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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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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. Stefano DellaVigna & Ulrike Malmendier, 2004. "Overestimating Self_Control: Evidence from the Health Club Industry," NBER Working Papers 10819, National Bureau of Economic Research, Inc.
  2. Sendhil Mullainathan & Andrei Shleifer, 2005. "The Market for News," American Economic Review, American Economic Association, American Economic Association, vol. 95(4), pages 1031-1053, September.
  3. Perloff, Jeffrey M & Salop, Steven C, 1985. "Equilibrium with Product Differentiation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 52(1), pages 107-20, January.
  4. Anderson, S. P. & De Palma, A. & Nesterov, Y., . "Oligopolistic competition and the optimal provision of products," CORE Discussion Papers RP, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) -1179, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  5. Judd, Kenneth L & Riordan, Michael H, 1994. "Price and Quality in a New Product Monopoly," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 61(4), pages 773-89, October.
  6. 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, MIT Press, vol. 119(2), pages 403-456, May.
  7. 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.
  8. Rosenthal, Robert W, 1980. "A Model in Which an Increase in the Number of Sellers Leads to a Higher Price," Econometrica, Econometric Society, Econometric Society, vol. 48(6), pages 1575-79, September.
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Cited by:
  1. Kaminski, Bogumil & Latek, Maciej, 2012. "A Simple Model of Bertrand Duopoly with Noisy Prices," MPRA Paper 41333, University Library of Munich, Germany.
  2. Paul Heidhues & Botond Köszegi, 2004. "The Impact of Consumer Loss Aversion on Pricing," CIG Working Papers, Wissenschaftszentrum Berlin (WZB), Research Unit: Competition and Innovation (CIG) SP II 2004-17, Wissenschaftszentrum Berlin (WZB), Research Unit: Competition and Innovation (CIG).
  3. Moisés J. Schwartz & Enrique E. Domínguez & Roberto Calderón-Colín, 2008. "Consumer Confusion," IMF Working Papers 08/177, International Monetary Fund.
  4. David Laibson & Leeat Yariv, 2007. "Safety in Markets: An Impossibility Theorem for Dutch Books," Levine's Bibliography 122247000000001746, UCLA Department of Economics.
  5. Laibson, David I. & Gabaix, Xavier, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," Scholarly Articles 4554333, Harvard University Department of Economics.
  6. Glenn Ellison & Sara Fisher Ellison, 2004. "Search, Obfuscation, and Price Elasticities on the Internet," NBER Working Papers 10570, National Bureau of Economic Research, Inc.
  7. Ioanna Chioveanu & Jidong Zhou, 2011. "Price Competition with Consumer Confusion," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 11-19, New York University, Leonard N. Stern School of Business, Department of Economics.
  8. Hasan, Syed Akif & Subhani, 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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