Market forces meet behavioral biases: cost misallocation and irrational pricing

Nabil Al-Najjar, Sandeep Baliga () and David Besanko

RAND Journal of Economics, 2008, vol. 39, issue 1, pages 214-237

Abstract: Psychological and experimental evidence, as well as a wealth of anecdotal examples, suggests that firms may confound fixed, sunk, and variable costs, leading to distorted pricing decisions. This article investigates the extent to which market forces and learning eventually eliminate these distortions. We envision firms that experiment with cost methodologies that are consistent with real-world accounting practices, including ones that confuse the relevance of variable, fixed, and sunk costs to pricing decisions. Firms follow naive adaptive learning to adjust prices and reinforcement learning to modify their costing methodologies. Costing and pricing practices that increase profits are reinforced. In some market structures, but not in others, this process of reinforcement causes pricing practices of all firms to systematically depart from standard equilibrium predictions. Copyright (c)2008, RAND.

Date: 2008
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