Industrial Organization and Experimental Economics

Huanren(Warren) Zhang

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

Two Papers to be Presented

I. Firm BehaviorTransparency in Markets for Experience Goods (Bastian Henze and Florian Schuett)

II. Consumer BehaviorUnderstanding Consumers' Choice of Pricing Schemes (Natalia Shestakova)

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.

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

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

Model:

1. Two firms simultaneously choose a level of quality

2. Observing each other’s quality level, firms simultaneously post a price

3. consumers make purchase decision

Model

Firm ’s per-unit cost of providing quality is .

Consumer ’s utility function

Marginal value for quality is normally distributed over .

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 *

Parameters

Marginal cost of quality Consumer’s taste distribution Fixed component of consumer utility Number of consumers Support of signaling noise distribution

* Quality levels

Theoretical Prediction: Full Information Solve the game backward: Assume (without loss of generality)

Marginal consumer with taste for quality

Theoretical Prediction: Full Information

Suppose . Denote Probability that prefers B is Probability that prefers A is Expected demand

Theoretical Prediction: Full Information

At the pricing stage, firm j solves

Bes responses:

Theoretical Prediction: Full Information

Solving for the Nash equilibrium prices

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

Theoretical Prediction: Full Information Two subgame perfect pure-strategy

Nash equilibrium: 1. Firm A offers highest possible quality

while firm B offers the lowest2. Firm B offers highest possible quality

while firm A offers the lowest For the given parameters, the

equilibria are and .

Theoretical Prediction: No information

Perfect Bayesian equilibrium (PBE): 1. players’ strategies must be optimal

given beliefs2. beliefs must be derived from

equilibrium strategies using Bayes’ rule whenever possible.

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.

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.

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.

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.

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 rematched with buyers in each period.

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

Results

Results

Results

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

II. Consumer Choice: Motivating Example

Suppose you consume 80 minutes/month, which plan will you choose?

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

The Model

Pricing Scheme

Demand uniform distributed over Consumer Problem

The Model: Illustration

“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.

EDH: Illustration

Results

Results

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.

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

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