We thank Martin Cripps, Ronald Dye, Federico Echenique, Jeff Ely, Claudio Mezzetti, Bill Sandholm, Lars Stole, Beverly Walther, the editor, Joe Harrington, and two referees for helpful comments. We also thank seminar participants at Cambridge, Davis, LSE, NBER, Oxford, UCL, Pompeu Fabra, IESE, UCSD, and the Second Annual Foundations of Business Strategy Conference at Olin for their comments.
Market forces meet behavioral biases: cost misallocation and irrational pricing
Article first published online: 11 APR 2008
The RAND Journal of Economics
Volume 39, Issue 1, pages 214–237, Spring 2008
How to Cite
Al-Najjar, N., Baliga, S. and Besanko, D. (2008), Market forces meet behavioral biases: cost misallocation and irrational pricing. The RAND Journal of Economics, 39: 214–237. doi: 10.1111/j.0741-6261.2008.00011.x
- Issue published online: 16 SEP 2008
- Article first published online: 11 APR 2008
Psychological and experimental evidence, as well as a wealth of anecdotal examples, suggests that firms may confound fixed, sunk, and variable costs, leading to distorted pricing decisions. This article investigates the extent to which market forces and learning eventually eliminate these distortions. We envision firms that experiment with cost methodologies that are consistent with real-world accounting practices, including ones that confuse the relevance of variable, fixed, and sunk costs to pricing decisions. Firms follow “naive” adaptive learning to adjust prices and reinforcement learning to modify their costing methodologies. Costing and pricing practices that increase profits are reinforced. In some market structures, but not in others, this process of reinforcement causes pricing practices of all firms to systematically depart from standard equilibrium predictions.