Abstract
The price-quality relationship receives attention from both practitioners and scholars. Yet, the reference price effect, a central aspect in modeling consumer behavior, is absent from the debate. This article addresses the role of the reference price dynamics in understanding the price-quality relationship. We develop an optimal control model of the dynamic behavior of a firm setting price and quality investment over time, accounting for a reference price effect based on prior selling prices. We contribute to the literature on the price-quality relationship by highlighting the conditions under which better quality may drive a lower price when consumers are prone to a reference price. Analytical results show that a counterintuitive negative price-quality relationship may appear even with a linear demand function. Numerical results emphasize the importance of the initial market conditions in the negative price-quality relationship.
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