Praveen K. Kopalle and Joan Lindsey-Mullikin

External reference price (ERP) is a well-established concept in marketing and has been found to have a significant impact on consumer purchase decisions. While internal reference prices may be stored in memory, external reference prices are clearly visible in stores, posted on signs that read e.g., “Compare at $X”. This paper improves the understanding of how consumers update their price expectations upon exposure to external reference prices. Based on prior research in marketing and social psychology, we hypothesize that external reference prices have an inverted U-shaped (quadratic) effect on consumer price expectations. The hypothesized effect is tested supported via an interactive computer-controlled shopping experiment where external reference price is varied at multiple levels, i.e., above, below, and equal to subjects’ prior expectations.

We find that when the difference between the external reference price and customers’ initial price expectations equaled zero, it produced a small but significant downward shift in price expectations. This may indicate that consumers are skeptical, though very slightly of price advertisements that confirm their expectations. When the external reference price, higher than initial expectations, was positive and increasing, the change in the consumers’ price expectations increased, but at a decreasing rate. This suggests that consumers believed the ERPs up to a point and then began to discount ERPs that were much higher than expected. On the other hand, when the ERP was less than their initial price expectations, the change in expectations was also negative. This implies that “positive news” appears to be discounted whereas “negative news” is more readily accepted.

By using the external reference price format, managers enhance consumers’ perceptions of savings and value by presenting a higher price for comparison. This research implies that an “optimal level” (i.e., neither too low nor too high) of external reference price can be determined. Of courseAlthough, the “optimal” external reference price could vary by product category since price expectations differ by product category. Nevertheless, our study provides the basis for retail managers to determine optimalan appropriate level of external reference price. Through the use of the proposed model, managers can avoid unrealistic ERP ranges that buyers won’t believe. Managers risk their credibility with consumers when they provide extreme ERPs, . Even in situations where considerable or extreme discounts are real, say, due to a special purchase, managers are risking their reputation as a credible retailer. With the model proposed in this study, managers can provide appropriate external reference prices for their products so that the ERPs are within a range that maintains their status as a credible retailer, i.e., by having ERPs that are neither too “low” nor too “high.” Operating Maintaining ERPs within a credible this range represents a value-based strategy – a strategy whereby buyers may experience incremental value from the transaction itself (Grewal, Monroe, and Krishnan 1998).

This research has demonstrated the strength of the external reference price format in changing customer price expectations. For example, we show that consumers do believe pricing claims that exceed their initial price expectation by over 200%. These tactics enable firms to artificially inflate customers’ perceptions of savings via unusually high external reference prices. Given the considerable scope for potential deception by firms via manipulating the external reference price, this research would be of interest to public policy makers who seek fair pricing practices for consumers. Public policy makers could (1) educate various consumer groups, particularly those who are uninformed about market prices, so consumers can maintain appropriate price expectations and (2) reprimand those firms using ERPs that stray too far away from established standards. The regulatory mechanism can also determine the market conditions such as source credibility or how fast consumers update their respective price expectationsthat may aid firms to exaggerate the ERPs.