Relative Thinking and Markups∗

In experiments subjects regularly trade off time and money at inconsistent rates, apparently becoming less sensitive to money when considering the purchase of a more-expensive item. In this paper I introduce a demand function that matches this behaviour, and derive the predictions for equilibrium market structure, and then finally discuss market evidence. The demand function is derived from a utility function which has contextdependent sensitivity to different goods (e.g., time, money). In market equilibrium with unit total demand the model predicts three phenomena: higher cost goods tend to have higher markups; higher cost goods tend to have greater price dispersion; and higher cost goods will have a larger number of sellers. The first two facts are commonly observed in the empirical IO literature. Finally I introduce a novel dataset of 3,500 markups from a branch of a chain drugstore, with cross-section evidence in support of the theory.