A Theory of Price Adjustment under Loss Aversion

Dennis Snower, Steffen Ahrens and Inske Pirschel

No 9964, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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: Loss aversion; Price sluggishness; State-dependent pricing (search for similar items in EconPapers)
JEL-codes: D03 D21 E31 E50 (search for similar items in EconPapers)
Date: 2014-05
New Economics Papers: this item is included in nep-com, nep-mac and nep-mic
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Citations: View citations in EconPapers (4)

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Related works:
Journal Article: A theory of price adjustment under loss aversion (2017)
Working Paper: A Theory of Price Adjustment under Loss Aversion (2014)
Working Paper: A Theory of Price Adjustment under Loss Aversion (2014)
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