Spurious Complexity And Common Standards In Markets For Consumer Goods

EARIE 2008 Toulouse, September 4-6, 2008

Spurious complexity and common standards in markets for consumer goods Alexia Gaudeul and Robert Sugden

Outline of the presentation Spurious complexity and libertarian paternalism Some examples for illustration. A model of consumer choice. Individuated standard and common standard. Dynamics: towards a common standard. Conclusion.

Spurious complexity In industrial organisation: investigation of whether firms can exploit consumers’ cognitive limitations by adding spurious complexity to tariff structures (e.g. Ellison and Ellison, 2004; Ellison, 2005; Gabaix and Laibson, 2006; Spiegler, 2006). Typical conclusion: firms do have incentives to do this; results make markets less competitive. In some markets (e.g. domestic supply of electricity and gas in UK), competing suppliers sell exactly the same product, competing only on price. Yet tariffs are quite complex and consumers often fail to choose the lowest-cost supplier [Chris Wilson and Catherine Waddams, ‘Do consumers switch to the best suppliers?’, CCP, 2006].

Libertarian paternalism Libertarian paternalism (Sunstein and Thaler, 2003); ‘regulation for conservatives’ (Camerer, Issacharoff, Loewenstein, O’Donaghue and Rabin, 2003): Claim that people find it difficult to process complex choice problems. Result: consumers may fail to choose in their own best interests due to ‘uninformed preferences’. Recommendation: paternalistic regulation to simplify consumers’ choice problems, possibly by reducing the number of choices given to consumers.

The common standard effect These literatures neglect a countervailing force: the ‘common standard effect’. Consumers’ choices are made less complex if competing firms follow common conventions about tariff structures, package sizes, labelling, etc. Such conventions facilitate competition. But therefore: common standards signal that goods which meet them are likely to give good value for money. So, consumers can learn by experience to favour products which meet common standards. And this gives firms an incentive to follow common standards. There are therefore mechanisms at work in markets that favour the emergence and persistence of conventions which reduce choice complexity for consumers.

Examples You want to drive from Dover to London. Three filling stations: A charges £0.96 per litre, B charges £0.97 per litre, C charges £4.56 per gallon. Which one do you choose? You consume 530 kWh/month in electricity. You have a choice between three tariffs: A: fixed charge of £10/month and unit charge of £0.14/kWh B: fixed charge of £10/month and unit charge of £0.15/kWh C: fixed charge of £20/month and unit charge of £0.13/kWh. Which one do you choose?

A model n identical firms selling a homogeneous good, competing on price. Free entry. N identical consumers. Each wants either to buy a fixed quantity (1 unit) or not to buy at all. Firms choose their prices pi and their standard si. Consumer h receive signal rhi of the value of firm i’s offering: rhi=α+βvhi-pi+ehi vhi is the idiosyncratic value of the firm’s product for h. ehi is an error term due to the difficulty in evaluating firm i’s offering. If two firms i and j share a standard (si=sj), then the consumer knows which one obtains the highest utility (the sign of [βvhi-pi][βvhj-pj]).

Equilibrium with common standards If all firms use the same standard and β=0 £/quantity

AC

price = pC

Common standard equilibrium

AR

N/n

quantity

If all firms use the same standard, then consumers can compare their value in an accurate way. If β=0, then they always choose the firm with the lowest price  perfect competition, price=min(AC)=MC  few firms, low prices.

Equilibrium with individuated standards If all firms use different standards (Perloff and Salop, 1985).:

£/quantity

individuated standards equilibrium

AC price = pIS

MR N/n

AR

quantity

If all firms use different standards, then consumers have to choose between firms based on their signal  model of idiosyncratic differentiation, except the differentiation is spurious  price s.t. MR=MC  higher prices.

Dynamics Suppose β=0 (no idiosyncratic differentiation) Consumers are either naïve (don’t care about standards) or savvy (choose only among common standards). There are two sectors, one with firms that share a common standard (CS) and one with firms that share no standard (IS). In taking their decisions about price, firms take the distribution of savvy and naïve consumers, and of CS and IS firms as given. Firms can change sector from period to period. Consumers can change their decision rule from period to period.

Dynamics 1

In zone A, many naïve consumers  IS firms make positive profit and price higher than CS firms who make zero profit. In zone B, too few naïve consumers  high average costs  IS losses. In zone C, very low demand for IS firms  low MC  possibility that pIS>MC and yet pIS<min(AC)=pCS.

Proportion of CS firms

B πCS> πIS USavvy>UNaïve

C A

πCS> πIS USavvy
πCS< πIS USavvy>UNaïve

0

Proportion of savvy consumers

1

Conclusion Common Standard rule is transferrable from sector to sector across the economy and is evolutionarily stable. Adherence to common standard is an ‘honest’ signal of low prices, i.e. a firm cannot ‘fake’ adherence and set high prices. Need only for ‘light touch’ regulation to favour the emergence of a common standard in one industry. Then consumers who know to favour common standard from other industries will be sufficiently numerous to make the common standard sustainable. No need to enforce the standard or to intervene in its design.