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Competition and Consumer Confusion

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  • David Laibson
  • Xavier Gabaix

Abstract

In many markets consumer biases do not affect prices, since competition forces firms to price their products close to marginal cost; competition protects the consumer. We show that noisy consumer product evaluations undermine the force of competition, enabling firms to charge high mark-ups in equilibrium, even in highly competitive environments. We analyze markets in which rational firms sell goods to consumers who evaluate products with noise. Using results from extreme value theory, we show that competition generally has a remarkably weak impact on markups. For normally distributed evaluation noise, we show that markups are proportional to the inverse of the square root of log(n), where n is the number of competitors. In this setting, a highly competitive industry with n=1,000,000 firms will retain 1/3 of the markup of a highly concentrated industry with only n=10 competitors. When we make noise an endogenous variable, we find that firms choose excess noise by making their products inefficiently confusing. Moreover, competition exacerbates this effect: a higher degree of competition causes firms to choose even more excess complexity. Firms with lower intrinsic quality and higher production costs choose the most excess complexity. Educating consumers to reduce their evaluation noise would generate large welfare gains. But the gains accrue mostly to the consumer, so firms can't profitably educate consumers and steal them away from competitors. Finally, we introduce an econometric framework that measures bounded rationality and confusion in the marketplace

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 663.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:663

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Related research

Keywords: bounded rationality; complexity; confusion; extreme value theory; discrete choice; profit; behavioral economics; behavioral industrial organization; mutual fund; industry; consumer protection;

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References

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  1. Perloff, Jeffrey M & Salop, Steven, 1984. "Equilibrium with product differentiation," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt4cq0m6s3, Department of Agricultural & Resource Economics, UC Berkeley.
  2. Ali Hortacsu & Chad Syverson, 2003. "Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of the S&P 500 Index Funds," NBER Working Papers 9728, National Bureau of Economic Research, Inc.
  3. ANDERSON, Simon P. & DE PALMA, André & NESTEROV, Yurii, 1994. "Oligopolistic Competition and the Optimal Provision of Products," CORE Discussion Papers 1994034, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  4. Judd, K.L. & Riordan, M.H., 1989. "Price And Quality In A New Product Monopoly," Working Papers e-89-8, Hoover Institution, Stanford University.
  5. Malmendier, Ulrike M. & Della Vigna, Stefano, 2003. "Overestimating Self-Control: Evidence from the Health Club Industry," Research Papers 1800, Stanford University, Graduate School of Business.
  6. Rosenthal, Robert W, 1980. "A Model in Which an Increase in the Number of Sellers Leads to a Higher Price," Econometrica, Econometric Society, vol. 48(6), pages 1575-79, September.
  7. Sendhil Mullainathan & Andrei Shleifer, 2005. "The Market for News," American Economic Review, American Economic Association, vol. 95(4), pages 1031-1053, September.
  8. Ali Hortaç Su & Chad Syverson, 2004. "Product Differentiation, Search Costs, And Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds," The Quarterly Journal of Economics, MIT Press, vol. 119(2), pages 403-456, May.
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Citations

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Cited by:
  1. Ioanna Chioveanu & Jidong Zhou, 2011. "Price Competition with Consumer Confusion," Working Papers 11-19, New York University, Leonard N. Stern School of Business, Department of Economics.
  2. Heidhues, Paul & Köszegi, Botond, 2005. "The Impact of Consumer Loss Aversion on Pricing," CEPR Discussion Papers 4849, C.E.P.R. Discussion Papers.
  3. Moisés J. Schwartz & Enrique E. Domínguez & Roberto Calderón-Colín, 2008. "Consumer Confusion: The Choice of AFORE in Mexico," IMF Working Papers 08/177, International Monetary Fund.
  4. Gabaix, Xavier & Laibson, David I., 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," Scholarly Articles 4554333, Harvard University Department of Economics.
  5. Glenn Ellison & Sara Fisher Ellison, 2004. "Search, Obfuscation, and Price Elasticities on the Internet," NBER Working Papers 10570, National Bureau of Economic Research, Inc.
  6. David Laibson & Leeat Yariv, 2007. "Safety in Markets: An Impossibility Theorem for Dutch Books," Levine's Bibliography 122247000000001746, UCLA Department of Economics.
  7. Kaminski, Bogumil & Latek, Maciej, 2012. "A Simple Model of Bertrand Duopoly with Noisy Prices," MPRA Paper 41333, University Library of Munich, Germany.
  8. Hasan, Dr. Syed Akif & Subhani, Dr. Muhammad Imtiaz & Osman, Ms. Amber & Mehar, Ayub, 2012. "Pricing behavior of firms when consumers have an Imperfect Recall," MPRA Paper 35682, University Library of Munich, Germany.

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