Does Loss Aversion Preclude Price Variation?

Abstract

Problem definition: In modern retailing, frequent discounts are seemingly at odds with the idea that price variation antagonizes loss-averse consumers and hence, diminishes their demand for products and services. Our research question then is whether (or not) loss aversion rules out price variation—and in particular, cyclic pricing. Academic/practical relevance: Pricing and revenue management subject to behavioral considerations are key research areas in operations management. Our approach contributes to this research by highlighting the importance of incorporating heterogeneity in consumers’ behavioral responses in pricing models. Methodology: We model a monopolist selling a product over time to loss-averse consumers who differ in their sensitivity to gains/losses. Although the market is thus segmented, the firm cannot price discriminate among consumers based on that sensitivity. We then characterize the structural properties of the firm’s optimal pricing policy. Results: We show that charging a long-run constant price may be suboptimal and then derive conditions under which the optimal policy is cyclic. These findings establish that loss aversion does not preclude price variation and thereby, underscore the importance of incorporating consumer heterogeneity into pricing policies. Managerial implications: For operations management scholars, our model highlights the importance of heterogeneity in consumers’ behavioral responses to firms’ policies and shows that structurally different insights are obtained from pricing models if this heterogeneity is appropriately accounted for. This approach offers new avenues in pricing and revenue management research. For managers, our model suggests that they could vary prices, under certain conditions, without worrying that price variation will antagonize consumers. Our model offers insights on what these conditions are, which managers may incorporate in devising the pricing policies.