The real-option value contained in consumers' initial purchase

Authors: Lieh-Ming Luo, Phil Yihsing Yang, Sandra H.T. Lee, Wei-Pen Tsai

Journal: Chiao Da Management Review. Dec. 2014, 34(2): 27-49.

Keywords: Initial purchase; Real options; Repeat purchase; Money-back guarantee; Product pricing

Abstract:
In this paper, we propose a model to evaluate the real options embedded in consumers’ initial purchase. Due to high uncertainty of perceived value for initially-purchased products, the real-option values contained in those products would be substantial, and thus should be considered. We fairly value the two real options about consumers’ initial purchase, i.e., the repeat-purchase call option and the Money-Back Guarantee put option. The mutually exclusive relationship between the two options leads to an interesting valuation issue. When applied to products involving two types of risks, i.e., valuation risk and breakage risk, mutual exclusion of the aforementioned two options makes model calibration rather challenging. The model expresses how these real options can create added-value for consumers and their interaction effects. In addition to model derivation, this study also conducts numerical analysis to illustrate effects of several factors on the options value. The research can broaden the understanding of consumers’ perceived value for initial purchases, and thereby can help management to improve product-pricing decision making, especially in the case of developing a new product or a new market.