Competition and Consumer Confusion

David Laibson and Xavier Gabaix

No 663, Econometric Society 2004 North American Summer Meetings from Econometric Society

Abstract: In many markets consumer biases do not affect prices, since competition forces firms to price their products close to marginal cost; competition protects the consumer. We show that noisy consumer product evaluations undermine the force of competition, enabling firms to charge high mark-ups in equilibrium, even in highly competitive environments. We analyze markets in which rational firms sell goods to consumers who evaluate products with noise. Using results from extreme value theory, we show that competition generally has a remarkably weak impact on markups. For normally distributed evaluation noise, we show that markups are proportional to the inverse of the square root of log(n), where n is the number of competitors. In this setting, a highly competitive industry with n=1,000,000 firms will retain 1/3 of the markup of a highly concentrated industry with only n=10 competitors. When we make noise an endogenous variable, we find that firms choose excess noise by making their products inefficiently confusing. Moreover, competition exacerbates this effect: a higher degree of competition causes firms to choose even more excess complexity. Firms with lower intrinsic quality and higher production costs choose the most excess complexity. Educating consumers to reduce their evaluation noise would generate large welfare gains. But the gains accrue mostly to the consumer, so firms can't profitably educate consumers and steal them away from competitors. Finally, we introduce an econometric framework that measures bounded rationality and confusion in the marketplace

Keywords: bounded rationality; complexity; confusion; extreme value theory; discrete choice; profit; behavioral economics; behavioral industrial organization; mutual fund; industry; consumer protection (search for similar items in EconPapers)
JEL-codes: D00 D80 L00 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-cbe, nep-com, nep-dcm and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

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