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Regular prices and sales

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Author Info

  • Heidhues, Paul

    ()
    (European School of Management and Technology)

  • Koszegi, Botond

    ()
    (Department of Economics, Central European University and Department of Economics, University of California at Berkeley)

Abstract

It is widely known that loss aversion leads individuals to dislike risk, and as has been argued by many researchers, in many instances this creates an incentive for firms to shield consumers and employees against economic risks. Complementing previous research, we show that consumer loss aversion can also have the opposite effect: it can lead a firm to optimally introduce risk into an otherwise deterministic environment. We consider a profit-maximizing monopolist selling to a loss-averse consumer, where (following \citeasnoun{koszegirabin}) we assume that the consumer's reference point is her recent rational expectations about the purchase. We establish that for any degree of consumer loss aversion, the monopolist's optimal price distribution consists of low and variable ``sale'' prices and a high and atomic ``regular'' price. Realizing that she will buy at the sale prices and hence that she will purchase with positive probability, the consumer chooses to avoid the painful uncertainty in whether she will get the product by buying also at the regular price. This pricing pattern is consistent with several recently documented facts regarding retailer pricing. We show that market power is crucial for this result: when firms compete ex ante for consumers, they choose deterministic prices.

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Bibliographic Info

Article provided by Econometric Society in its journal Theoretical Economics.

Volume (Year): 9 (2014)
Issue (Month): 1 (January)
Pages:

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Handle: RePEc:the:publsh:1274

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Web page: http://econtheory.org

Related research

Keywords: Reference-dependent utility; gain-loss utility; loss aversion; sales; supermarket pricing; sticky prices;

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References

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  1. James M. MacDonald & Daniel Aaronson, 2006. "How Firms Construct Price Changes: Evidence from Restaurant Responses to Increased Minimum Wages," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 88(2), pages 292-307.
  2. Shilony, Yuval, 1977. "Mixed pricing in oligopoly," Journal of Economic Theory, Elsevier, vol. 14(2), pages 373-388, April.
  3. Oleksiy Kryvtsov & Peter J. Klenow, 2004. "State-Dependent or Time-Dependent Pricing: Does It Matter For Recent U.S. Inflation?," Computing in Economics and Finance 2004 277, Society for Computational Economics.
  4. Patrick J. Kehoe & Virgiliu Midrigan, 2008. "Temporary price changes and the real effects of monetary policy," Working Papers 413, Federal Reserve Bank of Minneapolis.
  5. Rabin, Matthew, 2000. "Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion," Department of Economics, Working Paper Series qt61d7b4pg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  6. Anil K Kashyap, 1994. "Sticky Prices: New Evidence from Retail Catalogs," NBER Working Papers 4855, National Bureau of Economic Research, Inc.
  7. Winer, Russell S, 1986. " A Reference Price Model of Brand Choice for Frequently Purchased Products," Journal of Consumer Research, University of Chicago Press, vol. 13(2), pages 250-56, September.
  8. Karle, Heiko & Peitz, Martin, 2010. "Pricing and Information Disclosure in Markets with Loss-Averse Consumers," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 312, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
  9. Rotemberg, Julio J., 2005. "Customer anger at price increases, changes in the frequency of price adjustment and monetary policy," Journal of Monetary Economics, Elsevier, vol. 52(4), pages 829-852, May.
  10. Zhou, Jidong, 2008. "Reference Dependence and Market Competition," MPRA Paper 9370, University Library of Munich, Germany.
  11. Martin Pesendorfer, 2002. "Retail Sales: A Study of Pricing Behavior in Supermarkets," The Journal of Business, University of Chicago Press, vol. 75(1), pages 33-66, January.
  12. Emi Nakamura & Jon Steinsson, 2005. "Price Setting in a Forward-Looking Customer Market," Macroeconomics 0509010, EconWPA.
  13. Slade, Margaret E., 1999. "Sticky prices in a dynamic oligopoly: An investigation of (s,S) thresholds," International Journal of Industrial Organization, Elsevier, vol. 17(4), pages 477-511, May.
  14. Sibly, Hugh, 2002. "Loss averse customers and price inflexibility," Journal of Economic Psychology, Elsevier, vol. 23(4), pages 521-538, August.
  15. Nakamura, Emi & Steinsson, Jón, 2011. "Price setting in forward-looking customer markets," Journal of Monetary Economics, Elsevier, vol. 58(3), pages 220-233.
  16. Tversky, Amos & Kahneman, Daniel, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1039-61, November.
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Citations

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Cited by:
  1. Alexander K. Koch, & Julia Nafziger & Anton Suvorov & Jeroen van de Ven, 2012. "Self-Rewards and Personal Motivation," Economics Working Papers 2012-14, School of Economics and Management, University of Aarhus.
  2. Nakamura, Emi & Steinsson, Jón, 2011. "Price setting in forward-looking customer markets," Journal of Monetary Economics, Elsevier, vol. 58(3), pages 220-233.
  3. Pagel, Michaela, 2013. "Expectations-Based Reference-Dependent Life-Cycle Consumption," MPRA Paper 47138, University Library of Munich, Germany.
  4. Xavier Gabaix, 2011. "A Sparsity-Based Model of Bounded Rationality," NBER Working Papers 16911, National Bureau of Economic Research, Inc.

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