Research in marketing and psychology shows that customers exhibit reference-dependent preferences, which means the relative standing of a product in a choice set will affect its utility. Consequently, this reference dependency will affect the firms' decision on the price and quality. In particular, we study a model of two firms offering differentiated products in a covered duopoly market. They simultaneously choose the quality of the product and then compete in price. Customers decide which firm to purchase from based on a general utility function comprised of the standard consumption utility and the comparative utility which captures the reference-dependent value. We investigate the optimal pricing and quality decisions for each firm under the reference dependency effect. We also study the impact the reference dependency has on market share and profit of each firm. The goal of this paper attempts to fill the gap between our understanding of the reference-dependent behavior of customers and the firm's quality differentiation strategy.
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