DP4849 The Impact of Consumer Loss Aversion on Pricing

Author(s): Paul Heidhues, Botond Köszegi
Publication Date: January 2005
Keyword(s): (seemingly) Predatory pricing, countercyclical markups, kinked demand curve, monopoly pricing, price stickiness, promotions, reference-dependent utility, sales
JEL(s):
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4849

We develop a model in which a profit-maximizing monopolist with uncertain cost of production sells to loss-averse, yet rational, consumers. We first introduce (portable) techniques for analysing the demand of such consumers, and then investigate the monopolist?s pricing strategy. Compared to lower possible purchase prices, paying a higher price in the firm?s pricing distribution is assessed by consumers as a loss, decreasing demand for the firm?s product. We provide conditions under which a firm with continuously distributed marginal cost responds by (locally) eliminating this ?comparison effect? and choosing a discrete price distribution; that is, prices are ?sticky?. Price stickiness is more likely to obtain when the cost distribution has high density, the price responsiveness of demand is low, or consumers are likely to purchase. Whether or not prices are sticky, the monopolist wants to at least mitigate the comparison effect, leading to countercyclical mark-ups. On the other hand, if consumers expect to buy the product, they experience a loss if they end up not consuming it, increasing their willingness to pay for it. Thus, despite the tendency toward price stability, there are also circumstances in which a firm with unchanging cost offers random ?sales? to increase customers? expectation to consume, attracting more demand at high prices.