Behavioural Industrial Organization

Behavioural Industrial Organization

Sotiris GeorganasSotiris Georganas

Supply

Demand

price

p*

Basic markets – how do they work?

Basic markets – how do they work?

Does the simplistic demand-supply model make sense?Is there actually a game behind it?

Will real people behave according to the theoretical predictions?

Does the simplistic demand-supply model make sense?Is there actually a game behind it?

Will real people behave according to the theoretical predictions?

Introductory example: the first market experiment

Introductory example: the first market experiment

Chamberlin (JPE, 1948) conducted bilateral trading experiments with his graduate students at Harvard to illustrate how perfectly competitive equilibrium might not

work Subjects could each trade one unit of a good Bilateral negotiations Price higher than equilibrium 7 times, lower 39 times

He concluded “… economists may have been led unconsciously to share

their unique knowledge of the equilibrium point with their theoretical creatures. The buyers and sellers, who, of course, in real life have no knowledge of it whatever.” (p. 102)

Chamberlin (JPE, 1948) conducted bilateral trading experiments with his graduate students at Harvard to illustrate how perfectly competitive equilibrium might not

work Subjects could each trade one unit of a good Bilateral negotiations Price higher than equilibrium 7 times, lower 39 times

He concluded “… economists may have been led unconsciously to share

their unique knowledge of the equilibrium point with their theoretical creatures. The buyers and sellers, who, of course, in real life have no knowledge of it whatever.” (p. 102)

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Response by Vernon SmithResponse by Vernon Smith

Vernon Smith, a former Harvard student (and Nobel Prize laureate in 2002), changed Chamberlin’s trading institution in the following way: Instead of having subjects circulate and make

bilateral deals he used the oral double auction procedure.

He also implemented the method of “stationary replication”, which is a sequence of trading days with stationary demand and supply schedules.

“These two changes seemed to me the appropriate modifications to do a more credible job of rejecting competitive price theory, which after all, was for teaching, not believing...” (Smith 1991, p. 155).

Vernon Smith, a former Harvard student (and Nobel Prize laureate in 2002), changed Chamberlin’s trading institution in the following way: Instead of having subjects circulate and make

bilateral deals he used the oral double auction procedure.

He also implemented the method of “stationary replication”, which is a sequence of trading days with stationary demand and supply schedules.

“These two changes seemed to me the appropriate modifications to do a more credible job of rejecting competitive price theory, which after all, was for teaching, not believing...” (Smith 1991, p. 155).

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Details of the double auction

(homogeneous goods)

Details of the double auction

(homogeneous goods) Each buyer i is paid according to Bi(xi)-∑pi where xi denotes

the number of goods bought and Bi denotes the buyers’ utility from consuming xi goods.

Each seller is paid according to ∑pi-Si(xi). There is a limited time for trading per “market day”. If

trading ceases before the time limit is reached the “day” ends.

Within a market period a buyer can make price bids to the group of sellers for a specified quantity and/or accept a seller’s price offer for a specified quantity at any point in time.

Within a market period a seller can make price offers to the group of buyers for a specified quantity and/or accept a buyer’s price bid for a specified quantity at any point in time.

Each buyer i is paid according to Bi(xi)-∑pi where xi denotes the number of goods bought and Bi denotes the buyers’ utility from consuming xi goods.

Each seller is paid according to ∑pi-Si(xi). There is a limited time for trading per “market day”. If

trading ceases before the time limit is reached the “day” ends.

Within a market period a buyer can make price bids to the group of sellers for a specified quantity and/or accept a seller’s price offer for a specified quantity at any point in time.

Within a market period a seller can make price offers to the group of buyers for a specified quantity and/or accept a buyer’s price bid for a specified quantity at any point in time.

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Details…Details…

Improvement rule: A new bid must be better (higher) than the highest standing bid. A new offer must be better (lower) than the lowest standing offer.

If a bid (offer) is accepted a binding contract is concluded.

In general, individuals only know their own Bi(xi) or Si(xi) values.

Improvement rule: A new bid must be better (higher) than the highest standing bid. A new offer must be better (lower) than the lowest standing offer.

If a bid (offer) is accepted a binding contract is concluded.

In general, individuals only know their own Bi(xi) or Si(xi) values.

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Is the outcome in the DA obvious?

Is the outcome in the DA obvious?

Demand and supply change during a trading period.

Nothing ensures that trade will take place at the CE. Notice that the number of CE-trades is in general smaller than the number of economically feasible trades. In principle it might be possible that all feasible trades take place.

There is no rigorous game theoretic prediction. No well defined game!

Demand and supply change during a trading period.

Nothing ensures that trade will take place at the CE. Notice that the number of CE-trades is in general smaller than the number of economically feasible trades. In principle it might be possible that all feasible trades take place.

There is no rigorous game theoretic prediction. No well defined game!

Intro example 2: Cournot Mergers

Intro example 2: Cournot Mergers

N<5 firms in market - merger between two makes them suffer and outsiders gain! “Merger paradox”

Intuition? Merger beneficial if outsiders did not change production Optimal response of merged firm to unchanged

behaviour of others : lower output But optimal output of others rises => further drop in

optimal output of the new firm! In new equilibrium industry profits rise. But market

share of merged firm drops from 2/n to 1/(n-1)

N<5 firms in market - merger between two makes them suffer and outsiders gain! “Merger paradox”

Intuition? Merger beneficial if outsiders did not change production Optimal response of merged firm to unchanged

behaviour of others : lower output But optimal output of others rises => further drop in

optimal output of the new firm! In new equilibrium industry profits rise. But market

share of merged firm drops from 2/n to 1/(n-1)

Huck et al (2007) lab study of mergers

Huck et al (2007) lab study of mergers

Linear demand 4->3, 3->2 Total output close to theory However, individual outputs different

Merged firms produce more than unmerged Unmerged firms best respond to that

Mergers in larger market weakly profitable!

Linear demand 4->3, 3->2 Total output close to theory However, individual outputs different

Merged firms produce more than unmerged Unmerged firms best respond to that

Mergers in larger market weakly profitable!

Now what? The state of experimental-behavioral

economics

Now what? The state of experimental-behavioral

economics Over time we have gathered a wealth of

evidence regarding deviations from Nash equilibria in many different games

The number of experimental papers has grown exponentially

Recording deviations is not enough, we have to explain them

Modern economic theory is interested in incorporating the insights gained from that process to improve models

Over time we have gathered a wealth of evidence regarding deviations from Nash equilibria in many different games

The number of experimental papers has grown exponentially

Recording deviations is not enough, we have to explain them

Modern economic theory is interested in incorporating the insights gained from that process to improve models

All pay auctionAll pay auction

N bidders You pay your bid independently of winning

or not Let’s try it!

How did you play? Is that an equilibrium? Insight actually used to make real money

(swoopo and other penny auctions sites)

How is this similar to a patent race?

N bidders You pay your bid independently of winning

or not Let’s try it!

How did you play? Is that an equilibrium? Insight actually used to make real money

(swoopo and other penny auctions sites)

How is this similar to a patent race?

Takeover gameTakeover game

Two playersThe owner of a companyA manager that wants to buy itValue to owner V is unknown to

manager, but distribution uniform in the set {0,15,30,45,60,75,90}

Value to manager is 1.5*VHow much do you offer?

Two playersThe owner of a companyA manager that wants to buy itValue to owner V is unknown to

manager, but distribution uniform in the set {0,15,30,45,60,75,90}

Value to manager is 1.5*VHow much do you offer?

What is behavioral IOWhat is behavioral IO

Traditional IO is based on Nash equilibriumRational firms, rational consumersConsistent beliefs - best responses

Behavioural IORational firms best responding to irrational

consumers? Irrational firms - no best responses?Rational firms with wrong beliefs? Rational

consumers with wrong beliefs?

Traditional IO is based on Nash equilibriumRational firms, rational consumersConsistent beliefs - best responses

Behavioural IORational firms best responding to irrational

consumers? Irrational firms - no best responses?Rational firms with wrong beliefs? Rational

consumers with wrong beliefs?

Common deviations from “rationality” - bounded

rationality

Common deviations from “rationality” - bounded

rationalityQuantal response

Right beliefs - no best responseLevels of reasoning

Best response - wrong beliefsGuessing game!

N players, can say a number [0,100], winner is the person closest to ½ times the average number

Quantal responseRight beliefs - no best response

Levels of reasoningBest response - wrong beliefsGuessing game!

N players, can say a number [0,100], winner is the person closest to ½ times the average number

Undercutting gameUndercutting game

ResultsResultsGuessing gamesUndercutting games

Level k model also predicts aggregate behaviour well in 2x2 games, 3x3 games, auctions, hide-and-seek games…

Using models of bounded rationality

Using models of bounded rationality

QRE can explain behavior in all pay auctions Overbidding as we saw in lecture

Level k can explain the experience of the ECB with liquidity auctionsBanks demand liquidity – ECB supplies, if total

demand lower than supply there is a proportional rationing rule

Nash equilibrium if supply<demand: demand infinity!

What actually happened?

QRE can explain behavior in all pay auctions Overbidding as we saw in lecture

Level k can explain the experience of the ECB with liquidity auctionsBanks demand liquidity – ECB supplies, if total

demand lower than supply there is a proportional rationing rule

Nash equilibrium if supply<demand: demand infinity!

What actually happened?

Common deviations from “rationality” - psychological

traits

Common deviations from “rationality” - psychological

traits Loss aversion

A poker player does not remember his big gains, but always remembers his big losses (Matt Damon in Rounders)

Inequity aversion Regret minimization Hyperbolic discounting

Discounting day 2 payoffs in day 1 stronger than day 12 payoffs in day 11

Inertia - Nudges Sunk cost- and other fallacies

Example: all pay auction …

Loss aversion A poker player does not remember his big gains, but

always remembers his big losses (Matt Damon in Rounders)

Inequity aversion Regret minimization Hyperbolic discounting

Discounting day 2 payoffs in day 1 stronger than day 12 payoffs in day 11

Inertia - Nudges Sunk cost- and other fallacies

Example: all pay auction …

Are these behavioral traits useful in the real world?

Are these behavioral traits useful in the real world?

Stakes replications in poor countries with payoffs

comparable to monthly wages – Learning

… repetition, experience But many games played by non experts!

– Interaction with rational agents (product markets) … Behavioral IO: firms may exacerbate rather than

eliminate biases. – Sample too narrow

replications with many populations (professionals, game theorists, chess players…)

Stakes replications in poor countries with payoffs

comparable to monthly wages – Learning

… repetition, experience But many games played by non experts!

– Interaction with rational agents (product markets) … Behavioral IO: firms may exacerbate rather than

eliminate biases. – Sample too narrow

replications with many populations (professionals, game theorists, chess players…)

Using psychological traits: Why sales?

Using psychological traits: Why sales?

Kahnemann, Knetsch, and Thaler (1986) proposed that sales might have an irrational origin.

Survey: many subjects say that it is unfair for firms to raise prices when demand goes up

Firms have incentive to hold sales rather than reducing regular prices if firms lower regular prices when demand is low,

they will be branded as unfair if they raise prices back to normal when demand returns to normal

Kahnemann, Knetsch, and Thaler (1986) proposed that sales might have an irrational origin.

Survey: many subjects say that it is unfair for firms to raise prices when demand goes up

Firms have incentive to hold sales rather than reducing regular prices if firms lower regular prices when demand is low,

they will be branded as unfair if they raise prices back to normal when demand returns to normal

Why sales? pt2 Why sales? pt2

Rotemberg (2005) - more complex fairness-based model to account for firms’ occasional use of sales and for the stickiness of prices

consumers have reciprocal preferences and punish firms discontinuously if their estimate of the firm’s altruism crosses a threshold

model also relies on the firms’ objective function being a concave function of profits and on consumers feeling regretThis leads to sales and sticky prices

Rotemberg (2005) - more complex fairness-based model to account for firms’ occasional use of sales and for the stickiness of prices

consumers have reciprocal preferences and punish firms discontinuously if their estimate of the firm’s altruism crosses a threshold

model also relies on the firms’ objective function being a concave function of profits and on consumers feeling regretThis leads to sales and sticky prices

Information and obfuscation

Information and obfuscation

Milgrom (1981), Grossman (1981) – Information disclosure

Should you reveal relevant information to other players?E.g. about the quality of your product to your

cientsBest firm should reveal, to attract clientsBut then, the next best firm should also

reveal, else buyers would assume it is just an average quality firm

Unravelling- all others have to reveal!

Milgrom (1981), Grossman (1981) – Information disclosure

Should you reveal relevant information to other players?E.g. about the quality of your product to your

cientsBest firm should reveal, to attract clientsBut then, the next best firm should also

reveal, else buyers would assume it is just an average quality firm

Unravelling- all others have to reveal!

Information and obfuscation pt 2Information and obfuscation pt 2

Ellison and Ellison (2005) find differences btw theory and practicemattress manufacturers put different model names

on products sold through different stores and provide few technical specs so as to make it very difficult to compare prices

Credit cards: hard to imagine that the complex fee schedules in small print on the back of credit card offers could not be made simpler.

Ellison and Ellison (2005) find differences btw theory and practicemattress manufacturers put different model names

on products sold through different stores and provide few technical specs so as to make it very difficult to compare prices

Credit cards: hard to imagine that the complex fee schedules in small print on the back of credit card offers could not be made simpler.

Ιnformation and obfuscation: pt. 3Ιnformation and

obfuscation: pt. 3 Gabaix and Laibson (2004) suggest a very simple formalization Consumers have noisy estimates of utility they will receive from

consuming a product: they think they will get utility u+ε from consuming product i when they actually get utility u.

Obfuscation increases the variance of the random evaluation error ε in a model in which consumers have noisy estimates of their utility

Such a model is formally equivalent (from the firm’s perspective) to a model in which firms can invest in product differentiation

Firms will invest in obfuscation just as they invest in differentation to raise markups.

Gabaix and Laibson (2004) suggest a very simple formalization Consumers have noisy estimates of utility they will receive from

consuming a product: they think they will get utility u+ε from consuming product i when they actually get utility u.

Obfuscation increases the variance of the random evaluation error ε in a model in which consumers have noisy estimates of their utility

Such a model is formally equivalent (from the firm’s perspective) to a model in which firms can invest in product differentiation

Firms will invest in obfuscation just as they invest in differentation to raise markups.

Information and obfuscation: pt. 4Information and

obfuscation: pt. 4 Spiegler (2006) discusses another rule-of-thumb model Products inherently have a large number of dimensions. Boundedly rational consumers evaluate products on one

randomly chosen dimension and buy the product that scores most highly on this dimension.

In this model, consumers would evaluate the products correctly if products were designed to be equally good on all dimensions. Spiegler shows that this will not happen, however. Essentially, firms randomize across dimensions making the product

very good on some dimensions and not so good on others.

Spiegler (2006) discusses another rule-of-thumb model Products inherently have a large number of dimensions. Boundedly rational consumers evaluate products on one

randomly chosen dimension and buy the product that scores most highly on this dimension.

In this model, consumers would evaluate the products correctly if products were designed to be equally good on all dimensions. Spiegler shows that this will not happen, however. Essentially, firms randomize across dimensions making the product

very good on some dimensions and not so good on others.

Non-linear pricing: Paying not to go to the gym

Non-linear pricing: Paying not to go to the gym

DellaVigna, Malmendier (2005) Survey of all health clubs in Boston area

(100 clubs) Most common contract design:

monthly and annual fee & initiation feeno per-visit fee

Estimated marginal cost: $3-$6 + congestion costBelow-marginal-cost pricing of visit, p<C’

DellaVigna, Malmendier (2005) Survey of all health clubs in Boston area

(100 clubs) Most common contract design:

monthly and annual fee & initiation feeno per-visit fee

Estimated marginal cost: $3-$6 + congestion costBelow-marginal-cost pricing of visit, p<C’

Paying not to go to the gym pt 2

Paying not to go to the gym pt 2

Consumers are initially offered a two-part tariff upfront payment L and additional per visit charge p.

If consumers accept this offer, they learn the disutility d that they will incur if they visit the club, and then decide whether to visit costs p and gives a delayed benefit b.

two reasons why a health club will want to distort p away from marginal cost sophisticated rational consumers would like to commit

themselves to go to the health club more often naive rational consumers overestimate the number of

times that they will go to the club

Consumers are initially offered a two-part tariff upfront payment L and additional per visit charge p.

If consumers accept this offer, they learn the disutility d that they will incur if they visit the club, and then decide whether to visit costs p and gives a delayed benefit b.

two reasons why a health club will want to distort p away from marginal cost sophisticated rational consumers would like to commit

themselves to go to the health club more often naive rational consumers overestimate the number of

times that they will go to the club

GamblingGambling

Las Vegas hotels and restaurants:Price rooms and meals below cost, at

bonusHigh price on gambling (the house

always wins)Above marginal cost pricing of

addictive leisure goods, p>C’

Las Vegas hotels and restaurants:Price rooms and meals below cost, at

bonusHigh price on gambling (the house

always wins)Above marginal cost pricing of

addictive leisure goods, p>C’

Anchoring: Do workers know their disutility of

effort?

Anchoring: Do workers know their disutility of

effort? Ariely, Loewenstein and Prelec (2004) Asked subjects whether they would pay $2 to

attend a 15-minute poetry reading Asked other subjects whether they would attend

if they were paid $2. Later, asked whether they would attend for free.

Among those who were anchored on paying: 33%

Among those who were anchored on being paid: 8%

Ariely, Loewenstein and Prelec (2004) Asked subjects whether they would pay $2 to

attend a 15-minute poetry reading Asked other subjects whether they would attend

if they were paid $2. Later, asked whether they would attend for free.

Among those who were anchored on paying: 33%

Among those who were anchored on being paid: 8%

Shipping charges on ebayShipping charges on ebay

Hossain and Morgan (2006) conduct field experiments on eBay

find that auctioning goods with a high (but not too high) shipping charge raises more revenue than using an equivalent minimum bid and making shipping free.

Hossain and Morgan (2006) conduct field experiments on eBay

find that auctioning goods with a high (but not too high) shipping charge raises more revenue than using an equivalent minimum bid and making shipping free.

Do people perceive inflation correctly?Do people perceive inflation correctly?

Georganas, Healy and Li (2010) Present subjects with a basket of goods and instruct them

to buy a designated one each period Manipulate the speed and frequency of price changes

People underestimate inflation if cheap, frequently bought goods have low inflation

People overestimate inflation if such goods have high inflation This influences their consumption, saving, investment

decisions! Real life example: The introduction of the euro led to many

complaints of high inflation because of rounding etc Actually rounding hardly mattered, since 0.95 was

rounded to 1 (5% difference) but 999.5 just to 1000 (just 0.05% difference)

Georganas, Healy and Li (2010) Present subjects with a basket of goods and instruct them

to buy a designated one each period Manipulate the speed and frequency of price changes

People underestimate inflation if cheap, frequently bought goods have low inflation

People overestimate inflation if such goods have high inflation This influences their consumption, saving, investment

decisions! Real life example: The introduction of the euro led to many

complaints of high inflation because of rounding etc Actually rounding hardly mattered, since 0.95 was

rounded to 1 (5% difference) but 999.5 just to 1000 (just 0.05% difference)

What did we learn- Future?

What did we learn- Future?

IO models can be applied to the real world Sometimes they need some adjustments to account

for the way reality is different from our assumptions Consumers deviate from rationality in several

different, sometimes predictable ways Companies can best respond to that and/or also

deviate from fully rational behaviour

We have just begun scratching the surface There is a looooot of work to be done and

many things to find out… But you will only find out in grad school :)

IO models can be applied to the real world Sometimes they need some adjustments to account

for the way reality is different from our assumptions Consumers deviate from rationality in several

different, sometimes predictable ways Companies can best respond to that and/or also

deviate from fully rational behaviour

We have just begun scratching the surface There is a looooot of work to be done and

many things to find out… But you will only find out in grad school :)

Further readingFurther reading

U.Malmendier Lecure notes https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_malmendier_on_behavioral_economics_and_the_market.pdf

Excellent survey: G.Ellison http://econ-www.mit.edu/files/904 D.Ariely: Predictably irrational

U.Malmendier Lecure notes https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_malmendier_on_behavioral_economics_and_the_market.pdf

Excellent survey: G.Ellison http://econ-www.mit.edu/files/904 D.Ariely: Predictably irrational