A theory of price adjustment under loss aversion

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.JEL classification: D03, D21, E31, E50.

Asymmetric Labor-Supply Responses to Wage-Rate Changes - Evidence from a Field Experiment

“…Our findings can be rationalized by the theoretical model put forward by Ahrens et al (2014). They incorporate loss aversion in a model of labor supply and show that the labor supply curve is kinked at a reference wage.…”

“…The experiment is designed to exogenously establish a clear and salient reference wage. The literature typically finds that reference points depend on rational, individual expectations, suggesting that expectations about the per-unit wage form the reference point in the context of labor supply decisions in our experiment (e.g., Koszegi and Rabin, 2006;Abeler et al, 2011;Ahrens et al, 2014). Therefore, potential workers are told that the wage per transcribed picture is $0.15 in the job announcement.…”

“…The framework is informed by Ahrens et al (2014) who incorporate loss aversion into a standard labor-supply model. …”

“…Section 2 describes the real labor task and its implementation in Amazon's Mechanical Turk. In Section 3 we lay out the theoretical approach following Ahrens et al (2014), which incorporates loss aversion. Section 4 describes the data and our empirical approach.…”

Experiments on Macroeconomics: Methods and Applications

“…Loss aversion may also be used to explain price and wage rigidity and, thereby, the trade-off between unemployment and inflation: Ahrens, Pirschel, and Snower (2015) argue that downward wage rigidity may be associated with the perceived losses by workers who use their past nominal wage as reference point. Ahrens, Pirschel, and Snower (2017) show that loss aversion leads to a kink in the consumers' demand function that can explain price rigidities and, in particular, why price reductions are less frequently observed than price increases in response to permanent demand shocks. In this model, rational firms consider reference dependent utility functions of consumers and account for the effects that their prices have on future reference points.…”