Dynamic Competition in Deceptive Markets

This paper studies the impact of private customer data about consumer naiveté in markets for deceptive products in which firms use these data to distinguish their existing customers’ level of sophistication. To do so, I introduce a dynamic model in which competing firms can shroud hidden fees from naive customers, but not from sophisticated ones. Data on past usage is highly valuable to firms in competitive settings only if it identifies naive customers. Firms exploit private information on their existing customers’ types to make type-specific offers. Since naives believe to be sophisticated, consumers do not self-select when given type-specific offers, making it impossible for rivals to compete effectively. Privately informed firms make offers to induce sophisticated customers to switch already at higher prices. Thus, competitors cannot attract profitable naives without attracting unprofitable sophisticates as well. This adverse-attraction effect enables firms to keep positive margins on existing naives, while breaking even on sophisticates. Since this implies that margins of naive consumers decrease in the share of sophisticated ones, firms prefer a balanced customer base. Achieving positive continuation profits from exploiting naive consumers requires each firm to have a substantial customer base. Thus, even when firms compete before learning about customers’ types, firms have an incentive to coordinate on prices and competition is mitigated even more. I analyze the effects of a policy that discloses customer information to all firms and thereby increases consumer surplus, and illustrate the robustness of the results through several extensions. Creation Date: 2015-07-25