-
male shoppers in The Netherlands. The interview procedure was as follows.
Subjects were not informed beforehand about the purpose of the study. They
were told that some questions were to be posed on their preferences with res-
pect to brands in the category of products for personal care. Nine dierent
price levels, varying from D 2.19 to 4.80 were called out to each of the re-
spondents. In order to obtain substantial price variation while minimizing the
number of prices oered to each respondent, six dierent sequences of nine
prices were used. Respondents were randomly assigned to one of those six se-
quences. The lowest prices in these six sequences were, respectively, D 2.19,
2.20, 2.29, 2.30, 2.39 and 2.40. The prices in a sequence were obtained by suc-
cessively adding D 0.30 to the lowest price. The rst price called out to a
respondent was in the middle of the price sequence, while subsequent prices
were presented in random order to prevent order eects. Monroe (1990),
p. 125, describes such randomization as the appropriate procedure to over-
come order eects in price-research methods. At each price called out, re-
spondents were required to respond with a statement whether they intend
to buy the brand (1) at that price or not (0). The question asking consumers
for their purchase intent was conditioned on a purchase of the category being
made in the subsequent month. Respondents could indicate not to buy the
brand at any of the prices called out.
Whereas specic theory as to exactly what constitutes a psychological price
level is currently lacking, we dened prices ending in D 0.99 as potential
psychological prices (cf. Friedman, 1968). Therefore, the prices called out
to the respondents included two psychological prices: D 2.99 and D 3.99.
In a small audit, conducted among 31 supermarkets in the region where
the GaborGranger study was done, we investigated the occurrence of price
setting at the two psychological price levels mentioned. More than 50% of the
(482) items in the personal care products were priced at levels of D 2.99 and
D 3.99. These results illustrate the frequency with which psychological price
setting is used in practice.
Reference price levels were operationalized in this study as the last price
paid for a brand within the product class, assessed through direct question-
ing.
3
A number of demographic, socio-economic and usage characteristics of
the respondents were collected: age in years, monthly income in D 1000, us-
age frequency of the product in times per week, and whether respondents had
previously bought the brand.
5.2. Expected eects
The expectations of the direction of most of the eects captured in the
model depend upon whether consumers see price as a monetary sacrice,
or as an indicator of quality, since in the presence of price-seeking behavior,
the price-response relation is reversed. Table 2 presents a summary of the ex-
pected eects.
The coecients b
1ks
(PRICEk, k = 0; . . . ; K), presenting the price-eects in
the dierent price ranges, are hypothesized to be negative, if price is perceived
as a monetary sacrice. If price is perceived as an indicator of quality, how-
ever, these coecients are positive, indicating that utility increases with price.
3
The asymmetric eect relative to the price last paid could not be estimated for those consumers who
did not remember the price last paid, or for whom the remembered price last paid was outside of the price
range in the study.
Table 2
Expectations of model coecients
Term Coecient Price as monetary sacrice Price as quality indicator
PRICEk b
1ks
) +
REFERP b
2s
+ )
PRLOSS b
3s
) +
PSYPRk b
0ks
)
Manufacturers benet from high reference or expected price levels. High
reference prices (REFERP) ensure that price decreases appear more attrac-
tive to consumers, and regular prices do not seem so unattractive (cf. Blatt-
berg and Neslin, 1990, p. 41). We therefore expect the sign for b
2s
to be
positive. If price is used as an indicator of quality, however, manufacturers
benet from low reference price levels. Here, such low price-expectations will
lead to higher prices being perceived as indicating higher quality across the
entire price range. The sign for b
2s
is therefore expected to be negative in such
situations.
According to the Tversky and Kahneman (1991) prospect theory, consum-
ers should react more strongly to price losses, which gives us reason to expect
b
3s
, the additional eect of a price loss (PRLOSS) to be negative. If consum-
ers use price as an indicator of quality (cf. Hardie et al., 1993), loss-aversion
may occur as well for perceived quality. Consequently, it may be expected
that for prices above the reference price (price losses) a gain in quality is per-
ceived. Therefore the b
3s
are expected to be positive in situations where price
is used as an indicator of quality.
The terms PSYPRk (for k = 1; . . . ; K) the discontinuity in utility at the
psychological price levels. If the kth psychological price causes such discon-
tinuities, b
0ks
is hypothesized to be negative, otherwise b
0ks
is zero. It is not a
priori clear what the eects of psychological prices are in the presence of a
price-perceived quality relationship.
5.3. Results
Our model was applied to the above GaborGranger data of 377 consum-
ers. We specied from S=1 to S=6 segments. Two knots were included in
the spline function, at the psychological price levels of D 2.99 and D 3.99,
respectively. Thus we have two knots and three price ranges: price 62.99;
3.00 < price < 3.99 and price P4.00. Table 3 shows the number of itera-
tions, the log-likelihood, ICOMP, R
2
and entropy (E
s
) criteria for each of
the S=1 to S=6 solutions. The ICOMP criterion indicated the S=5 seg-
ment solution to be optimal. However, the dierences between the S=4
and S=5 segment solutions were small. In the latter solution one segment
was split into two segments with similar interpretation and managerial impli-
cations. We report the S=4 segment solution, because it is more parsimoni-
ous. The four segments were proled by regressing the logit-transformed
posterior probabilities on the consumer descriptor variables.
R
2
is 0.435 for the S=4 segment solution. The value of E
4
of 0.913 indi-
cates that the segments were very well separated. The estimates of the param-
eters of the four segment solution are contained in Table 4. The parameters
of the four segments are well interpretable, and conform to our expectations
to a large extent, as will be detailed below. Fig. 1 displays the form of the
price-utility function in the four segments. (The gure was calculated from
the PRICE# and PSYPR# coecients, holding the other eects constant).
Segment 1 contains 30.6% of the sample and displays a negative price re-
sponse function (Fig. 1). In the lower price range demand is inelastic
(PRICE0). Above D 2.99 utility decreases faster with price (PRICE1,
p < 0.10). This decrease is enhanced in the highest price range (PRICE2,
p < 0.10). To this segment of consumers, price represents the amount of
money that must be sacriced in order to obtain the brand, and therefore
Table 4
Parameter estimates for the S=4 solution
Parameter /Segment 1 2 3 4
INTCPT 7.240
b
3.880
b
)20.960
b
)11.190
b
PRICE0 )0.012 )0.020
b
0.068
b
0.056
b
PSYPR1 (2.99) )0.022 1.987
b
0.794 0.520
PRICE1 )0.024
a
)0.032
b
)0.058
b
)0.028
PSYPR2 (3.99) )0.783
a
1.390 0.075 )3.710
b
PRICE2 )0.020
a
)0.009 )0.014
a
)0.072
b
PRLOSS )0.042
b
)0.025
b
0.143
b
0.035
b
REFERP 0.009
b
0.015
b
)0.011
b
)0.017
b
h
s
(relative size of segment s) 0.306 0.314 0.205 0.175
a
p < 0.10.
b
p < 0.05.
Table 3
Statistics of the S=1 to S=6 solutions
No. of Classes No of Iterations Log L ICOMP R
2
Entropy E
s
1 2 )2184.320 4447.256 0.094 )
2 14 )1801.777 3778.856 0.277 0.903
3 49 )1549.788 3354.552 0.376 0.910
4 28 )1383.251 3130.700
b
0.435 0.913
5 19 )1290.894 3052.293
a
0.465 0.911
6 33 )1242.535 3071.440 0.480 0.912
a
Denotes minimum ICOMP.
b
Denotes the solution selected.
prices aect purchase probabilities negatively. At D 2.99 there is no signi-
cant psychological price eect. Apparently at prices upto D 3.00 consumers
hardly perceive price-changes to be important. At D 3.99, there is a signi-
cant psychological price eect. Apparently, D 3.99 is perceived as a reduced
price relative to a possible fair price of D 4.00. At prices above D 4.00,
consumers are more sensitive to price changes, since the perceived sacrice
increases sharply. The eect of the reference price (REFERP) is positive, in-
dicating that higher expected prices lead to higher intentions of buying the
brand. This was expected to occur in the presence of negative linear price ef-
fects (PRICEk). If the reference price is higher, the whole price-sequence of-
Fig. 1. The price-utility function in segments 14, personal care brand.
fered appears to be less of a monetary sacrice. The coecient of PRLOSS is
negative, which indicates that prices above the reference price more negative-
ly aect purchase probabilities than prices below the reference price. This was
expected on the basis of prospect theory, according to which consumers react
more strongly to price losses (higher prices) than to price gains. Membership
in segment 1 is associated with lower income, and not previously having pur-
chased the brand.
In Segment 2, comprising 31.4% of the sample, utility also decreases as a
function of price. The decrease is not monotonic: in the second price range
(PRICE1) it is stronger than in the rst price range (PRICE0). The price
response function decreases at the same rate in the third price range
(PRICE2). To these consumers price represents a monetary sacrice. For
this segment the psychological price eects are quite dierent from those
in segment 1. A signicant psychological price eect is present at D
2.99 (PSYPR1). There is no psychological price eect at D 3.99
(PSYPR2). Apparently, at D 2.99 price is perceived to be reduced relative
to a fair price of D 3.00. The coecient of REFERP is positive, indicating
that higher reference price leads to a higher probability of indicating a buy,
which is consistent with expectations and the ndings in the rst segment.
Just as in segment 1, we nd a negative coecient for PRLOSS. Note, how-
ever, that loss aversion is less strong in this segment as compared to seg-
ment 1. Consumers that have previously purchased the brand have a
higher probability of belonging to this segment.
Segment 3 is smaller than the segments 1 and 2 and contains 20.5% of
the sample. Contrary to segments 1 and 2, in this segment utility increases
with price in the rst price range (PRICE0). The price responses in the sec-
ond and third price range are almost inelastic. Consumers in this segment
use price as an indicator of quality. Note that consumers apparently
trade-o perceived-quality and perceived-sacrice. The priceperceived
quality relationship is primarily found in the lowest price range, but in
the higher price ranges the monetary sacrice becomes more important,
so that the positive price eect levels o. No signicant psychological price
eects are observed in this segment. When the price-response is positive,
psychological prices may not be perceived as price reductions relative to
a fair price, so that transaction utility is not increased at such price levels.
Consistent with the positive price relation, the coecient of reference price
(REFERP) is negative, which was expected. This indicates that low price
expectations (i.e. a low price last paid) will lead to prices across the entire
oered price sequence being perceived as indicating higher quality, which
results in higher purchase probabilities. The coecient of PRLOSS is pos-
itive, which conrms our expectations on the basis of prospect theory. Since
price is an indicator of quality in this segment, higher prices losses corres-
pond to perceived quality gains, so that the term PRLOSS, representing
higher prices relative to the reference price, indicates perceived quality
gains. The coecient for prices above the reference price (PRLOSS) is pos-
itive, indicating a stronger priceperceived quality relation for these prices.
This nding supports prospect theory, which predicts the eect of a per-
ceived quality loss to be greater than that of a corresponding quality gain.
The large negative intercept indicates that consumers in this segment have a
much lower overall probability of choosing the brand, as compared to seg-
ments 1 and 2. Segment membership does not display strong associations
with consumer descriptors, although consumers in this segment tend to
have a somewhat higher (p < 0.10) income. This corresponds to the nd-
ings of e.g. Steenkamp (1989), p. 205, that consumers with higher incomes
are more quality conscious.
Segment 4 is the smallest segment and contains 17.5 percent of the
sample. Here a clear bell-shaped price response function is observed, as
was reported to occur in the original studies of Gabor and Granger
(1966). At lower price levels consumers' utility signicantly increases with
price (PRICE0). Since PRICE1 is not signicant, the increase appears to
continue in the middle price range. In the highest price range the price-
response is clearly negative. This segment of consumers use price as an
indicator of quality in the lower and middle price range. For prices above
D 3.00 the importance of the perceived sacrice is apparently greater
than that of perceived quality, and the price response function decreases.
At D 2.99, where the price-response function is positive, there is no sig-
nicant psychological price eect. This nding is consistent with the re-
sults for segment 3, where also no psychological price eects were
found for prices that were used as an indicator of quality. At D 3.99
there is a signicant psychological price eect. Note that the psychological
price eect is very large indeed, and that this eect occurs at the onset of
the negative price-response function. Consistent with our expectations the
coecient of REFERP is negative. Just as in segment 3, and consistent
with prospect theory, the coecient for PRLOSS is positive, indicating
that prices below the price last paid are less strong indicators of quality.
Judged by the magnitude of the coecients, the loss aversion is much
greater in segment 3 than in segment 4. Again, as evidenced by the inter-
cept, the overall probability of choosing the brand is low as compared to
segments 1 and 2. Consumers that have not previously purchased the
brand have a higher probability of belonging to this segment. This nding
may indicate that these consumers are less sure of the quality of the
brand, and therefore depend more heavily on price as a quality cue
(Steenkamp, 1989, p. 95).
6. Validation
In this section the predictive validity of our model is compared to the la-
tent class logit model with linear price eects. The deterministic part of the
utility function of this model has the following, simple structure
V
ij[s
= c
00s
c
10s
p
ij
; (8)
where for an individual consumer in segment s, c
00s
denotes the intercept and
c
10s
represents the linear price eect. This is the model proposed by Kama-
kura and Russell (1989) in a binary context. Two validation studies were car-
ried out, establishing internal and external validity, respectively.
First, as there were no holdout data available, we randomly eliminated
10% of the data of the GaborGranger study, estimated the models on the
remaining data, and predicted choices for the eliminated price levels. To this
end, Eq. (5) was used. This procedure was repeated ve times for each model.
To evaluate the predictive accuracy we calculated the correlation between
predictions and holdout data. This dependent measure was analyzed by uni-
variate Analysis of Variance to test dierences among the methods (the AN-
OVA has 90% power to detect eects that account for approximately 15% of
the variance, Cohen, 1991).
The predictive t of the latent class spline model was signicantly better
than that of the latent class linear model: the validation correlation for the
former was 0.636, the validation correlation for the latter 0.603 (Standard er-
ror of the dierence, SED=0.005, p < 0.001). The results support the inter-
nal validity of our results. The proposed spline model is superior to the model
with linear price eects only, although the dierence is modest. The improve-
ment is about 5% in the present application, and will depend on the extent to
which the price response functions are nonlinear.
Second, the external validity of our model for the eects of psycholog-
ical pricing in GaborGranger price studies was investigated. This implies
the validation of the data collection procedure which measures purchase
intentions and the validation of the model which has been calibrated using
these data. Market shares and prices were obtained for the brand in 12
two-monthly periods for a representative sample of stores in The Nether-
lands, from A.C. Nielsen. The period concerns two years, covering the pe-
riod in which the data for the GaborGranger study were collected. The
market shares were adjusted for price-eects of competing brands using re-
gression methods, and one extreme observation was eliminated from the
data. The two models were used to predict the brand's market shares in
the (remaining) 11 periods in the basis of aggregate level prices for each
segment.
The correlations of observed and predicted shares were 0.500 for the latent
class linear logit model, and 0.517 for the latent class spline model. The cor-
relation of market shares and prices calculated directly from the two-monthly
data was 0.479. The predictive validity of both latent class models thus
outperform the predictive t of a regression model tted on the market shares
themselves. The correlations conrm the somewhat better predictive validity
of the latent class spline model. The improvement of the spline model is of the
same order of magnitude as found above. The results support the external va-
lidity of the GaborGranger procedure in conjunction with the proposed
model as a procedure for assessing price sensitivity.
7. Discussion and conclusions
Below we discuss the substantive ndings derived from our model.
7.1. Priceperceived quality
Our study has yielded supportive evidence of a number of hypotheses and
previous empirical ndings. It has provided additional support for consum-
ers' use of price as an indicator of quality, in two out of four segments of
the market. One of these segments displayed a bell-shaped price response
function. Such a response curve was already observed by Gabor and Granger
(1966) in their original studies (see also Monroe, 1990, p. 114). The bell-
shaped curve can be explained as a situation where at lower price levels the
importance of perceived quality, as inferred from price, is higher than the im-
portance of perceived sacrice, whereas the reverse holds at higher price
levels.
In our application consumers appeared to be very heterogeneous in their
reaction to price. This is in accordance with the ndings of e.g. Zeithaml
(1988), and Dickson and Sawyer (1990). The allocative (price as perceived
monetary sacrice) and informative (price as an indicator of quality) aspects
of price were found to operate simultaneously in two consumer segments,
while the allocative aspects clearly dominated in two other segments. This
nding corresponds with the ndings of Lichtenstein and Burton (1989)
who reported both priceperceived-quality groups of consumers and no-
priceperceived-quality groups of consumers.
7.2. Loss aversion
The application of our model has provided additional support for the ex-
istence of loss aversion with respect to price (see Kahneman and Tversky,
1979). For all four segments the parameter estimates of PRLOSS
(
^
b
3s
; s = 1; . . . ; 4) are signicantly dierent from zero. We have provided
supportive evidence for the ndings of Hardie et al. (1993), that consumers
display loss aversion with respect to quality as well. In the segments with a
positive price response function, emanating from the use of price as an indi-
cator of quality, such loss aversion with respect to quality was inferred. Con-
sumers in these segments relied less on prices below the reference price
(indicating quality loss) as indicators of quality. Research is needed to further
substantiate these ndings (see Bell and Lattin, 1993). Segments of consum-
ers diered in the extent to which they displayed such loss aversion, both with
respect to price and with respect to quality.
7.3. Psychological price eects
Finally, and most importantly, the results have demonstrated that psycho-
logical price setting may cause discontinuities in demand (see Monroe, 1973).
Whereas Blattberg and Wisniewski (1987) already demonstrated such eects
on the aggregate level using scanner data, our study includes psychological
prices in a consumer choice model and demonstrates the eects at the disag-
gregate level. Although the existence of discontinuous eects on demand is
supported by our results, it appears from our study that they do not occur
at all psychological price levels and for all market segments. As has been es-
tablished in the literature on deal-proneness (cf. Blattberg and Neslin, 1990,
pp. 7781), consumers may vary in the extent to which they are sensitive to
price reductions. Segments exist in which the perceived price reduction at the
psychological price level does not lead to an increase in transaction utility.
Also, it appeared that consumers may perceive a price reduction at one
psychological price level, but not at another. From these ndings, it may be
concluded that the importance of psychological price setting may be overes-
timated in pricing decisions in the market place.
7.4. Limitations and future research
We conclude that the approach proposed here is a valuable tool in the inv-
estigation of consumers' price sensitivity and we argue that the benets of our
model accrue from its use in conjunction with the GaborGranger method
and related methods used in pricing research (see Monroe, 1990, pp. 106
137). A limitation of the GaborGranger procedure is that the eects of pric-
es of competitive brands are not considered explicitly. Our model can in fu-
ture research be extended to multibrand situations. The external validity of
the proposed procedure was supported by our validation study on store-level
market shares, although the gain in predictive validity over competing proce-
dures was modest. Future research should corroborate these ndings. It is
clear that the external validity of the proposed procedure can yet be further
enhanced by designing in-store experiments in which actual choices are ob-
served in response to price changes, e.g. through check-out scanning devices.
The analyses of such experimental scanner data may provide evidence of the
existence of bell-shaped price-response curves, loss aversion, and psycholog-
ical pricing eects in actual market situations. We leave this for future re-
search.
Acknowledgements
We wish to acknowledge A.C. Nielsen, Netherlands for providing
aggregate-level sales data. We also thank the reviewers and especially
Alan J. Mac Fadyen for helpful suggestions on an earlier version of this
paper.
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