Market Forces and Behavioral Biases: Cost-Misallocation and Irrational Pricing

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 paper 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.