The Bright Side of Loss Aversion in Dynamic and Competitive Markets

Abstract

A well-established phenomenon of consumer buying behavior is that consumers evaluate prices relative to a reference point and exhibit loss aversion; i.e., their propensity to buy is more negatively affected by prices above the reference point than it is positively affected by prices below the reference point. The objective of this paper is to analytically examine how the competitive strategy and profitability of firms are affected by the presence of consumer loss aversion in the price dimension. Although we assume that consumer loss aversion increases consumer propensity to search for lower prices, we find that it does not necessarily lead to lower prices or profits when firms compete over multiple periods and when the consumer reference price in subsequent periods is affected by current prices. Specifically, consumer loss aversion could lead to higher prices and profits when consumer valuation is sufficiently high relative to search costs and the proportion of consumers with positive search costs is in an intermediate range. We also show that when forward-looking firms incorporate the negative effect of price promotions on future profits, the equilibrium range of price promotions may actually increase.