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A Theory of Price Adjustment under Loss Aversion

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  • Steffen Ahrens
  • Inske Pirschel
  • Dennis Snower
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.

Suggested Citation

  • Steffen Ahrens & Inske Pirschel & Dennis Snower, 2014. "A Theory of Price Adjustment under Loss Aversion," CESifo Working Paper Series 4789, CESifo.
    • Handle: RePEc:ces:ceswps:_4789
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    1. David P. Myatt, 2019. "A Theory of Stable Price Dispersion," Economics Series Working Papers 873, University of Oxford, Department of Economics.
    2. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers 1810, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
    3. Tramontana, Fabio, 2021. "When a boundedly rational monopolist meets consumers with reference dependent preferences," Journal of Economic Behavior & Organization, Elsevier, vol. 184(C), pages 30-45.
    4. Willem H. Boshoff & Johannes Paha, 2021. "List Price Collusion," Journal of Industry, Competition and Trade, Springer, vol. 21(3), pages 393-409, September.
    5. Yaman, Firat & Offiaeli, Kingsley, 2022. "Is the price elasticity of demand asymmetric? Evidence from public transport demand," Journal of Economic Behavior & Organization, Elsevier, vol. 203(C), pages 318-335.
    6. Ahrens, Steffen & Pirschel, Inske & Snower, Dennis J., 2014. "A theory of wage adjustment under loss aversion," Kiel Working Papers 1977, Kiel Institute for the World Economy (IfW Kiel).
    7. Seiler, Volker, 2021. "China-to-FOB price transmission in the rare earth elements market and the end of Chinese export restrictions," Energy Economics, Elsevier, vol. 102(C).
    8. Jorge Vasquez & Marek Weretka, 2020. "Co-worker altruism and unemployment," GRAPE Working Papers 55, GRAPE Group for Research in Applied Economics.
    9. Prasanna, Ashreeta & Mahmoodi, Jasmin & Brosch, Tobias & Patel, Martin K., 2018. "Recent experiences with tariffs for saving electricity in households," Energy Policy, Elsevier, vol. 115(C), pages 514-522.
    10. Ahmad Naimzada & Nicolò Pecora & Fabio Tramontana, 2019. "A cobweb model with elements from prospect theory," Journal of Evolutionary Economics, Springer, vol. 29(2), pages 763-778, April.
    11. Zhaoyu Cao & Xu Zhao & Yucheng Zou & Kairong Hong & Yanwei Zhang, 2021. "Multidimensional Fair Fuzzy Equilibrium Evaluation of Housing Expropriation Compensation from the Perspective of Behavioral Preference: A Case Study from China," Mathematics, MDPI, vol. 9(6), pages 1-22, March.
    12. Paha, Johannes, 2019. "Anchoring, Reference Prices, and List Price Collusion," VfS Annual Conference 2019 (Leipzig): 30 Years after the Fall of the Berlin Wall - Democracy and Market Economy 203625, Verein für Socialpolitik / German Economic Association.
    13. Fan, Ying, 2022. "Demand shocks and price stickiness in housing market dynamics," Economic Modelling, Elsevier, vol. 110(C).
    14. Bulutay, Muhammed & Hales, David & Julius, Patrick & Tasch, Weiwei, 2021. "Imperfect tacit collusion and asymmetric price transmission," Journal of Economic Behavior & Organization, Elsevier, vol. 192(C), pages 584-599.
    15. Camille Cornand & Frank Heinemann, 2018. "Experiments on macroeconomics: methods and applications," Working Papers halshs-01809937, HAL.
    16. Wang, Zhihong & Li, Yangyang & Gu, Fu & Guo, Jianfeng & Wu, Xiaojun, 2020. "Two-sided matching and strategic selection on freight resource sharing platforms," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 559(C).
    17. Mukhlis MUKHLIS & Raja MASBAR & Sofyan SYAHNUR & M. Shabri Abd. MAJID, 2020. "Dynamic Causalities Between World Oil Price And Indonesia’S Cocoa Market: Evidence From The 2008 Global Financial Crisis And The 2011 European Debt Crisis," Regional Science Inquiry, Hellenic Association of Regional Scientists, vol. 0(2), pages 217-233, June.
    18. Vásquez, Jorge & Weretka, Marek, 2021. "Co-worker altruism and unemployment," Games and Economic Behavior, Elsevier, vol. 130(C), pages 224-239.

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    More about this item

    Keywords

    price sluggishness; loss aversion; state-dependent pricing;
    All these keywords.

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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