A simple test for distinguishing between internal reference price theories

A large literature demonstrates the empirical importance of internal reference price effects. There are several theories regarding how and why these effects arise. We offer a simple test that distinguishes between the two leading theories based on economically rational behavior: price as a signal of quality and price as a predictor of future prices. Our test builds on differences in how past consumer purchases interact with internal reference prices. We first validate the reliability of our test by applying it to synthetic data. We then apply our test to purchases of ketchup and diapers and find: (1) quality signaling is the dominant mechanism behind reference price effects in both categories; (2) consistent with the quality-signaling theory, reference price effects diminish as various measures of consumer experience increase; but (3) in both categories there are many individuals for whom price-prediction effects dominate quality-signaling effects.