Behavioral Aspects of Price Setting and Their Policy Implications

In the textbook conception of economics, consumers use prices to determine the bundle of purchases that maximize their utility subject to the constraint that the total value of these purchases cannot exceed their income. In this paper, I consider the implications of letting consumers have somewhat different reactions to prices. First, I allow consumers to be unsophisticated when they use price information to plan their expenditures. This is a departure from the cognitive assumptions used in standard economic analysis. Second, I let consumers have emotional reactions to prices, including reactions that are motivated by concern for the welfare of others (as opposed to being driven by pure self-interest). The paper also discusses how these consumer reactions affect how firms set prices, as well as their implications for government intervention in markets. Before turning to the psychological facets involved in understanding, setting, and regulating prices, it is worth recalling that the standard view that consumers regard prices only as incentives to guide their purchases has very little evidence on its side. Consistent with this theory, consumers prefer low prices to high prices—meaning that people do have a preference for being able to make more purchases. But this preference demonstrates only that one of people's desires is being able to acquire goods and says little about whether they do this well or whether they also have other objectives that guide their choices. The additional conditions that rational utility maximization imposes on understanding consumer behavior are difficult to test, in part because consumers do not spend all their income at once. A vast empirical literature has thus devoted itself to analyzing whether people respond to incentives by entering less frequently into transactions whose terms are