Pricing when Customers Care about Fairness but Misinfer Markups

Abstract

This paper proposes a theory of price rigidity consistent with survey evidence that firms stabilize prices out of fairness to their consumers. The theory relies on two psychological assumptions. First, customers care about the fairness of prices: fixing the price of a good, consumers enjoy it more at a low markup than at a high markup. Second, customers underinfer marginal costs from prices: when prices rise due to an increase in marginal costs, customers underappreciate the increase in marginal costs and partially misattribute higher prices to higher markups. Firms anticipate customers' reaction and trim their price increases. Hence, the passthrough of marginal costs into prices falls short of one-prices are somewhat rigid. Embedded in a simple macroeconomic model, our pricing theory produces nonneutral monetary policy, a short-run Phillips curve that involves both past and future inflation rates, a hump-shaped impulse response of output to monetary policy, and a nonvertical long-run Phillips curve.

What Goes Up May Not Come Down: Asymmetric Incidence of Value-Added Taxes

“…Okun (1981) reports some evidence that firms might respond to fairness considerations when setting prices because of the risk of losing some of their loyal customers which threatens future profits. Eyster et al (2017), in an effort to rationalize our finding, show that introducing the insights from Kahneman et al (1986a) in a simple monopolistic pricing model yields asymmetric pass-through of taxes. Eyster et al (2017) make two main assumptions.…”

“…See Appendix D.3 for a more detailed discussion ofEyster et al (2017) andKahneman et al (1986a).40 We find no evidence of mean reversion in VAT rates in our data, but because VAT changes are a relatively rare event, it is possible that firms may have biased expectations.…”

“…When taxes decrease, the opposite holds true: perceived markups are likely to be lower than true markups and firms have no incentive to educate consumers. Eyster et al (2017) show that this asymmetric behavior leads to asymmetric pass-through of taxes. Further, their model is consistent with Figure 6a, which shows that firms with low markups are more likely to pass through tax increases than firms with high markups, while pass-through in the case of tax decreases is homogeneous across firms.…”

“…when markups are perceived to be high when in reality they are low. Eyster et al (2017) show that when costs (or taxes) increase it is more profitable for firms to reveal markups rather than conceal them because perceived markups are likely to increase relative to true markups. When taxes decrease, the opposite holds true: perceived markups are likely to be lower than true markups and firms have no incentive to educate consumers.…”

What Goes Up May Not Come Down: Asymmetric Incidence of Value-Added Taxes

“…Eyster et al (2017) discuss recent empirical evidence on customers' concerns about the fairness of prices.…”