Mike, who has reference-dependent preferences over beer and money, goes to the local pub with a friend, but is not planning on drinking any beer or spending any of his $50 in cash. Let his end-of-evening outcomes in pints of beer consumed and cash be c1 and c2, respectively, and let his reference point in pints of beer and cash be r1 and r2, respectively. Then, Mike's utility is given by v(6c1 - 6r1) + v(c2 -r2); where v(x) = x for x >= 0, and v(x) = 1:5x for x < 0.
(a) Calculate Mike's buying price for a pint of beer by writing down his reference point and solving for the price pB such that he is indifferent between getting a pint for pB and not getting or paying anything.
(b) Suppose Mike unexpectedly gets a pint of beer as part of a promotion at the pub, and incorporates its consumption into his reference point in beer. Calculate his selling price by writing down his reference point and solving for the price pS that makes him indifferent between keeping his pint and receiving nothing and giving up his pint and getting pS.
(c) Now suppose that after Mike gets his promo pint but before he decides whether to sell it, he notices that he lost $10 on the way to the pub. He does not yet incorporate this $10 loss into his reference point for cash. Calculate his selling price for the pint of beer. Explain intuitively why your answer is di fferent from that in part (b).
(d) Finally, suppose that the pub advertises that it will have a $1/pint promotion. Thinking that this is worth it, Mike plans to buy a pint, and incorporates this plan into his reference point. Once he arrives at the pub, Mike is told that the pub has run out of the promotional beer. What is Mike's buying price for a beer now? [Note: for this question, assume that Mike has not lost $10 on the way to the pub.]
(e) The above strategy of promising an attractive offer but then making it unavailable is an example of the bait-and-switch" strategy in retail sales. Explain intuitively how the bait-and-switch strategy works.
(f) Give a real-life example of a bait-and-switch strategy that you think relies at least partly on reference-dependent preferences.