Behavioural Industrial Organization. Response by Vernon Smith. Introductory example: the first market experiment 3/16/2010. Sotiris Georganas.

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1 price Behavioural Industrial Organization Supply Sotiris Georganas p* Demand Introductory example: the first market experiment Chamberlin (JPE, 1948)conducted bilateral trading experiments with his graduate students at Harvard to prove the failure of the competitive model. 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) Response 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). 4 1

2 Details of the double auction (homogeneous goods) Each buyer iis paid according to B i (x i )- p i where xi denotes the number of goods bought and B i denotes the buyers utility from consuming x i goods. Each seller is paid according to p i -S i (x i ). 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. 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 B i (x i ) or S i (x i ) values. 5 6 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! 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 7 2

3 What is behavioral IO Traditional IO is based on Nash equilibrium Rational firms, rational consumers Consistent beliefs - best responses Behavioural IO Rational 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 Quantal response Right beliefs - no best response Levels of reasoning Best response - wrong beliefs Guessing game! N players, can say a number [0,100], winner is the person closest to ½ times the average number Undercutting game Results Guessing games Undercutting games Also predicts aggregate behaviour well in 2x2 games, 3x3 games, auctions, hide-and-seek games 3

4 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 auctions Banks 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 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 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 Why sales? pt2 Rotemberg (2005) - more complex fairnessbased model to account for firms occasional use of sales and for the stickiness of prices consumers have reciprocal preferences and punish firms discontiniously 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 regret This leads to sales and sticky prices 4

5 Information and obfuscation Milgrom (1981), Grossman (1981) -Best firm reveals, all others have to reveal Ellison and Ellison (2005) find differences btw theory and practice mattress 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. 2 Gabaix and Laibson (2004) suggest a very simple formalization Consumers have noisy estimates of the 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. 3 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 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 5

6 Shipping charges on ebay What did we learn- Future? 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. 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 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 loooootof work to be done and many things to find out But you will only find out in grad school :) 6