ISE Magazine, vol.46, no.1, pp.1-3, 2014 (Non-Refreed Journal)
There is now substantial evidence that pricing and inventory management are intimately tied. A further inquiry would be ‘What role does the consumer behavior have on pricing and inventory decisions?’
As consumers buy a particular product frequently, they develop their own price expectations. This expectation acts as a benchmark price. Consider a 40 Oz jar of peanut butter. If you see that it is priced at $10 you immediately have a perception of it as ‘underpriced’ or ‘overpriced’. If you think that it is expensive, what would be your ‘loss’ if you were to buy it? Marketing literature provides us with a concept to model this behavior. Consumers develop a reference price against which an announced price is compared. The reference price and the announced price jointly affect the demand. Moreover, the reference price dynamically evolves through time. A firm that announces a discounted price may increase its revenue in the short term, but this discount affects its future benefits through the reference price. Therefore the firms face a trade-off between immediate gains and future benefits. Is this another conundrum for the inventory manager?
Dr. M. Güray Güler, now at Karadeniz Technical University, and professors Taner Bilgiç and Refik Güllü of Boğaziçi University in Istanbul, Turkey address this problem in their paper: “Joint Inventory and Pricing Decisions with Reference Effects”. The authors assume that the demand in each period is random and contingent on the price and the price history, as captured by the reference price. The firm has to give a pricing decision and determine the inventory level at each period to maximize its discounted expected profit. The good news is: the replenishment policy is still an order-up-to policy which is widely used in the practice of inventory management. However, the optimal order-up-to level now depends on the reference price as well. For example, if a firm has excessive inventory at the beginning of the period, it is not at liberty to decrease the price too much because doing so will decrease the reference price in the future. Based on a computational study, they show that the firm stocks and charges more as long as the consumers believe that the product is a good bargain.