A Theory of Price Adjustment under Loss Aversion

Steffen Ahrens, Inske Pirschel and Dennis J. Snower ()
Additional contact information
Dennis J. Snower: Hertie School of Governance

No 8138, IZA Discussion Papers from Institute of Labor Economics (IZA)

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: state-dependent pricing; loss aversion; price sluggishness (search for similar items in EconPapers)
JEL-codes: D03 D21 E31 E50 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2014-04
New Economics Papers: this item is included in nep-com, nep-mac and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Published - published in: Journal of Economic Behavior & Organization, 2017, 134, 78-95

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https://docs.iza.org/dp8138.pdf (application/pdf)

Related works:
Journal Article: A theory of price adjustment under loss aversion (2017)
Working Paper: 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)
Working Paper: A theory of price adjustment under loss aversion (2014)
Working Paper: A theory of price adjustment under loss aversion (2014)
Working Paper: A theory of price adjustment under loss aversion (2014)
Working Paper: A Theory of Price Adjustment under Loss Aversion (2013)
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