1. Behavioural Industrial Organization Sotiris Georganas

2. Supply Demand price p*

3. Basic markets – how do they work? G Does the simplistic demand-supply model make sense? G Is there actually a game behind it? G Will real people behave according to the theoretical predictions? G Does the simplistic demand-supply model make sense? G Is there actually a game behind it? G Will real people behave according to the theoretical predictions?

4. Introductory example: the first market experiment G Chamberlin (JPE, 1948) conducted bilateral trading experiments with his graduate students at Harvard G to illustrate how perfectly competitive equilibrium might not work G Subjects could each trade one unit of a good G Bilateral negotiations G Price higher than equilibrium 7 times, lower 39 times G He concluded G “… 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) G Chamberlin (JPE, 1948) conducted bilateral trading experiments with his graduate students at Harvard G to illustrate how perfectly competitive equilibrium might not work G Subjects could each trade one unit of a good G Bilateral negotiations G Price higher than equilibrium 7 times, lower 39 times G He concluded G “… 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)

5. 5 Response by Vernon Smith G Vernon Smith, a former Harvard student (and Nobel Prize laureate in 2002), changed Chamberlin’s trading institution in the following way: G Instead of having subjects circulate and make bilateral deals he used the oral double auction procedure. G He also implemented the method of “stationary replication”, which is a sequence of trading days with stationary demand and supply schedules. G “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). G Vernon Smith, a former Harvard student (and Nobel Prize laureate in 2002), changed Chamberlin’s trading institution in the following way: G Instead of having subjects circulate and make bilateral deals he used the oral double auction procedure. G He also implemented the method of “stationary replication”, which is a sequence of trading days with stationary demand and supply schedules. G “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).

6. 6 Details of the double auction (homogeneous goods) G Each buyer i is 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. G Each seller is paid according to ∑p i -S i (x i ). G There is a limited time for trading per “market day”. If trading ceases before the time limit is reached the “day” ends. G 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. G 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. G Each buyer i is 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. G Each seller is paid according to ∑p i -S i (x i ). G There is a limited time for trading per “market day”. If trading ceases before the time limit is reached the “day” ends. G 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. G 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.

7. 7 Details… G 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. G If a bid (offer) is accepted a binding contract is concluded. G In general, individuals only know their own B i (x i ) or S i (x i ) values. G 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. G If a bid (offer) is accepted a binding contract is concluded. G In general, individuals only know their own B i (x i ) or S i (x i ) values.

8. 8 Is the outcome in the DA obvious? G Demand and supply change during a trading period. G 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. G There is no rigorous game theoretic prediction. G No well defined game! G Demand and supply change during a trading period. G 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. G There is no rigorous game theoretic prediction. G No well defined game!

9. Intro example 2: Cournot Mergers G N<5 firms in market - merger between two makes them suffer and outsiders gain! G “Merger paradox” G Intuition? G Merger beneficial if outsiders did not change production G Optimal response of merged firm to unchanged behaviour of others : lower output G But optimal output of others rises => further drop in optimal output of the new firm! G In new equilibrium industry profits rise. But market share of merged firm drops from 2/n to 1/(n-1) G N<5 firms in market - merger between two makes them suffer and outsiders gain! G “Merger paradox” G Intuition? G Merger beneficial if outsiders did not change production G Optimal response of merged firm to unchanged behaviour of others : lower output G But optimal output of others rises => further drop in optimal output of the new firm! G In new equilibrium industry profits rise. But market share of merged firm drops from 2/n to 1/(n-1)

10. Huck et al (2007) lab study of mergers G Linear demand G 4->3, 3->2 G Total output close to theory G However, individual outputs different G Merged firms produce more than unmerged G Unmerged firms best respond to that G Mergers in larger market weakly profitable! G Linear demand G 4->3, 3->2 G Total output close to theory G However, individual outputs different G Merged firms produce more than unmerged G Unmerged firms best respond to that G Mergers in larger market weakly profitable!

11. Now what? The state of experimental-behavioral economics G Over time we have gathered a wealth of evidence regarding deviations from Nash equilibria in many different games G The number of experimental papers has grown exponentially G Recording deviations is not enough, we have to explain them G Modern economic theory is interested in incorporating the insights gained from that process to improve models G Over time we have gathered a wealth of evidence regarding deviations from Nash equilibria in many different games G The number of experimental papers has grown exponentially G Recording deviations is not enough, we have to explain them G Modern economic theory is interested in incorporating the insights gained from that process to improve models

12. All pay auction G N bidders G You pay your bid independently of winning or not G Let’s try it! G How did you play? Is that an equilibrium? G Insight actually used to make real money (swoopo and other penny auctions sites) G How is this similar to a patent race? G N bidders G You pay your bid independently of winning or not G Let’s try it! G How did you play? Is that an equilibrium? G Insight actually used to make real money (swoopo and other penny auctions sites) G How is this similar to a patent race?

13. Takeover game G Two players G The owner of a company G A manager that wants to buy it G Value to owner V is unknown to manager, but distribution uniform in the set {0,15,30,45,60,75,90} G Value to manager is 1.5*V G How much do you offer? G Two players G The owner of a company G A manager that wants to buy it G Value to owner V is unknown to manager, but distribution uniform in the set {0,15,30,45,60,75,90} G Value to manager is 1.5*V G How much do you offer?

14. What is behavioral IO G Traditional IO is based on Nash equilibrium G Rational firms, rational consumers G Consistent beliefs - best responses G Behavioural IO G Rational firms best responding to irrational consumers? G Irrational firms - no best responses? G Rational firms with wrong beliefs? Rational consumers with wrong beliefs? G Traditional IO is based on Nash equilibrium G Rational firms, rational consumers G Consistent beliefs - best responses G Behavioural IO G Rational firms best responding to irrational consumers? G Irrational firms - no best responses? G Rational firms with wrong beliefs? Rational consumers with wrong beliefs?

15. Common deviations from “rationality” - bounded rationality G Quantal response G Right beliefs - no best response G Levels of reasoning G Best response - wrong beliefs G Guessing game! G N players, can say a number [0,100], winner is the person closest to ½ times the average number G Quantal response G Right beliefs - no best response G Levels of reasoning G Best response - wrong beliefs G Guessing game! G N players, can say a number [0,100], winner is the person closest to ½ times the average number

16. Undercutting game

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

18. Using models of bounded rationality G QRE can explain behavior in all pay auctions G Overbidding as we saw in lecture G Level k can explain the experience of the ECB with liquidity auctions G Banks demand liquidity – ECB supplies, if total demand lower than supply there is a proportional rationing rule G Nash equilibrium if supply<demand: demand infinity! G What actually happened? G QRE can explain behavior in all pay auctions G Overbidding as we saw in lecture G Level k can explain the experience of the ECB with liquidity auctions G Banks demand liquidity – ECB supplies, if total demand lower than supply there is a proportional rationing rule G Nash equilibrium if supply<demand: demand infinity! G What actually happened?

19. Common deviations from “rationality” - psychological traits G Loss aversion G A poker player does not remember his big gains, but always remembers his big losses (Matt Damon in Rounders) G Inequity aversion G Regret minimization G Hyperbolic discounting G Discounting day 2 payoffs in day 1 stronger than day 12 payoffs in day 11 G Inertia - Nudges G Sunk cost- and other fallacies G Example: all pay auction G … G Loss aversion G A poker player does not remember his big gains, but always remembers his big losses (Matt Damon in Rounders) G Inequity aversion G Regret minimization G Hyperbolic discounting G Discounting day 2 payoffs in day 1 stronger than day 12 payoffs in day 11 G Inertia - Nudges G Sunk cost- and other fallacies G Example: all pay auction G …

20. Are these behavioral traits useful in the real world? G Stakes G replications in poor countries with payoffs comparable to monthly wages G – Learning G … repetition, experience G But many games played by non experts! G – Interaction with rational agents (product markets) … G Behavioral IO: firms may exacerbate rather than eliminate biases. G – Sample too narrow G replications with many populations (professionals, game theorists, chess players…) G Stakes G replications in poor countries with payoffs comparable to monthly wages G – Learning G … repetition, experience G But many games played by non experts! G – Interaction with rational agents (product markets) … G Behavioral IO: firms may exacerbate rather than eliminate biases. G – Sample too narrow G replications with many populations (professionals, game theorists, chess players…)

21. Using psychological traits: Why sales? G Kahnemann, Knetsch, and Thaler (1986) proposed that sales might have an irrational origin. G Survey: many subjects say that it is unfair for firms to raise prices when demand goes up G Firms have incentive to hold sales rather than reducing regular prices G 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 G Kahnemann, Knetsch, and Thaler (1986) proposed that sales might have an irrational origin. G Survey: many subjects say that it is unfair for firms to raise prices when demand goes up G Firms have incentive to hold sales rather than reducing regular prices G 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

22. 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 regret G This 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 regret G This leads to sales and sticky prices

23. Information and obfuscation G Milgrom (1981), Grossman (1981) – Information disclosure G Should you reveal relevant information to other players? G E.g. about the quality of your product to your cients G Best firm should reveal, to attract clients G But then, the next best firm should also reveal, else buyers would assume it is just an average quality firm G Unravelling- all others have to reveal! G Milgrom (1981), Grossman (1981) – Information disclosure G Should you reveal relevant information to other players? G E.g. about the quality of your product to your cients G Best firm should reveal, to attract clients G But then, the next best firm should also reveal, else buyers would assume it is just an average quality firm G Unravelling- all others have to reveal!

24. Information and obfuscation pt 2 G Ellison and Ellison (2005) find differences btw theory and practice G 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. G Ellison and Ellison (2005) find differences btw theory and practice G 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.

25. Ιnformation and obfuscation: pt. 3 G Gabaix and Laibson (2004) suggest a very simple formalization G 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 G Firms will invest in obfuscation just as they invest in differentation to raise markups. G Gabaix and Laibson (2004) suggest a very simple formalization G 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 G Firms will invest in obfuscation just as they invest in differentation to raise markups.

26. Information and obfuscation: pt. 4 G Spiegler (2006) discusses another rule-of-thumb model G Products inherently have a large number of dimensions. G Boundedly rational consumers evaluate products on one randomly chosen dimension and buy the product that scores most highly on this dimension. G 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. G Essentially, firms randomize across dimensions making the product very good on some dimensions and not so good on others. G Spiegler (2006) discusses another rule-of-thumb model G Products inherently have a large number of dimensions. G Boundedly rational consumers evaluate products on one randomly chosen dimension and buy the product that scores most highly on this dimension. G 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. G Essentially, firms randomize across dimensions making the product very good on some dimensions and not so good on others.

27. Non-linear pricing: Paying not to go to the gym G DellaVigna, Malmendier (2005) G Survey of all health clubs in Boston area (100 clubs) G Most common contract design: G monthly and annual fee & initiation fee G no per-visit fee G Estimated marginal cost: $3-$6 + congestion cost G Below-marginal-cost pricing of visit, p<C’ G DellaVigna, Malmendier (2005) G Survey of all health clubs in Boston area (100 clubs) G Most common contract design: G monthly and annual fee & initiation fee G no per-visit fee G Estimated marginal cost: $3-$6 + congestion cost G Below-marginal-cost pricing of visit, p<C’

28. Paying not to go to the gym pt 2 G Consumers are initially offered a two-part tariff G upfront payment L and additional per visit charge p. G 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 G costs p and gives a delayed benefit b. G two reasons why a health club will want to distort p away from marginal cost G 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 G Consumers are initially offered a two-part tariff G upfront payment L and additional per visit charge p. G 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 G costs p and gives a delayed benefit b. G two reasons why a health club will want to distort p away from marginal cost G 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

29. Gambling G Las Vegas hotels and restaurants: G Price rooms and meals below cost, at bonus G High price on gambling (the house always wins) G Above marginal cost pricing of addictive leisure goods, p>C’ G Las Vegas hotels and restaurants: G Price rooms and meals below cost, at bonus G High price on gambling (the house always wins) G Above marginal cost pricing of addictive leisure goods, p>C’

30. Anchoring: Do workers know their disutility of effort? G Ariely, Loewenstein and Prelec (2004) G Asked subjects whether they would pay $2 to attend a 15-minute poetry reading G Asked other subjects whether they would attend if they were paid $2. G Later, asked whether they would attend for free. G Among those who were anchored on paying: 33% G Among those who were anchored on being paid: 8% G Ariely, Loewenstein and Prelec (2004) G Asked subjects whether they would pay $2 to attend a 15-minute poetry reading G Asked other subjects whether they would attend if they were paid $2. G Later, asked whether they would attend for free. G Among those who were anchored on paying: 33% G Among those who were anchored on being paid: 8%

31. Shipping charges on ebay G 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. G 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.

32. Do people perceive inflation correctly? G Georganas, Healy and Li (2010) G Present subjects with a basket of goods and instruct them to buy a designated one each period G Manipulate the speed and frequency of price changes G People underestimate inflation if cheap, frequently bought goods have low inflation G People overestimate inflation if such goods have high inflation G This influences their consumption, saving, investment decisions! G Real life example: The introduction of the euro led to many complaints of high inflation because of rounding etc G Actually rounding hardly mattered, since 0.95 was rounded to 1 (5% difference) but 999.5 just to 1000 (just 0.05% difference) G Georganas, Healy and Li (2010) G Present subjects with a basket of goods and instruct them to buy a designated one each period G Manipulate the speed and frequency of price changes G People underestimate inflation if cheap, frequently bought goods have low inflation G People overestimate inflation if such goods have high inflation G This influences their consumption, saving, investment decisions! G Real life example: The introduction of the euro led to many complaints of high inflation because of rounding etc G Actually rounding hardly mattered, since 0.95 was rounded to 1 (5% difference) but 999.5 just to 1000 (just 0.05% difference)

33. What did we learn- Future? G IO models can be applied to the real world G Sometimes they need some adjustments to account for the way reality is different from our assumptions G Consumers deviate from rationality in several different, sometimes predictable ways G Companies can best respond to that and/or also deviate from fully rational behaviour G We have just begun scratching the surface G There is a looooot of work to be done and many things to find out… G But you will only find out in grad school :) G IO models can be applied to the real world G Sometimes they need some adjustments to account for the way reality is different from our assumptions G Consumers deviate from rationality in several different, sometimes predictable ways G Companies can best respond to that and/or also deviate from fully rational behaviour G We have just begun scratching the surface G There is a looooot of work to be done and many things to find out… G But you will only find out in grad school :)

34. Further reading G U.Malmendier Lecure notes https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_m almendier_on_behavioral_economics_and_the_market.pdf https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_m almendier_on_behavioral_economics_and_the_market.pdf G Excellent survey: G.Ellison http://econ-www.mit.edu/files/904http://econ-www.mit.edu/files/904 G D.Ariely: Predictably irrational G U.Malmendier Lecure notes https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_m almendier_on_behavioral_economics_and_the_market.pdf https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_m almendier_on_behavioral_economics_and_the_market.pdf G Excellent survey: G.Ellison http://econ-www.mit.edu/files/904http://econ-www.mit.edu/files/904 G D.Ariely: Predictably irrational