Reference Dependence and Market Competition∗

This paper studies 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 exhibit loss aversion, then the more “prominent” firm whose product is taken as the reference point by more consumers will randomize over a high and a low price. Relative to the standard model without behavioral factors, the presence of consumer reference dependence can harm firms and benefit consumers by intensifying price competition. If advertising increases product prominence, consumer reference dependence can also induce ex ante identical firms to differentiate their advertising intensities.