Omitted Budget Constraint Bias in Single-Unit Demand Models and Implications for Competitive Pricing and Targeting
37 Pages Posted: 30 Sep 2017 Last revised: 21 Apr 2020
Date Written: April 20, 2020
The problem of inferring unrealistically high prices from choice-based conjoint optimization exercises is widely known among market research practitioners and applied marketing researchers. The literature suggests two approaches to alleviate this problem. One focuses on making the hypothetical choice situation more realistic ('incentive-aligned conjoint analysis'). The other approach seeks to discard respondents from the sample that appear not to provide usable information, or simply answer randomly ('data cleaning'). This paper highlights a different reason for inferring abnormally high prices - the omission of budget constraints in the standard single-unit demand discrete-choice framework - and proposes a methodology to estimate heterogeneous budget constraints to correct for the bias. We review the theory of utility separation that motivates category specific budgets, discuss identification, and show how to derive equilibrium prices when category budgets matter. The proposed methodology substantially increases the face validity of implied competitive prices in an industry-grade discrete-choice experiment and improves targeting decisions by disentangling price-sensitivity within a budget from the budget constraint itself. Finally, we illustrate how inferred category budgets relate to a rich set of observed consumer characteristics and that ignoring budgets may obfuscate systematic relations between consumer characteristics and choice behavior.
Keywords: category budgets, demand estimation, competitive pricing, choice-based conjoint, Bayesian inference
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