Competition and Price Variation when Consumers Are Loss Averse

We modify the Salop (1979) model of price competition with differentiated products by assuming that consumers are loss averse relative to a reference point given by their recent expectations about the purchase. Consumers' sensitivity to losses in money increases the price responsiveness of demand—and hence the intensity of competition—at higher relative to lower market prices, reducing or eliminating price variation both within and between products. When firms face common stochastic costs, in any symmetric equilibrium the markup is strictly decreasing in cost. Even when firms face different cost distributions, we identify conditions under which a focal-price equilibrium (where firms always charge the same “focal” price) exists, and conditions under which any equilibrium is focal. (JEL D11, D43, D81, L13)