Industrial Organization and Experimental Economics

1. Industrial Organization and Experimental Economics Huanren(Warren) Zhang

2. Why lab experiments? • Test theoretical prediction in controlled experiments • In the field all kinds of factors intertwined together, hard to pin down determinative factors • When without theories, observed regularities in lab experiments can help discover new theories

3. Two Papers to be Presented • I. Firm Behavior Transparency in Markets for Experience Goods (Bastian Henze and Florian Schuett) • II. Consumer Behavior Understanding Consumers' Choice of Pricing Schemes (Natalia Shestakova)

4. I. Transparency: Motivating Example • European lawmakers mandate disclosure of information on Internet Service Providers’ network management (increase transparency for an experience good) • Theory predicts firms will voluntarily disclose the information because producer surplus is higher when quality is observable.

5. Firm Behavior: Relevant Literature • (Shaked and Sutton, 1982): When quality is observable, firms are predicted to engage in vertical differentiation in order to relax price competition. • (Akerlof, 1970): When consumers cannot observe quality, firms will supply inefficiently low quality

6. So the authors want to… • Investigate the role of transparency in the market for an experience good using a lab experiment To do that, they • Vary the degree to which consumers are informed about quality (four different treatments) and compare the results

7. Model: • Two firms simultaneously choose a level of quality • Observing each other’s quality level, firms simultaneously post a price • consumers make purchase decision

8. Model • Firm ’s per-unit cost of providing quality is . • Consumer ’s utility function • Marginal value for quality is normally distributed over .

9. Four Treatments • no-info: none of the buyers observe the quality on offer • full-info: all buyers perfectly observe quality • subset: half of the buyers perfectly observes quality while the other half does not • signal: all buyers observe a signal about quality where is uniformly distributed on *

10. Parameters • Marginal cost of quality • Consumer’s taste distribution • Fixed component of consumer utility • Number of consumers • Support of signaling noise distribution * • Quality levels

11. Theoretical Prediction: Full Information • Solve the game backward: • Assume (without loss of generality) • Marginal consumer with taste for quality

12. Theoretical Prediction: Full Information • Suppose . Denote • Probability that prefers B is • Probability that prefers A is • Expected demand

13. Theoretical Prediction: Full Information • At the pricing stage, firm j solves • Bes responses:

14. Theoretical Prediction: Full Information • Solving for the Nash equilibrium prices

15. Theoretical Prediction: Full Information • Profit functions = =( Note: the high-quality firm’s profit is increasing in its own quality whatever its rival’s quality and the low-quality firm’s profit is decreasing in its own quality

16. Theoretical Prediction: Full Information • Two subgame perfect pure-strategy Nash equilibrium: • Firm A offers highest possible quality while firm B offers the lowest • Firm B offers highest possible quality while firm A offers the lowest • For the given parameters, the equilibria are and .

17. Theoretical Prediction: No information • Perfect Bayesian equilibrium (PBE): • players’ strategies must be optimal given beliefs • beliefs must be derived from equilibrium strategies using Bayes’ rule whenever possible.

18. Theoretical Prediction: No information • One pooling PBE: • Both firms choose the lowest quality and price at marginal cost . • Consumers believe the quality for the products on offer is at the lowest level • Consumers’ out-of-equilibrium beliefs: any firm choosing a different price also has the lowest quality.

19. Theoretical Prediction: No information • No theory has addressed whether there can be a signaling equilibrium when firms choose from a set of more than two possible levels of quality. • But it is unlikely that separation would remain an equilibrium when there are more than two levels of quality.

20. Theoretical Prediction: Subset • The literature has not analyzed the case of multiple quality levels. • The presence of informed consumers makes the existence of a separating equilibrium, where prices signal qualities, more likely. • The informed consumers exert a positive informational externality on uninformed consumers: creating a cost of mimicking high-quality firms.

21. Theoretical Prediction: Imperfect Signal • No theories exist dealing with the case of imperfect information about quality. • Intuitively we would expect a similar argument as in the subset treatment to apply, and the theoretical predictions for both treatments would be similar.

22. Experimental Design • 30 periods followed 2 practice periods • Subjects randomly assigned to be either a seller or a buyers, and the roles remain the same for the entire experiment • Each session has three groups of sellers and three groups of buyers. • With probability of 1/3, sellers are rematchedwith buyers in each period.

23. Experimental Design • Fully informed buyers (full-info and subset treatments) were played by the computer. • full-info: 4 sessions, 6 subjects each (12 automated buyers) • subset: 5 sessions, 12 subjects each (6 automated buyers) • no-info : 3 sessions, 18 subjects each • signal: 4 sessions, 18 subjects each

24. Results

25. Results

26. Results

27. Conclusion: Transparency • Firms do not differentiate quality under full information. • Under no information, quality is low. At the same time, firms manage to maintain prices substantially above marginal cost*. • In the subset and signal treatments, quality is significantly above the no-information level • Consumer’s surplus increases with the increase of quality transparency

28. II. Consumer Choice: Motivating Example • Suppose you consume 80 minutes/month, which plan will you choose?

29. Consumer Choice: Background • Traditional economics assumes people are rational (like a powerful calculating machine) • Experimental economics of individual behavior is closely related to behavioral economics • Behavioral economics claims that people’s rationality is bounded • Instead of calculating the optimal solution, people use heuristics (rules of thumb) to find a satisfactory solution

30. The Model • Pricing Scheme • Demand uniform distributed over • Consumer Problem

31. The Model: Illustration

32. “Expected Demand” Heuristic (EDH) • Instead of minimizing expected expenditure, where   is the expected demand. • Prediction EDH: following expected demand heuristic, consumers tend to choose the scheme with an expenditure function which is nonlinear over the demand range, even when this scheme is not first-best.

33. EDH: Illustration

34. Results

35. Results

36. Results • Result 1: n the 27 main experimental tasks, only 55.6% of choices are first-best. • Result 2: Expected demand heuristic is the best in predicting subjects’ choices. • Match heuristic gives reasonable prediction.

37. Conclusion: Consumer Choice • The “irrationalities” observed in experiments on individual decision-making gives rise to behavioral economics • People use heuristics to speed up the decision-making process, but this sometimes gives suboptimal solution

38. Final Comments • Experiments can test the predictive power of a theory in a controlled environment • When no relevant theories are available, experiments can give valuable empirical implication • Empirical regularities observed in lab experiments can help improve current theories or develop new theories