Loss Aversion and the Uniform Pricing Puzzle for Vertically Differentiated Products

Abstract

The uniform pricing puzzle for vertically differentiated products states that a monopolist sells high and low quality products at the same price despite the fact that quality is perfectly observable and that there are no significant costs of adjusting prices. The puzzle is relevant for movies, books, music, and mobile apps, among others. We show that the puzzle can be resolved by accounting for consumer loss aversion in monetary and consumption utilities and by assuming that consumers face a random utility shock. The novelty of our approach is that the reference transaction is endogenously set as part of a 'personal equilibrium' and includes only past purchases of products of the same quality.

Keywords: expectations-based loss aversion, personal equilibrium, uniform pricing puzzle, vertically differentiated products

JEL Classification: D03, D21, L1, L2