Price setting in forward-looking customer markets

We propose a new explanation for price rigidity. If consumers form habits in individual goods, then firms face a time-inconsistency problem. The consumers’ habits imply that low prices in the future help attract customers in the present. Firms would therefore like to promise low prices in the future. But when the future arrives they have an incentive to exploit consumers’ habits and price gouge. In this model, unlike the standard no-habit model, price rigidity is an equilibrium outcome. Equilibrium price rigidity can be sustained because rigid prices help firms overcome the time-inconsistency problem. If consumers have incomplete information about firms’ desired prices, the firm-preferred equilibrium has the firm price at or below a “price cap”. Our model therefore provides an explanation for the simultaneous existence of a rigid regular price and frequent sales, a pattern that is difficult to reconcile with existing models of price rigidity. Our model also explains why firms fear adverse reactions to price changes, why sales prices are more flexible than regular prices, why firms make explicit promises not to change prices and why price are more rigid to repeat customers than to one-time customers.