Reference Dependence and Market Competition

Abstract

This paper examines the implications of consumer reference dependence for market competition. If consumers take some product (e.g., the first product they consider) as the reference point when evaluating others and they exhibit loss aversion, then the more “prominent” firm whose product is taken as the reference point by more consumers will randomize between a high and a low price. We also find that consumer loss aversion in the price dimension intensifies competition while that in the product dimension softens competition. With consumer reference dependence, asymmetric prominence can arise as an equilibrium outcome when firms advertise before engaging in price competition.

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