Analyzing the effects of past prices on reference price formation

We propose a new reference price framework for brand choice. In this framework, we employ a Markov-switching process with an absorbing state to model unobserved price recall of households. Reference prices result from the prices households are able to remember. Our model can be used to learn how many prices observed in the past are used for reference price formation. Furthermore, we learn to what extent households have sufficient price knowledge to form an internal reference price. For A.C. Nielsen scanner panel data on catsup purchases, we find that the prices observed at the previous purchase occasion have an average recall probability of about 20%. Furthermore, the average probability that a household has sufficient price knowledge to form a reference price is estimated at about 30%. Even though price recall is very limited the impact of reference price formation on brand choice is substantial, and it is stronger than two popular alternative models in the literature suggest. Moreover, contrary to the two alternative models, our model does not suggest asymmetry between price gains and losses.