Process improvement under the reference price effect

Abstract

Cost-reducing process improvement, leading to price reductions and consequently sales growth, is becoming increasingly relevant in today’s uncertain economic environment. However, existing process improvement studies involving sales growth typically assume that consumers only consider the current price of a product when making a purchase. In reality, sales growth also often stems from the reference price effect, where consumers factor in both the current and past prices. By incorporating the reference price effect, we examine the process improvement investment decisions and pricing strategies in a decentralized supply chain. We develop a two-period game-theoretic model, where the supplier invests in process improvement to reduce production costs, and the supplier and the retailer set their prices. This approach differs from existing reference price effect literature, where prices are predetermined exogenously in a decentralized supply chain. We find that the reference price effect stimulates process improvement investment, making both firms more profitable. However, a more prominent reference price effect may significantly decrease supply chain efficiency in the presence of process improvement, resulting in lower profits that move away from what an integrated firm would achieve. When firms set their own prices, the reference price effect intensifies competition for profits and worsens misalignment caused by process improvement. This outcome contrasts with existing studies, which usually argue that the reference price effect increases efficiency. Therefore, managers should consider consumer responses to price changes when making process improvement investment decisions and analyze their impacts on both supply chain profitability and efficiency.