| Abstract: |
Consumers often have to decide whether to go to a remote store for a lower
price. Only the absolute price difference between the stores should be
relevant in this case, but several experiments showed that people exhibit
"relative thinking": they are affected also by the relative savings (relative
to the good's price). This article analyzes the effects of this bias on firm
strategy and market outcomes using a two-period game-theoretic model of
location differentiation. Relative thinking causes consumers to make less
effort to save a constant amount when they buy more expensive goods. In the
location differentiation context this behavior can be modeled by consumers who
behave as if their transportation costs are an increasing function of the
good's price. This gives firms an additional incentive to raise prices, in
order to increase the perceived transportation costs of consumers, which
consequently softens competition and allows higher profits. Therefore, the
response of firms to relative thinking raises prices and profits and reduces
consumer surplus, in both periods. Total welfare is unchanged in the first
period, and in the second period it is either unchanged or reduced, depending
on whether the objective or subjective transportation costs are used to
compute welfare. The main results of the model (firms' response to relative
thinking increases prices and reduces consumer surplus) are likely to hold
also in the context of search. The article also explains why "relative
thinking" is a more appropriate term than "mental accounting" (which was often
used before) to describe this behavior, and discusses why people might exhibit
relative thinking. |