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Market forces meet behavioral biases: cost misallocation and irrational pricing

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  • Nabil Al-Najjar
  • Sandeep Baliga
  • David Besanko

Abstract

Psychological and experimental evidence, as well as a wealth of anecdotal examples, suggests that firms may confound fixed, sunk, and variable costs, leading to distorted pricing decisions. This article investigates the extent to which market forces and learning eventually eliminate these distortions. We envision firms that experiment with cost methodologies that are consistent with real-world accounting practices, including ones that confuse the relevance of variable, fixed, and sunk costs to pricing decisions. Firms follow naive adaptive learning to adjust prices and reinforcement learning to modify their costing methodologies. Costing and pricing practices that increase profits are reinforced. In some market structures, but not in others, this process of reinforcement causes pricing practices of all firms to systematically depart from standard equilibrium predictions. Copyright (c)2008, RAND.

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Bibliographic Info

Article provided by RAND Corporation in its journal The RAND Journal of Economics.

Volume (Year): 39 (2008)
Issue (Month): 1 ()
Pages: 214-237

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Handle: RePEc:bla:randje:v:39:y:2008:i:1:p:214-237

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Cited by:
  1. Doruk İriş & Luís Santos-Pinto, 2013. "Tacit Collusion under Fairness and Reciprocity," Games, MDPI, Open Access Journal, vol. 4(1), pages 50-65, February.
  2. Santos-Pinto, Luís, 2006. "Reciprocity, inequity-aversion, and oligopolistic competition," MPRA Paper 3143, University Library of Munich, Germany, revised 14 Apr 2007.
  3. Mark Armstrong & Steffen Huck, 2011. "Behavioral Economics as Applied to Firms: A Primer," Antitrust Chronicle, Competition Policy International, vol. 1.
  4. Skouras, Thanos & Kitromilides, Yiannis, 2013. "The irresistible charm of the Microfoundations, or the overwhelming force of the discipline's Hard Core?," MPRA Paper 48372, University Library of Munich, Germany.
  5. Buchheit, Steve & Feltovich, Nick, 2010. "Experimental evidence of a sunk–cost paradox: a study of pricing behavior in Bertrand–Edgeworth duopoly," SIRE Discussion Papers 2010-124, Scottish Institute for Research in Economics (SIRE).
  6. Stefan Reichelstein & Anna Rohlfing-Bastian, 2014. "Levelized Product Cost: Concept and Decision Relevance," CESifo Working Paper Series 4590, CESifo Group Munich.
  7. Juselius , Mikael & Kim, Moshe & Ringbom, Staffan, 2009. "Do markup dynamics reflect fundamentals or changes in conduct?," Research Discussion Papers 12/2009, Bank of Finland.
  8. Russell Pittman, 2009. "Who Are You Calling Irrational? Marginal Costs, Variable Costs, and the Pricing Practices of Firms," EAG Discussions Papers 200903, Department of Justice, Antitrust Division.

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