Do Consumers Correctly Expect Price Reductions? Testing Dynamic Behavior

The literature on both theoretical and empirical dynamics requires agents to solve complex dynamic programs, which assumes implicitly that agents are fully rational and have the most accurate expectations given their information set. We claim that this assumption is easily testable provided that market-level data on prices and purchases are available. Using data on albums exhibiting frequent episodes of promotions, we perform a test derived from the predictions of a simple demand model and find that consumers hold simple expectations on the timing of promotions: everything happens as if consumers were expecting a Markov price process. Our results are consistent with the idea that the rationality of consumers is bounded because of limited memory or limited capacity. These results have important implications in terms of demand estimation, firms' optimal pricing strategy and computation of the welfare.