Pricing strategies with reference effects in competitive industries

This paper examines the effect of reference prices on companies operating within competitive industries. We confirm that even with competition, firms optimally price high in the short term to generate a high reference price and then decrease this price over time. Competitors' prices converge toward each other over time, emphasizing the short‐term nature of reference prices. We then show that pricing optimally to take advantage of reference prices generates a positive externality for other firms in an industry, such that competitors may generate higher profit. The longer the focus of a given firm, the more profit the firm generates, but less relative to its competitors. This arises because the externalities created through pricing high to increase reference prices outweigh the benefits of the higher reference prices themselves. If pricing managers are compensated relative to their competition, this suggests that short‐termism may be implicitly encouraged to the detriment of profit.