A theory of price adjustment under loss aversionSteffen Ahrens, Inske Pirschel and Dennis J. Snower No 2014-065, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk Abstract: We present a new partial equilibrium theory of price adjustment, based on consumer loss aversion. In line with prospect theory, the consumers' perceived utility losses from price increases are weighted more heavily than the perceived utility gains from price decreases of equal magnitude. Price changes are evaluated relative to an endogenous reference price, which depends on the consumers' rational price expectations from the recent past. By implication, demand responses are more elastic for price increases than for price decreases and thus firms face a downward-sloping demand curve that is kinked at the consumers' reference price. Firms adjust their prices flexibly in response to variations in this demand curve, in the context of an otherwise standard dynamic neoclassical model of monopolistic competition. The resulting theory of price adjustment is starkly at variance with past theories. We find that - in line with the empirical evidence - prices are more sluggish upwards than downwards in response to temporary demand shocks, while they are more sluggish downwards than upwards in response to permanent demand shocks. Keywords: price sluggishness; loss aversion; state-dependent pricing (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:zbw:sfb649:sfb649dp2014-065 Access Statistics for this paper More papers in SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk Contact information at EDIRC. |
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