Monopoly pricing when consumers are antagonized by unexpected price increases: A "cover version" of the Heidhues-Koszegi-Rabin model

This paper reformulates and simplifies a recent model by Heidhues and Ko{double acute}szegi (The impact of consumer loss aversion on pricing, Mimeo, 2005), which in turn is based on a behavioral model due to Ko{double acute}szegi and Rabin (Q J Econ 121:1133-1166, 2006). The model analyzes optimal pricing when consumers are loss averse in the sense that an unexpected price hike lowers their willingness to pay. The main message of the Heidhues-Ko{double acute}szegi model, namely that this form of consumer loss aversion leads to rigid price responses to cost fluctuations, carries over. I demonstrate the usefulness of this "cover version" of the Heidhues-Ko{double acute}szegi-Rabin model by obtaining new results: (1) loss aversion lowers expected prices; (2) the firm's incentive to adopt a rigid pricing strategy is stronger when fluctuations are in demand rather than in costs.