Monday, January 09, 2006

Why goods prices end in nine

If consumers break brices into two bits -- say the ones place and the cents -- and economize on search costs by looking only at the ones place, then producers will rationally maximize the cents. But since consumers are rational they "know" that the cents are 99 because they know the expected value of cents. Yet this denies the firm the opportunity to price in intermediate values of cents (because consumers don't look and assume it to be 99). So then the demand function faced by the firm is essentially a step function of the value of the ones place rather than a much smoother function of dollars and cents. This step function has to be inside the dollars and cents demand function. The producer is hurt by the way consumers perceive prices. This model can be extended to larger denominated things by thinking about consumers who only look at the hundreds place, or the thousands place...The effect on the consumer is ambiguous, though you suspect that she is made worse off by being forced to save a bit more than she wanted.

*See Kaushik Basu 1997. "Why are so many goods priced to end in nine? And why this practice hurts producers." Economic Letters 54: 41-44.

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