A Theory of Price Adjustment Under Loss Aversion

32 Pages Posted: 3 May 2014

See all articles by Steffen Ahrens

Steffen Ahrens

Technische Universität Berlin (TU Berlin); Kiel Institute for the World Economy

Inske Pirschel

Kiel Institute for the World Economy

Dennis J. Snower

University of Kiel - Institute for World Economics (IfW); Institute for the Study of Labor (IZA); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)

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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: price sluggishness, loss aversion, state-dependent pricing

JEL Classification: D03, D21, E31, E50

Suggested Citation

Ahrens, Steffen and Pirschel, Inske and Snower, Dennis J., A Theory of Price Adjustment Under Loss Aversion. IZA Discussion Paper No. 8138, Available at SSRN: https://ssrn.com/abstract=2432422 or http://dx.doi.org/10.2139/ssrn.2432422

Steffen Ahrens (Contact Author)

Technische Universität Berlin (TU Berlin) ( email )

Straße des 17
Juni 135
Berlin, 10623
Germany

Kiel Institute for the World Economy ( email )

Institute for the World Economy
Kiel, Schleswig-Hosltein
Germany

Inske Pirschel

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, Schleswig-Hosltein D-24100
Germany

Dennis J. Snower

University of Kiel - Institute for World Economics (IfW) ( email )

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D-24118 Kiel
Germany
+49+431-8814-235 (Phone)

Institute for the Study of Labor (IZA)

P.O. Box 7240
Bonn, D-53072
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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