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The effect of relative thinking on firm strategy and market outcomes: A location differentiation model with endogenous transportation costs

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  • Azar, Ofer H.

Abstract

Consumers often have to decide whether to go to a remote store for a lower price. Only the absolute price difference between the stores should be relevant in this case, but several experiments showed that people exhibit "relative thinking": they are affected also by the relative savings (relative to the good's price). This article analyzes the effects of this bias on firm strategy and market outcomes using a two-period game-theoretic model of location differentiation. Relative thinking causes consumers to make less effort to save a constant amount when they buy more expensive goods. In the location differentiation context this behavior can be modeled by consumers who behave as if their transportation costs are an increasing function of the good's price. This gives firms an additional incentive to raise prices, in order to increase the perceived transportation costs of consumers, which consequently softens competition and allows higher profits. Therefore, the response of firms to relative thinking raises prices and profits and reduces consumer surplus, in both periods. Total welfare is unchanged in the first period, and in the second period it is either unchanged or reduced, depending on whether the objective or subjective transportation costs are used to compute welfare. The main results of the model (firms' response to relative thinking increases prices and reduces consumer surplus) are likely to hold also in the context of search. The article also explains why "relative thinking" is a more appropriate term than "mental accounting" (which was often used before) to describe this behavior, and discusses why people might exhibit relative thinking.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4455.

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Date of creation: 2007
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Handle: RePEc:pra:mprapa:4455

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Keywords: Competitive Strategy; Relative Thinking; Pricing; Mental Accounting; Consumer Psychology; Consumer Attitudes & Behavior; Cognitive Processes; Behavioral Decision Making; Industrial Organization; Product Differentiation;

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References

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  1. Daniel Kahneman, 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics," American Economic Review, American Economic Association, American Economic Association, vol. 93(5), pages 1449-1475, December.
  2. Dana, James D, Jr, 1994. "Learning in an Equilibrium Search Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 35(3), pages 745-71, August.
  3. Ofer H. Azar, 2013. "Firm strategy and biased decision making: the price dispersion puzzle," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 45(7), pages 901-910, March.
  4. Duxbury, Darren & Keasey, Kevin & Zhang, Hao & Chow, Shue Loong, 2005. "Mental accounting and decision making: Evidence under reverse conditions where money is spent for time saved," Journal of Economic Psychology, Elsevier, Elsevier, vol. 26(4), pages 567-580, August.
  5. Richard H. Thaler, 2008. "Mental Accounting and Consumer Choice," Marketing Science, INFORMS, INFORMS, vol. 27(1), pages 15-25, 01-02.
  6. Ofer H. Azar, 2005. "Relative Thinking Theory," Microeconomics, EconWPA 0504002, EconWPA.
  7. Ofer H. Azar, 2011. "Does Relative Thinking Exist In Real‐World Situations? A Field Experiment With Bagels And Cream Cheese," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 49(2), pages 564-572, 04.
  8. Thaler, Richard, 1980. "Toward a positive theory of consumer choice," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 1(1), pages 39-60, March.
  9. Ofer H. Azar, 2011. "Relative thinking in consumer choice between differentiated goods and services and its implications for business strategy," Judgment and Decision Making, Society for Judgment and Decision Making, Society for Judgment and Decision Making, vol. 6(2), pages 176-185, February.
  10. Moon, Philip & Keasey, Kevin & Duxbury, Darren, 1999. "Mental accounting and decision making:: The relationship between relative and absolute savings," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 38(2), pages 145-153, February.
  11. Frisch, Deborah, 1993. "Reasons for Framing Effects," Organizational Behavior and Human Decision Processes, Elsevier, Elsevier, vol. 54(3), pages 399-429, April.
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Cited by:
  1. Azar, Ofer H., 2009. "Do consumers make too much effort to save on cheap items and too little to save on expensive items? experimental results and implications for business strategy," MPRA Paper, University Library of Munich, Germany 20962, University Library of Munich, Germany.
  2. Don J. Webber & Michael Horswell, 2009. "Microeconomic foundations of geographical variations in labour productivity," Working Papers, Department of Accounting, Economics and Finance, Bristol Business School, University of the West of England, Bristol 0913, Department of Accounting, Economics and Finance, Bristol Business School, University of the West of England, Bristol.
  3. Pedro Bordalo & Nicola Gennaioli & Andrei Shleifer, 1969. "Competition for Attention," Working Paper, Harvard University OpenScholar 76811, Harvard University OpenScholar.
  4. Azar, Ofer H., 2011. "Do people think about absolute or relative price differences when choosing between substitute goods?," Journal of Economic Psychology, Elsevier, Elsevier, vol. 32(3), pages 450-457, June.

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