Journal of Retailing 86 (1, 2010) 69–84 Price as an Indicator of Quality: Implications for Utility and Demand Functions Min Ding a,∗ , William T. Ross Jr. a,1 , Vithala R. Rao b,2 a Smeal College of Business, Pennsylvania State University, University Park, PA 16802, USA b Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853-6201, USA Received 5 December 2008; received in revised form 18 January 2010; accepted 18 January 2010 Abstract Consumers often infer quality information from prices and rely on their reference prices. This paper incorporates both behavioral regularities into the classic utility function. The analytical investigation reveals five qualitatively different types of consumers, three of which are relatively new to modeling literature. The authors test the model’s theoretical insights using a new experimental method, random allocation of scarce inventories (RASI), which is designed to align people’s incentives, such that they state their true rank order preferences. The results support the existence of five different types of consumers; the authors discuss the managerial implications for pricing strategies. © 2010 New York University. Published by Elsevier Inc. All rights reserved. Keywords: Price and quality; Utility functions; Incentive alignment; Analysis Introduction Contrary to classic economic theory, consumers do not always buy the lowest priced product in a category, even when the products are otherwise similar. 3 One behavioral explanation, supported by empirical evidence (Leavett 1954; Lichtenstein and Burton 1989; Monroe and Krishnan 1985; Rao 1984, 1993; Rao and Monroe 1988; Schindler 1991; Stiving 2000), suggests that consumers infer information (e.g., quality) from price. As ∗ Corresponding author at: Pennsylvania State University, 408 Business Build- ing, University Park, PA 16802, United States. Tel.: +1 814 865 0622; fax: +1 814 865 3015. E-mail addresses: minding@psu.edu (M. Ding), wtr2@psu.edu (W.T. Ross Jr.), vrr2@cornell.edu (V.R. Rao). 1 Tel.: +1 814 865 0623; fax: +1 814 865 3015. 2 Tel.: +1 607 255 3987; fax: +1 607 254 4590. 3 This complex relationship should be evident to anyone who has looked for a book from an online bookstore. Consider a recent search for Ender’s Game by Orson Scott Card as an example: Amazon.com carried the book new for $6.99 but also offered used copies from 47 affiliated sites, varying in price from $2.98 to $6.99; new copies from 19 affiliated sites, varying in price from $3.91 to $6.99; and collectible copies, including a first edition, from three sites, varying in price from $5.15 to $6.95. There seems to be little or no difference among the options except for price, and Amazon guarantees the reliability of all sites. The mere existence of such a variety of prices implies that at least some people have more complicated utility functions. a result, price appears to play two opposite roles—allocative and informational—in consumers’ purchasing decisions (Rao and Sattler 2000; also see Gabor and Granger 1966). On the one hand, higher price decreases consumer utility, because they must pay more for the product. On the other hand, higher price may induce higher quality perceptions, which increase utility (Monroe and Krishnan 1985). Intuitively, this complex relation- ship may lead to a nonmonotonous (individual) utility function over price, which then should create an (aggregate) demand function that is not necessarily downward sloped, as assumed ubiquitously in literature and practice. 4 Understanding the shape of the demand function is funda- mental to managerial decisions, because an incorrect assumption about its shape leads to suboptimal decisions. In addition, a firm may suffer if it assumes a single type of demand function when several types actually mark different consumers. Ignor- ing such consumer demand heterogeneity will deprive the firm of opportunities to optimize its marketing mix and compete effectively with other firms in the market. Despite anecdotal evidence of more complicated demand functions, the classic 4 Following convention, we define a utility function as one person’s prefer- ences for a given product according to some of its characteristics (e.g., price); the demand function is the number of units of a product that a market will demand (purchase) at a given price level. 0022-4359/$ – see front matter © 2010 New York University. Published by Elsevier Inc. All rights reserved. doi:10.1016/j.jretai.2010.01.002