The Effects of Consumers’ Price Expectations on Sellers’ Dynamic Pricing Strategies

Abstract

The authors propose a dynamic market equilibrium model to investigate how consumers form price expectations and how these expectations influence their sequential search behavior and prices in the market. They derive a perfect Bayesian Nash equilibrium and show that whereas higher current period prices induce search, consumers who observe higher historical prices form higher price expectations, become more pessimistic, and search less. Furthermore, the authors show that when prices increase as a result of an increase in marginal costs, consumers respond by searching more, which then leads to higher prices and instant price adjustment. In contrast, because consumer search activities decline when prices fall, sellers may respond by lowering their prices just enough to dampen consumers’ search tendencies when costs decrease. The authors test their theoretical model and its implications and find support for it in a series of simulated market experiments.