The effect of relative thinking on firm strategy and market outcomes: A location differentiation model with endogenous transportation costs
AbstractConsumers 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 InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 4455.
Date of creation: 2007
Date of revision:
Competitive Strategy; Relative Thinking; Pricing; Mental Accounting; Consumer Psychology; Consumer Attitudes & Behavior; Cognitive Processes; Behavioral Decision Making; Industrial Organization; Product Differentiation;
Other versions of this item:
- Azar, Ofer H., 2008. "The effect of relative thinking on firm strategy and market outcomes: A location differentiation model with endogenous transportation costs," Journal of Economic Psychology, Elsevier, vol. 29(5), pages 684-697, November.
- D10 - Microeconomics - - Household Behavior - - - General
- M31 - Business Administration and Business Economics; Marketing; Accounting - - Marketing and Advertising - - - Marketing
- L10 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - General
- L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
- D43 - Microeconomics - - Market Structure and Pricing - - - Oligopoly and Other Forms of Market Imperfection
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-08-18 (All new papers)
- NEP-CBE-2007-08-18 (Cognitive & Behavioural Economics)
- NEP-COM-2007-08-18 (Industrial Competition)
- NEP-EXP-2007-08-18 (Experimental Economics)
- NEP-MIC-2007-08-18 (Microeconomics)
- NEP-MKT-2007-08-18 (Marketing)
- NEP-URE-2007-08-18 (Urban & Real Estate Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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