Loss-Averse Consumers May Not Result In Loss-Averse Markets

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Market demand is often assumed to be shaped by the same characteristics as individual consumer behaviour – for instance, to be more responsive to losses than gains if consumers are loss averse. But new research shows that such assumptions can be misleading.

Zhenyu Hu and Javad Nasiry demonstrate that the diversity of consumer valuations for a product – whether a consumer sees a price as a loss, gain, or neutral – means individual consumer behaviour does not necessarily get mirrored in market demand.

“Typically, pricing models assume market demand inherits consumer-level behaviour. For example, based on prospect theory, consumers are thought to be loss averse and to react more strongly to losses than gains of the same magnitude. This behavioural bias is often generalised to conclude that market demand is likewise more sensitive to losses than to gains. But our work indicates that this approach is not correct,” the authors said.

In their model, consumers have different valuations for a product. These valuations include, among other things, the “psychological surplus” to the consumer, which is the difference between a product’s price and the consumer’s own reference price and thus captures how the consumer feels about the transaction. The distribution of the valuations determines how market demand responds to surcharges versus discounts (or losses versus gains).

“For loss-neutral consumers, overall market demand is more sensitive to losses only when the market consists mainly of high-valuation consumers. When consumers are mostly bargain hunters, overall demand will be more sensitive to gains. And when valuations are uniformly distributed, then market demand will be equally sensitive to gains and losses,” they said.

Hu and Nasiry do not rule out the possibility that the market inherits the loss aversion of individual consumers – rather, the point is that psychological biases are individual-level phenomena that do not necessarily translate into aggregate market demand. Care must therefore be taken in incorporating behavioural biases at the aggregate level because of the significant implications for pricing policies.
“When valuations are exponentially distributed, the optimal price path becomes cyclic. This finding challenges the established understanding that price fluctuations antagonise loss-averse consumers. While this is true for individual-level demand, our results prove that it does not hold at the aggregate level when the heterogeneity among consumers is accounted for,” they said.

Market demand thus may be more sensitive to gains than losses even if consumers are loss averse. So while dynamic pricing may put off some individuals, it is not necessarily detrimental to a firm operating in a market of loss-averse consumers.

“Our results have profound implications not only for how best to characterise the market demand of behaviourally-biased consumers, but also for determining firms’ optimal pricing policy,” the authors concluded.