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The Sunk Cost Bias and Managerial Pricing Practices

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  • Nabil Al-Najjar
  • Sandeep Baliga

    ()
    (Northwestern University)

  • David Besanko

Abstract

This paper provides an explanation for why the sunk cost bias persists among firms in a competitive environment in which rich learning possibilities are allowed. 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 coststo 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. We show that all firms eventually display the sunk cost bias in their pricing behavior

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 851.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:851

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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Keywords: Sunk Cost Bias; Bertrand Oligopoly; Dynamic Learning;

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References

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  1. Milgrom, Paul & Roberts, John, 1990. "Rationalizability, Learning, and Equilibrium in Games with Strategic Complementarities," Econometrica, Econometric Society, vol. 58(6), pages 1255-77, November.
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  4. Federico Echenique, 1999. "Comparative Statics by Adaptative Dynamics and the Correspondence Principle," Documentos de Trabajo (working papers) 2099, Department of Economics - dECON.
  5. Parayre, Roch, 1995. "The strategic implications of sunk costs: A behavioral perspective," Journal of Economic Behavior & Organization, Elsevier, vol. 28(3), pages 417-442, December.
  6. Samuelson, Larry, 2001. "Introduction to the Evolution of Preferences," Journal of Economic Theory, Elsevier, vol. 97(2), pages 225-230, April.
  7. Friedman, James W. & Mezzetti, Claudio, 2001. "Learning in Games by Random Sampling," Journal of Economic Theory, Elsevier, vol. 98(1), pages 55-84, May.
  8. Aviad Heifetz & Chris Shannon & Yossi Spiegel, 2007. "The Dynamic Evolution of Preferences," Economic Theory, Springer, vol. 32(2), pages 251-286, August.
  9. Chaim Fershtman & Kenneth L Judd, 1984. "Equilibrium Incentives in Oligopoly," Discussion Papers 642, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  10. David A. Brown & Peter Booth & Francesco Giacobbe, 2004. "Technological and organizational influences on the adoption of activity-based costing in Australia," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 44(3), pages 329-356.
  11. Theo Offerman & Jan Potters, 2006. "Does Auctioning of Entry Licences Induce Collusion? An Experimental Study," Review of Economic Studies, Oxford University Press, vol. 73(3), pages 769-791.
  12. Smith, Vernon L, 1991. "Rational Choice: The Contrast between Economics and Psychology," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 877-97, August.
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Cited by:
  1. David Kelsey & Frank Milne, 2008. "Imperfect Competition and Corporate Governance," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 10(6), pages 1115-1141, December.
  2. Heifetz, Aviad & Segev, Ella & Talley, Eric, 2007. "Market design with endogenous preferences," Games and Economic Behavior, Elsevier, vol. 58(1), pages 121-153, January.
  3. Aviad Heifetz & Chris Shannon & Yossi Spiegel, 2007. "The Dynamic Evolution of Preferences," Economic Theory, Springer, vol. 32(2), pages 251-286, August.
  4. Lynette Molyneaux & John Foster & Liam Wagner, 2010. "Is there a more effective way to reduce carbon emissions?," Energy Economics and Management Group Working Papers 04, School of Economics, University of Queensland, Australia.
  5. Buccirossi, Paolo & Spagnolo, Giancarlo, 2006. "Optimal Fines in the Era of Whistleblowers," CEPR Discussion Papers 5465, C.E.P.R. Discussion Papers.

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