Loss Aversion, Price and Quality*

The Spence model (1975) is extended so that customers’ utility depends on their disposition to the firm in addition to quantity and quality of the good consumed. Disposition is determined by customers’ perception of firm’s pricing and quality decisions, which perception is ‘reference dependent’. The profit maximising, efficient, and Ramsey price and quality combinations are derived. Adjustment to a change in economic conditions may call for price rigidity, quality rigidity or both depending on the level of the reference price and quality. * I would like to thank Peter Earl and Ian McDonald for their thoughtful comments on this work. All errors remain my responsibility. Loss Aversion, Price and Quality Virtually all goods have attributes other than their price. Aspects of quality, interpreted broadly to include durability, service level, reliability of supply, quantity per unit package, and advertising to establish a brand image, can be varied for most goods. As customers judge these goods on the basis of both price and quality, the choice of quality is often as important to a firm as is its choice of price. Therefore, following a change in economic conditions (such as a demand or cost shock), firms will wish to reevaluate their provision of quality as well as their price. However, although Carlton (1989) has emphasised it is not price adjustment alone which clears markets following a change in economic conditions, the overwhelming volume of the literature focuses on price setting assumes quality is set exogenously. This paper is concerned with a monopolist’s adjustment of price and quality to changed economic conditions. It is motivated by the casual observation that in some instances firms adjust price without varying quality, while in other instances vary quality without adjusting price. For example during and following renovations (which lowers then raises the ease and enjoyment of shopping) a retailer does not change price. However the same retailer may have a post-Christmas sale with a given store configuration. A restaurant that becomes popular allows service standards (longer waits for a table, busier and less attentive waiting staff, more crowding) to fall rather than raise price. The same restaurant may offer discounted meals at lunchtimes or quiet nights.