Abstract
We consider the Salop (1979) model of product differentiation and assume that consumers are uncertain about the qualities and prices of firms’ products. They can inspect all products at zero cost. A share of consumers is expectation-based loss averse. For these consumers, a purchase plan, which involves buying products of varying quality and price with positive probability, creates disutility from gain-loss sensations. Even at modest degrees of loss aversion they may refrain from inspecting all products and choose an individual default that is strictly dominated in terms of surplus. Firms’ strategic behavior exacerbates the scope for this effect. The model generates “scale-dependent psychological switching costs” that increase in the value of the transaction. We find empirical evidence for the predicted association between switching behavior and loss aversion in new survey data.
Highlights
For many markets, there is mounting evidence that a large fraction of consumers chooses inferior products or does not switch to options that dominate the individual default
On the x-axis, we display the average price of the transaction; on the y-axis, we show the estimated search costs or switching costs
We examine to what extent our results hold if we consider heterogeneous firms, alternative search models, a combination of physical and psychological switching costs, pessimistic beliefs, and an alternative personal equilibrium definition for loss-averse consumers
Summary
There is mounting evidence that a large fraction of consumers chooses inferior products or does not switch to options that dominate the individual default. The consumer’s true switching costs are given by the negative gain-loss utility This term positively depends on the differences between product values and prices Γ the consumer encounters if she follows the original plan. We only need to assume that the degree of horizontal product differentiation is small relative to the size of potential gain-loss sensations In this case, consumers may exhibit inattentive behavior even if they have rational expectations, and there are no physical search and switching costs. Expectation-based loss-averse consumers are uncertain about the qualities and prices of firms’ products This generates consumer inattention to cross-sectional information (other products), rather than to dynamic information flows, and explains scale-dependent switching costs.
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