Competition for Attention
Pedro Bordalo, Nicola Gennaioli, Andrei Shleifer
UCL Conference on
Behavioral IO and Consumer Protection,
October 2014
1 / 19
A Marketing View of Competition
I
Successful firms “frame” competition by focusing consumers’
attention on their best, differentiated attribute
Levitt 1983, Rangan and Bowman 1992, Mauborgne and Kim 2005
I
I
I
De-commoditized markets: consumers focus on quality. Firms
compete on and advertise quality
I
“pamper the consumer with a lot of services, bundled into a
unique package she is willing to pay extra for”
I
fashion goods, premium coffee, business class travel
Commoditized markets: consumers focus on price. Firms
compete on and advertise low prices
I
“products are perceived as homogeneous, and price is the
dominant buying criterion”
I
standard home goods, economy air travel
This view does not follow from standard economic models
2 / 19
Instability of Consumer Preferences
I
Lab evidence
I
I
I
Violations of IIA (e.g. decoy effects)
Context dependent Willingness to Pay (anchoring)
Field evidence:
I
I
Sales as discounts from fake “regular” prices
Large shifts in demand caused by price variations
(hard to explain with income effects)
I
Hastings and Shapiro (2013), Garret and Sobel (1997)
3 / 19
This Paper
I
Standard model where firms compete in quality and price
I
Assume that consumers are salient thinkers (BGS 2013)
I
I
Consumers focus on and overweight salient product attributes
I
Salient attribute is the attribute that is “most different” across
the goods in the choice set
I
Salient thinking accounts for lab and field evidence
Study the implications for market equilibrium
4 / 19
Preview of Results
I
Firms compete for consumers’ attention.
I
I
Two types of equilibria: quality-salient and price-salient.
I
I
I
Attention Externality: strategic positioning of one product
affects how the competitor’s product is perceived.
In quality-salient equilibria, consumers are too sensitive to
quality and quality can be over-provided.
In price-salient equilibria, consumers are too sensitive to price
and quality can be under-provided.
The cost structure determines salient attribute in equilibrium:
I
I
High average costs of quality → quality-salient equilibria
Change in costs leads to innovation
(commoditization and de-commoditization)
5 / 19
Setup: Firms
I
I
Two firms, 1 and 2. Each firm k = 1, 2:
I
produces a good with quality qk at a cost ck (qk ).
I
sets price pk ≥ ck (qk ).
Qualities and prices are set competitively in a two stage game:
I
in the first stage, each firm k makes costless commitment to
produce quality qk ∈ [0, +∞)
I
in the second stage, firms set optimal prices given quality (and
cost) committed to in first stage.
I
Qualities and prices are measured in utils and known to the
consumers.
6 / 19
Setup: Consumers
I
Measure 1 of identical consumers with unit demand.
I
Consumers inflate the weight associated to the attribute
perceived as salient in the choice context:

 qk − δpk if quality is salient
S
δq − pk if price is salient
u (qk , pk ) =
 k
qk − pk if equal salience
I
For δ = 1, consumers have standard preferences.
For δ < 1, consumers overweight the salient attribute
(we call them salient thinkers).
I
Salience of quality increases in percentage difference between
q1 and q2 . Similarly for salience of price.
7 / 19
The special role of the quality/price ratio
I
Let q1 ≥ q2 and p1 ≥ p2 (will hold in equilibrium).
I
The advantage of good 1 (Quality) is salient if :
p1
q1
>
q2
p2
I
q1
q2
>
p1
p2
The advantage of good 2 (Price) is salient if:
q1
p1
<
q2
p2
I
or
or
q2
q1
>
p2
p1
If good k has a higher quality-price ratio than k 0 :
I
good k’s advantage (quality or price) is salient for both goods
I
good k is overvalued relative to good k 0
8 / 19
Price Competition: rational benchmark
I
I
I
Firm k = 1, 2 produces given quality qk at given cost ck .
I
Assume q1 ≥ q2 , and c1 ≥ c2 .
I
Firms simultaneously set prices (at or above costs).
In the rational benchmark, firms set prices to extract surplus:
I
If qk − ck > qk 0 − ck 0 , firm k captures the market,
sets price pk = qk − (qk 0 − ck 0 ),
makes profit equal to differential surplus.
I
If q1 − c1 = q2 − c2 , no profits in equilibrium
(Bertrand competition).
With salient thinkers, firms set prices to draw consumers’
attention to their product’s advantage.
9 / 19
Salience and Competitive Pricing: Intuition
I
If firm k finds it profitable to produce, then the optimal price
pk at which it captures the market solves:
max
pk
pk − ck
s.t. u S (qk , pk ) ≥ u S (q−k , p−k ),
qk /pk ≥ q−k /p−k .
I
Cutting price pk :
I
increases consumer surplus from good k
I
boosts relative valuation of good k by making its advantage
salient
10 / 19
Equilibria with Salient Thinkers
To highlight the role of salience assume:
1
δ(c1 − c2 ) < q1 − q2 < (c1 − c2 )
δ
Then, pure strategy equilibria under price competition satisfy:
I
if qc11 > qc22 , then the high quality firm 1 captures the market,
makes positive profits and quality is salient.
I
if qc11 < qc22 , then the low quality firm 2 captures the market,
makes positive profits and price is salient.
I
if
q1
c1
=
q2
c2 ,
I
the firm delivering the highest (rational) surplus qk − ck
captures the market. Both firms make zero profits.
quality and price are equally salient.
11 / 19
Endogenous Quality
I
In stage 1 of the game, firm k = 1, 2 sets quality qk .
I
In stage 2, each firm sets optimal price given qk , ck (qk ).
I
Assume convex costs, ck (q) = vk (q) + Fk , s.t. v 00 (q) > 0.
I
Assume firm 1 has weakly lower costs:
0 < v1 (q) ≤ v2 (q), 0 < v10 (q) ≤ v20 (q) and 0 ≤ F1 ≤ F2
I
Rational benchmark: for firm k, it is (weakly) optimal to
maximize surplus qk − [vk (qk ) + F ] setting qk∗ s.t. vk0 (qk∗ ) = 1
12 / 19
Endogenous Quality with Salient Thinkers
I
Consider first the case in which firms have identical costs:
c1 (q) = c2 (q) = v (q) + F .
I
Focus on symmetric equilibria.
I
Suppose both firms are at the rational symmetric equilibrium
I
I
providing quality q ∗ where c 0 (q ∗ ) = 1.
We ask:
Does firm 1 have incentive to move away from surplus
maximizing quality q ∗ (assuming firm 2 does not respond)?
I
Generically, it does.
13 / 19
Endogenous Quality with Salience Thinkers: Intuition
I
Quality reduction: q 0 = q ∗ − ∆q at cost c 0 = c(q ∗ ) − ∆c
I
New product is successful iff its lower price is salient, namely
q∗
∆c
c(q ∗ )
q ∗ − ∆q
>
⇔
>
c(q ∗ ) − ∆c
c(q ∗ )
∆q
q∗
I
Quality increase: q 0 = q ∗ + ∆q at cost c 0 (q ∗ ) + ∆c
I
New product is successful iff its higher quality is salient, namely
q ∗ + ∆q
q∗
∆c
c(q ∗ )
>
⇔
<
c(q ∗ ) + ∆c
c(q ∗ )
∆q
q∗
I
Depending on the relationship between marginal and average
cost at the rational benchmark, salience creates incentives to
increase or reduce quality provision.
14 / 19
Equilibrium with Identical Firms
I
When c(q) = c · q 2 /2 + F ,

1/δc



 q
2F
qS =
c




δ/c
equilibrium quality provision is:
if
F >
if
F ∈
if
F <
1
2δ 2 c
h
δ2
1
2c , 2δ 2 c
i
δ2
2c
I
For δ < 1, provision of quality is inefficient, q S 6= 1/c.
I
Quality and price equally salient, goods are correctly valued.
Yet, unprofitable to deviate towards q ∗ .
I
Quality distortion depends on fixed cost F .
I
F low → low prices → small price differences can be salient
I
F high → high prices → small extra costs not salient
15 / 19
Innovation
Change in product characteristics in response to a cost shock
(starting from long run symmetric equilibrium).
Let firm 1 receive a beneficial shock to its marginal cost,
c1 < c2 = c
I
If c1 < c/2, firm 1 boosts its quality and price.
I
I
If c1 > c/2, boosting quality causes increase in cost that
cannot be met by a price increase, lest price become salient.
I
I
A drastic reduction in variable costs allows for a large and
salient quality upgrade, q1 > q S , so firm 1 captures the market.
If F < Fb , firm 1 keeps quality at q S and simply lowers price:
price competition among homogeneous goods!
Commodity magnet.
16 / 19
Application I: decommoditization of the coffee market
Provide a rationale for the rise in quality of certain consumer
products, such as premium coffee.
I
In the ’70s, the industry provided drip coffee at low prices
(e.g. neighborhood diner)
I
I
I
Our account:
I
I
I
I
Starbucks discovers how to boost quality (taste, consistency
and in-shop environment) at moderate higher costs.
Increases market share with higher quality and prices.
Industry locked in price-salient equilibrium with low operating
costs. Small innovations translate into price cuts (free refills).
Starbuck’s innovation drastically reduces variable cost c1 . Can
boost the quality of its product as well as its operating costs,
keeping the product’s quality salient.
By drawing consumers’ attention to the higher quality of its
product, Starbucks was able to charge much higher prices.
Generalised increase in taste for quality: decommoditization
17 / 19
Application II: Financial Innovation
Provide a rationale for investors’ reach for yield as new financial
assets are introduced.
I
Quality of financial asset is net return R, cost of financial asset
is risk v (given exogenously). Rational valuation is R − v .
I
I
I
Firms produce return out of risk and compete in fees.
Rational benchmark: zero fees.
Innovation: one firm reduces the extra risk necessary to
produce extra return, and can update its asset.
I
I
Successful if baseline level of returns is low: when investments
yield 1%, having an extra 0.5% is very salient, particularly
because risk increases less in % terms (due to innovation).
Investors focus on return and neglect extra risk. Risk taking is
excessive, and innovating firm makes excess profits. Innovation
can spread.
18 / 19
Open issues
I
Entry and dynamics of innovation.
I
I
Horizontal differentiation.
I
I
If incumbent firms are in price salient equilibria (with low
prices), salience hampers quality increasing innovations, while
it facilitates price reducing innovations.
Firms segment the market between consumers attracted to
different attributes, drawing attention away from price, thus
earning higher profits (political competition, or shrouded
attributes).
Advertising.
I
Purpose is to inform about, and draw attention to, the
products attributes the seller wants consumers to think about.
I
Simultaneously informative and persuasive.
19 / 19