Reference-Dependent Consumer Preferences and Price Setting

Diploma Thesis by Holger Gerhardt
December 23, 2004

Abstract:

In this thesis, a model is presented which assumes reference-dependent preferences in the style of Tversky and Kahneman (1991). It attempts to answer the question whether consumers’ loss aversion leads to price stickiness, assuming that firms maximize profits. This is done by analyzing a monopolistic firm with constant marginal cost which faces a loss-averse representative customer.

It is shown that the demand functions of loss-averse consumers are kinked; thus, so is the firm’s profit function. Moreover, the kink is shown to be so pronounced that the maximum profit is attained at the associated price, as long as the producer’s unit cost lies inside a certain interval. This is interpreted as “price stickiness”, since the profit-maximizing price does not respond to shocks on the firm’s unit cost when the shocks are small enough.

Two different specifications of consumers’ reference points are proposed: in the basic model, the reference point is set exogenously and not allowed to vary over time. In an extended version of the model, the reference point depends on past consumption. The extended version is found to mimic real market prices better than the basic version. My way of modeling the determination of the reference points is defended against two competing hypotheses about their nature, proposed by Sibly (2002) and by Heidhues and Köszegi (2004).

The extended version is modified in a second extended version to allow for consumer heterogeneity, i.e. consumers have idiosyncratic reference points. This way, it is shown that the results of the first extended version survive aggregation. Because of this result, I argue that customer heterogeneity can be neglected and the model can be used in its representative-agent version, which is much easier to solve than the version incorporating consumer heterogeneity.

The main result of my model is that it combines one kind of non-responsiveness of the profit-maximizing price—to cost shocks—with another kind of immediate responsiveness—to changes in demand. Such changes in demand occur, e.g., when the agents’ nominal income changes. Thus, expansionary monetary policy has in most cases no real, but only inflationary effects, despite the observation that prices are constant over longer periods of time.

Finally, topics for further research are suggested: most importantly, upcoming versions of the model should incorporate forward-looking behavior of both firms and consumers; the analysis should be extended from partial to general equilibrium; and a calibrated version of the model should be compared with actual data on prices and costs thereafter. In addition to this theoretical work, further empirical research on the origins and effects of reference points is considered necessary.