Behavioural Industrial
Organization
Sotiris Georganas
price
Supply
p*
Demand
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?
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)
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).
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Details of the double auction
(homogeneous goods)
 Each buyer i is paid according to Bi(xi)-∑pi where xi denotes the
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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…
 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?
 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!
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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)
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!
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
All 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?
Takeover game
 Two players
 The owner of a company
 A manager that wants to buy it
 Value 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*V
 How much do you offer?
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
Undercutting games
Guessing games
Level k model also
predicts aggregate
behaviour well in 2x2
games, 3x3 games,
auctions, hide-andseek games…
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?
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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
 …
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…)
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 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
 This leads to sales and sticky prices
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
cients
 Best firm should reveal, to attract clients
 But 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 2
 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. 3
 Gabaix and Laibson (2004) suggest a very simple
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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. 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.
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 fee
 no per-visit fee
 Estimated marginal cost: $3-$6 + congestion
cost
 Below-marginal-cost pricing of visit, p<C’
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
Gambling
 Las Vegas hotels and restaurants:
 Price rooms and meals below cost, at
bonus
 High 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?
 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 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.
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)
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 :)
Further reading
U.Malmendier Lecure notes
https://www.uzh.ch/isb//studium/courses07/pdf//3727_lecture2_m
almendier_on_behavioral_economics_and_the_market.pdf
 Excellent survey: G.Ellison http://econ-www.mit.edu/files/904
 D.Ariely: Predictably irrational
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