The effect of relative thinking on firm strategy and market outcomes: A location differentiation model with endogenous transportation costs

Ofer Azar

MPRA Paper from University Library of Munich, Germany

Abstract: Consumers often have to decide whether to go to a remote store for a lower price. Only the absolute price difference between the stores should be relevant in this case, but several experiments showed that people exhibit "relative thinking": they are affected also by the relative savings (relative to the good's price). This article analyzes the effects of this bias on firm strategy and market outcomes using a two-period game-theoretic model of location differentiation. Relative thinking causes consumers to make less effort to save a constant amount when they buy more expensive goods. In the location differentiation context this behavior can be modeled by consumers who behave as if their transportation costs are an increasing function of the good's price. This gives firms an additional incentive to raise prices, in order to increase the perceived transportation costs of consumers, which consequently softens competition and allows higher profits. Therefore, the response of firms to relative thinking raises prices and profits and reduces consumer surplus, in both periods. Total welfare is unchanged in the first period, and in the second period it is either unchanged or reduced, depending on whether the objective or subjective transportation costs are used to compute welfare. The main results of the model (firms' response to relative thinking increases prices and reduces consumer surplus) are likely to hold also in the context of search. The article also explains why "relative thinking" is a more appropriate term than "mental accounting" (which was often used before) to describe this behavior, and discusses why people might exhibit relative thinking.

Keywords: Competitive Strategy; Relative Thinking; Pricing; Mental Accounting; Consumer Psychology; Consumer Attitudes & Behavior; Cognitive Processes; Behavioral Decision Making; Industrial Organization; Product Differentiation (search for similar items in EconPapers)
JEL-codes: D10 D43 L10 L13 M31 (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cbe, nep-com, nep-exp, nep-mic, nep-mkt and nep-ure
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://mpra.ub.uni-muenchen.de/4455/1/MPRA_paper_4455.pdf original version (application/pdf)

Related works:
Journal Article: The effect of relative thinking on firm strategy and market outcomes: A location differentiation model with endogenous transportation costs (2008)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:4455

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Joachim Winter ().