The Impact of Consumer Loss Aversion on Pricing

Abstract:     
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 analyzing 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 markups. 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 higher prices.

Keywords: Reference-dependent utility, price stickiness, monopoly pricing, kinked demand curve, countercyclical markups, sales, promotions, (seemingly) predatory pricing

JEL Classifications: D11, D42, L12, L16, L66, L67

Working Paper Series