The Free Market Illusion Psychological Limitations of Consumer Choice

Point of departure for market regulation is that enhancing competition helps maximizing social surplus since consumer discipline stimulates innovativeness, quality improvements, and cost effectiveness. These effects however, can only take place if several conditions are met. One of these conditions is consumer rationality. Such rationality is determined by the interaction of consumer psychological characteristics and environmental conditions under which consumers have to make choices. In this paper we therefore study the potential for consumer rationality in conjunction with market developments. We find that, beyond a certain level of competitiveness, consumers increasingly rely on heuristics instead of relying on rational choice. This ultimately results in fewer incentives for innovativeness. To some degree the market itself will make up for the “rationality defects” by developing long term relations in which consumers and firms benefit from information exchange and invest in customized product offers. The paper concludes by making an inventory of possible implications for government interventions.