Theoretical Economics 9 (2014), 217–251

It is widely known that loss aversion leads individuals to dislike risk, and as has been argued by many researchers, in many instances this creates an incentive for firms to shield consumers and employees against economic risks. Complementing previous research, we show that consumer loss aversion can also have the opposite effect: it can lead a firm to optimally introduce risk into an otherwise deterministic environment. We consider a profit-maximizing monopolist selling to a loss-averse consumer, where (following \citeasnoun{koszegirabin}) we assume that the consumer's reference point is her recent rational expectations about the purchase. We establish that for any degree of consumer loss aversion, the monopolist's optimal price distribution consists of low and variable ``sale'' prices and a high and atomic ``regular'' price. Realizing that she will buy at the sale prices and hence that she will purchase with positive probability, the consumer chooses to avoid the painful uncertainty in whether she will get the product by buying also at the regular price. This pricing pattern is consistent with several recently documented facts regarding retailer pricing. We show that market power is crucial for this result: when firms compete ex ante for consumers, they choose deterministic prices.

Keywords: Reference-dependent utility, gain-loss utility, loss aversion, sales, supermarket pricing, sticky prices

JEL classification: D03, D42, D81, L13