Behavioral economics as applied to firms: A primer

Competition Policy International

Volumn 6, Issue 1, 2010, Pages 3-45

  Armstrong, Mark ^b   Huck, Steffen ^a  

^a UNIVERSITY COLLEGE LONDON   (United Kingdom)

^b NONE

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EID: 77951531595     PISSN: 15540189     EISSN: 15546853     Source Type: Journal    
DOI: None     Document Type: Article

References (150)

1. See Armstrong for a review of some of this literature and its implications for consumer protection policy, Mark Armstrong, Interactions Between Competition and Consumer Policy, COMPETITION POL'Y INT'L 4, 97-148 (2008).
2. See Spiegler for an account of economic models which assume profit-maximizing behavior by firms but bounded rationality on the part of consumers, RAN SPIEGLER, BOUNDED RATIONALITY AND INDUSTRIAL ORGANIZATION (in press).
3. As observed by Ellison, fifty years ago the focus was instead very much on non-optimizing behavior by firms rather than consumers, Glenn Ellison, Bounded Rationality in Industrial Organization, ADVANCES IN ECONOMICS AND ECONOMETRICS: THEORY AND APPLICATIONS, 145, (R. Blundell,W. Newey, & T. Persson, eds,) (2006).
4. The recent financial crisis may well have stemmed in part from a variety of behavioral biases of some of the banks' executives. For instance, some managers may have been over-optimistic about the risks they were taking in their lending strategies, and there may have been a herd mentality among some managers, who imitated apparently successful lending strategies and who may have felt there was "safety in numbers."
5. Hayek argued that a central merit of competitive markets, specifically price-taking behavior by consumers and firms, is that agents' strategies are then relatively simple. (Agents need to know only their endowments, preferences, and the market prices to optimize.) Frederick Hayek in The Use of Knowledge in Society, AMER. ECON. R. 35, 519-530 (1945), at §VI.
6. Gale & Sabourian argue that in oligopolistic markets, where optimal strategies may be extremely complex, if agents incur "complexity costs" when they pursue complex strategies then the outcome might be more competitive than the standard theory suggests. Douglas Gale & Hamid Sabourian, Complexity and Competition, ECONOMETRICA 73, 739-769 (2005).
7. The take-up of technological improvements in agriculture provides useful evidence. Ellison & Fudenberg quote a historian of the English agricultural revolution as writing "land tilled in very ancient ways lay next to fields in which crop rotations were followed." They report that the agricultural practices known as the "new husbandry" diffused through England and France at the rate of just one mile per year. Glenn Ellison & Drew Fudenberg, Rules of Thumb for Social Learning, J. POL. ECON. 101, 612-643 (1993).
8. A recent pair of papers by Goldfarb & Yang and Goldfarb & Xiao illustrate this. For instance, it appears that older and better-educated managers tended to enter markets with fewer competitors after the U.S. telecommunications market was deregulated in 1996. Avi Goldfarb & Botao Yang, Are All Managers Created Equal?, J. MARKETING RES. 46, 612-622 (2009);
9. Avi Goldfarb & Mo Xiao, Who Thinks About the Competition? Managerial Ability and Strategic Entry in US Local Telephone Markets, working paper University of Toronto (2010).
10. See Bertrand & Schoar for an empirical analysis of the importance of "manager fixed effects." For instance, they find that managers with an MBA tend to follow strategies that are more aggressive. They find that managers differ in their attitude to mergers, dividend policy, and cost-cutting policy. Marianne Bertrand & Antoinette Schoar, Managing with Style: The Effect of Managers on Firm Policies, Q. J. ECON. 118, 1169-1208 (2003).
11. Apparently, a proportion of wine producers in California do not care purely about the profit they generate, and instead enjoy producing high-quality, high-price wine. (Profit-maximizing wineries tend to offer lower quality wine.) See Fiona Scott Morton & Joel Podolny, Love or Money? The Effects of Owner Motivation in the California Wine Industry, J. INDUS. ECON. 50, 431-456 (2002).
12. An interesting example of this was seen in the Genzyme-Novazyme merger-to-monopoly which was approved by the FTC in 2004. This was a merger of two firms both engaged in R & D for treating a rare disease, where the prime danger from the merger was whether the discovery of a successful treatment would be delayed relative to the duopoly outcome. One factor in the decision was that the proposed CEO of the merged entity had two children with the disease, who may therefore not have wished to delay discovery. See the statement by the then FTC chairman Timothy Muris, available at www.ftc.gov/os/2004/01/ murisgenzymestmt.pdf.
13. MILTON FRIEDMAN, ESSAYS IN POSITIVE ECONOMICS, 22 (1953).
14. For further details, see Charles Holt, Industrial Organization: A Survey of Laboratory Research, THE HANDBOOK OF EXPERIMENTAL ECONOMICS, §3 (John Kagel & Alvin Roth eds.) (1995).
15. For a collection of papers discussing the use of experiments for competition policy, see EXPERIMENTS AND COMPETITION POLICY, (Jeroen Hinloopen & Hans-Theo Normann eds.) (2009).
16. For instance, see Douglas DeJong, Robert Forsythe, & Wilfred Uecker, A Note on the Use of Businessmen as Subjects in Sealed Offer Markets, J. ECON. BEHAVIOR AND ORG. 9, 87-100 (1988).
17. More recently, for an illustration of how competition agency practitioners behaved on average in a similar way to students in a particular regulatory decision problem, see Bruce Lyons, Gordon Menzies, & Daniel Zizzo, Professional Interpretation of the Standard of Proof: An Experimental Test on Merger Regulation, Centre for Competition Policy Working Paper 10-12 (2010).
18. Charles Plott, An Updated Review of Industrial Organization Applications of Experimental Methods, THE HANDBOOK OF INDUSTRIAL ORGANIZATION, Vol.II, at 1165, (Richard Schmalensee & Robert Willig eds.) (1989).
19. In much empirical work on naturally occurring markets, marginal costs are inferred from observed data such as prices by assuming firms maximize their profit. At the end of this paper we discuss the dangers of this method when firms might potentially not be optimizers. The fact that marginal costs are rarely directly observable makes it hard to perform tests of the profit-maximization hypothesis. Steven Levitt in Bagels and Donuts for Sale: A Case Study in Profit Maximization, mimeo (2008), is a rare example of such a test. He obtained data from a relatively "simple" firm which supplies bagels and donuts to businesses, and where marginal costs are known. He finds that the firm is extremely good at predicting demand for given prices, but apparently prices too low given the estimated demand elasticity. (Interestingly, the decision-maker for this firm is a well-trained economist, who has published in the Journal of Political Economy.)
20. For an account of the theory of collusion, assuming rational firms, see Marc Ivaldi, Bruno Jullien, Patrick Rey, Paul Seabright, & Jean Tirole, The Economics of Tacit Collusion, Report for DG Competition, European Commission, (2003).
21. For instance, in the case of Bertrand price competition and homogenous products, the fully collusive outcome can be sustained in an infinitely repeated interaction with n symmetric suppliers if the discount factor δ satisfies δ > 1 - 1/n. With reasonable choices for the discount factor and say, monthly price adjustment, collusion should be possible in oligopolies consisting of a hundred firms.
22. George Stigler, A Theory of Oligopoly, J. POL. ECON. 72, 44-61 (1964).
23. For instance, see Margaret Levenstein & Valerie Suslow, Cartel Bargaining and Monitoring: The Role of Information Sharing, THE PROS AND CONS OF INFORMATION SHARING (Mats Bergman ed.), (2006).
24. Some experiments randomly match subjects in each period, so that firms play against different rivals in each period. However, real markets do not frequently operate like this, and so we mainly focus on experiments where subjects interact repeatedly in the same groups.
25. For a brief survey, see Steffen Huck, Hans-Theo Normann, & Jorg Oechssler, Two are Few and Four are Many: Number Effects in Experimental Oligopolies, J. ECON. BEHAVIOR AND ORG. 53, 435-446 §§ 2 and 3 (2004).
26. Robert Feinberg & Thomas Husted, An Experimental Test of Discount Rate Effects on Collusive Behavior in Duopoly Markets, J. INDUS. ECON. 41, 153-160 (1993).
27. Feinberg argues that social welfare may sometimes be higher when firms' managers are relatively myopic or short-termist, perhaps because of high managerial turnover or the kinds of incentive schemes they are offered, since collusion thereby becomes harder to sustain. For the same reason, it seems plausible that shareholders who wish to achieve collusion would not wish to put in place a manager who was myopic or had hyperbolic time preferences. Robert Feinberg, In Defense of Corporate Myopia, MANAGERIAL AND DECISION ECON. 16, 205-210 (1995).
28. It might seem that this apparent falsification of rational play is not necessarily important in practice, as most real markets do not have a known "endpoint." Nevertheless, the unravelling argument applies even if the endpoint is uncertain, but it is known for sure that the interaction will have ceased by some date (e.g., if subjects in the laboratory do not believe that the experiment could possibly go on for more than a day, or if it is common knowledge that the world will have ended in 10 billion years).
29. Supra note 19.
30. As an aside, it is interesting in this regard to recall Robert Bork's assertion that any merger that left at least three rivals should be presumptively lawful. However, tacit collusion is not the only problem for concentrated markets; even the one-shot interaction could be insufficiently competitive when there are few firms. See ROBERT BORK, THE ANTITRUST PARADOX: A POLICY AT WAR WITH ITSELF (1978).
31. For instance, see Martin Dufwenberg & Uri Gneezy, Price Competition and Market Concentration: An Experimental Study, INT'L J. INDUS. ORG. 18, 7-22 (2000);
32. Michael Baye & John Morgan, Price Dispersion in the Lab and on the Internet: Theory and Evidence, RAND 35, 449-466 (2004);
33. and Jeroen Hinloopen & Adriaan Soetevent, Laboratory Evidence on the Effectiveness of Corporate Leniency Programs, RAND 39, 607-616 (2008).
34. Steffen Huck, Hans-Theo Normann, & Jorg Oechssler, Learning in Cournot Oligopoly: An Experiment, ECON. J. 109, C80-C95 (1999)
35. and Steffen Huck, Hans-Theo Normann, & Jorg Oechssler, Does Information About Competitors' Actions Increase or Decrease Competition in Experimental Oligopoly Markets?, INT'L J. INDUS. ORG. 18, 39-57 (2000).
36. Theo Offerman, Jan Potters, & Joep Sonnemans, Imitation and Belief Learning in an Oligopoly Experiment, REV. ECON. STUDIES 69, 973-997 (2002).
37. An interesting real-world experiment is reported in Svend Albaek, Peter Mollgaard, & Per Overgaard, Government-Assisted Oligopoly Coordination? A Concrete Case, J. INDUS. ECON. 45, 429-443 (1997). The Danish antitrust authority changed policy so that transaction prices in the concrete market were published, and subsequently the average prices rose significantly. The authors argue that the most plausible reason is that this enabled the firms to coordinate their prices at a high level. (Pubitemid 127344709)
38. Offerman et al., supra note 27, also investigated the case where rival outputs but not rival profits were reported, and found that the market was less competitive than when no firm-specific information was reported. It would be interesting in future work to see what happens when rival firms' profits (or even just the average profits achieved by firms) but not their actions were revealed. It is possible that firms with higher profits than average might keep their strategy unchanged, but firms who do poorly revise their strategies, in accordance with a model of satisficing behavior discussed in section V. Bigoni allows firms to choose the kinds of information they see (e.g., aggregate output of rivals, individual rival outputs, individual rival profits) when operating under a time constraint, see Maria Bigoni, Information and Learning in Oligopoly: An Experiment, mimeo, (2008).
39. Huck et al., (2000), supra note 26, find that when firms set prices rather than quantities, the revelation of firm-specific data reduces prices only slightly.
40. Jan Potters, Transparency About Past, Present and Future Conduct, EXPERIMENTS AND COMPETITION POLICY (Jeroen Hinloopen & Hans-Theo Normann eds.) (2009).
41. Ola Andersson & Erik Wengstrom, Do Antitrust Laws Facilitate Collusion? Experimental Evidence of Costly Communication in Duopolies, SCANDINAVIAN J. ECON. 109, 321-339 (2007).
42. Explicit collusion in naturally occurring markets appears to be feasible with large numbers of participants. For instance, in their study of 41 cartels in Europe, Levenstein & Suslow, supra note 17, find that 18 involved more than five firms.
43. Giancarlo Spagnolo, Divide et Impera: Optimal Leniency Programs, CEPR Discussion Paper 4840 (2004).
44. Massimo Motta & Michele Polo, Leniency Programs and Cartel Prosecution, INT'L J. INDUS. ORG. 21, 347-379 (2003).
45. Jose Apesteguia, Martin Dufwenberg, & Reinhard Selten, Blowing the Whistle, ECON. THEORY 31, 143-166 (2007).
46. Hinloopen & Soetevent, supra note 25.
47. Armen Alchian, Uncertainty, Evolution, and Economic Theory, J. POL. ECON. 57, 211-222, at 218, (1950).
48. For a model along these lines, see John Conlisk, Costly Optimizers Versus Cheap Imitators, J. ECON. BEHAVIOR AND ORG. 1, 275-293 (1980).
49. The situation is somewhat related to Grossman & Stiglitz's analysis of the incentives for investors to become better informed about the return of an uncertain asset: If all investors choose to be better informed, the asset's price reflects the information, and there is no need for any individual investor to become informed if there is a cost to doing so, Sanford Grossman & Joseph Stiglitz, Information and Competitive Price Systems, AMER. ECON. REV. 66, 246-253 (1976).
50. It is also related to Burdett & Judd's analysis of a consumer's incentive to search for a low price: If all consumers choose to search then the market is highly competitive, and there is no need for any individual consumer to search if there is a cost to doing so, Kenneth Burdett & Kenneth Judd, Equilibrium Price Dispersion, ECONOMETRICA 51, 955-969 (1983).
51. Banerjee & Bikhchandani, et al., consider a situation in which similar agents need to decide between two options (say, whether to adopt technology X or technology Y), and each agent has a private signal as to which option is better and can also observe the previous choices (but not the payoffs) made by other agents. (The order in which agents have to make their choice is pre-determined in these models.) Even if agents are completely rational, it is possible that they become locked into the wrong choice. For instance, if technology X is in fact superior, but by chance the first few agents have private signals which induce them to choose Y, then subsequent agents will infer that the superior action is likely to be Y despite their own private signals to the contrary. (If instead, agents could observe the private signals of the earlier adopters, this inefficient herding could not occur.) Abhijit Banerjee, A Simple Model of Herd Behavior, Q. J. ECON 107, 797-817 (1992),
52. and Sushil Bikhchandani, David Hirshleifer, & Ivo Welch, A Theory of Fads, Fashion, Custom, and Cultural Change as Information Cascades, J. POL. ECON. 100, 992-1026 (1992).
53. See Georg Weizsacker, Do We Follow Others When We Should? A Simple Test of Rational Expectations, AMER. ECON. REV. (forthcoming), for an analysis of data from several experiments on the Bikhchandani et al. model, Id .
54. David Scharfstein & Jeremy Stein, Herd Behavior and Investment, AMER. ECON. REV. 80, 465-479 (1990).
55. Id. at 466.
56. The authors (Id.) quote Keynes as writing: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." Tse & Tucker empirically investigate the timing of earnings warnings, and find that a manger is more likely to issue an earnings warning if a peer has done so in the previous days. They conclude that the data are better explained by managers attempting to maintain their reputations than by the impact of a common shock. Senyo Tse & Jennifer Wu Tucker, Within-Industry Timing of Earnings Warnings: Do Managers Herd? REV. OF ACCT. STUDIES (forthcoming).
57. It is important that firms experiment occasionally, otherwise the process will grind to a halt after one period when all firms imitate the most profitable firm in the first period (which is unlikely to have chosen the optimal price immediately), and then all prices are unchanged thereafter. An alternative framework is presented in Ellison & Fudenberg, supra note 4, §II where firms choose between one of two technologies, and the relative payoff from using one technology rather than the other is uncertain. If in any period firms choose the technology which performed best in the previous period, then the chosen technology will flip over time depending on which one happened to work best one period earlier. Thus, instead of converging to the consistent use of the superior technology, the outcome is merely that the better technology is used more frequently. The authors go on to investigate less naïve rules of thumb-where a firm conditions its choice on how many firms use that technology-which have superior efficiency properties. (The reason why market shares matter for firms is that they reveal information about the relative performance of the two technologies for more than just the single previous period.)
58. David Ridley analyzes a model in which a second firm sometimes decides to enter a market only if its rival has first entered, in order to save on the costs of acquiring its own market information. He provides some anecdotes about how competitors of McDonald's often locate near a new McDonald's franchise, and he quotes a manager of a coffee shop chain as saying: "The reason we want to open across the street from every Starbucks is they do a great job at finding good locations." David Ridley, Herding Versus Hotelling: Market Entry with Costly Information, J. ECON. AND MGMT. STRATEGY 17, 607-631 (2008).
59. Fernando Vega-Redondo, The Evolution of Walrasian Behavior, ECONOMETRICA 65, 375-384 (1997).
60. Mark Schaffer, Are Profit-Maximizers the Best Survivors?, J. ECON. BEHAVIOR AND ORG. 12, 29-45 (1989).
61. Karl Schlag proposes an alternative model of imitation which yields a contrasting long-run prediction. In Schlag's model, there are many distinct oligopolies, and a firm in one market imitates the best-performing firm in another oligopoly, not the best-performing rival in the same market (as in Vega- Redondo's model). The result of this alternative specification is that firms move towards the Cournot- Nash equilibrium rather than the perfectly competitive outcome. Karl Schlag, Why Imitate, and If So, How? A Boundedly Rational Approach to Multi-Armed Bandits, J. ECON. THEORY 78, 130-156 (1998),
62. and Karl Schlag, Which One Should I Imitate?, J. MATH. ECON. 31, 493-522 (1999).
63. See Jose Apesteguia, Steffen Huck, & Jorg Oechssler, Imitation: Theory and Experimental Evidence, J. ECON. THEORY 136, 217-235 (2007) for further discussion of the two approaches. In addition, Vega-Redondo's result that imitation leads to competitive outcomes does not necessarily hold when firms have longer memory. If, say, firms choose the most profitable action over the previous two periods, the Cournot equilibrium is then a stable outcome (although the perfectly competitive outcome remains stable as well).
64. See Carlos Alos-Ferrer, Cournot Versus Walras in Dynamic Oligopolies with Memory, INT'L J. INDUS. ORG. 22, 193-217 (2004).
65. See Paul Rhode & Mark Stegeman, Non-Nash Equilibria of Darwinian Dynamics with Application to Duopoly, INT'L J. INDUS. ORG. 19, 415-453 (2001) for more details.
66. See Yasuhito Tanaka, Stochastically Stable States in an Oligopoly with Differentiated Products: Equivalence of Price and Quantity Strategies, J. MATH. ECON. 34, 235-253 (2000) and Rhode & Stegeman Id. for a general argument. If firms are not symmetrically placed, then imitation may not tend towards competitive outcomes, nor is imitation equivalent to the maximization of relative profits.
67. See, Jose Apesteguia, Steffen Huck, Jorg Oechssler, & Simon Weidenholzer, Imitation and the Evolution of Walrasian Behavior: Theoretically Fragile but Behaviorally Robust, J. ECON. THEORY (forthcoming).
68. Burkhard Schipper, Imitators and Optimizers in Cournot Oligopoly, J. ECON. DYNAMICS AND CONTROL 33, 1981-1990 (2009).
69. See Peter Duersch, Jorg Oechssler, & Burkhard Schipper, Unbeatable Imitation, mimeo, (2009) for further details about how imitators do almost as well against even the smartest opponents in a wide class of games. The main kind of game where imitators do poorly is something like "rock-paper-scissors, " where a smart player can systematically trick the naïve imitator into always playing the wrong action. (These kinds of games do not seem common in market situations, however.)
70. Huck, Normann, & Oechssler (supra note 26);
71. Offerman, Potters, Sonnemans (supra note 27);
72. and Apesteguia, Huck, and Oechssler (supra note 49).
73. Huck et al., supra note 26.
74. Offerman et al., supra note 27 at 989.
75. Goel & Thakor propose a model in which merger waves can be caused by concerns for relative compensation by CEOs. If CEO compensation is based in part on firm size, then if one merger occurs which boosts that CEO's pay, other CEO feel envious and set about finding their own take-over targets. Anand Goel & Anjan Thakor, Do Envious CEOs Cause Merger Waves?, REV. FIN. STUDIES 23, 487- 517 (2010).
76. For instance, see Andrew Clark, Paul Frijters, & Michael Shields, Relative Income, Happiness, and Utility: An Explanation for the Easterlin Paradox and Other Puzzles, J. ECON. LIT. 46, 95-144 (2008).
77. Robert Gibbons & Kevin Murphy, Relative Performance Evaluation for Chief Executive Officers, INDUS. AND LABOR REL. REV. 43, 30-51 (1990).
78. John Vickers, Delegation and the Theory of the Firm, ECON. J. 95, 138-147, at 143, (1985).
79. The impact of making the firm wish to maximize relative profits is that the firm then behaves as the Stackelberg leader, even though both firms in fact choose quantities simultaneously. It is important that rivals observe the incentive scheme so that they know the firm's objective and can react to it accordingly.
80. Nolan Miller & Amit Pazgal, Relative Performance as a Strategic Commitment Mechanism, MANAGERIAL AND DECISION ECON. 23, 51-68 (2002).
81. Vicente Salas Fumas, Relative Performance Evaluation of Management, INT'L J. OF INDUS. ORG. 10, 473-489 (1992).
82. Carl Lundgren, Using Relative Profit Incentives to Prevent Collusion, REV. INDUS. ORG. 11, 533-550 (1996).
83. See Güth et al.'s path-breaking experiment and the many papers which followed,Werner Güth, Rolf Schmittberger, & Bernd Schwarze, An Experimental Analysis of Ultimatum Bargaining, J. ECON. BEHAVIOR AND ORG. 3, 367-388 (1982).
84. See Ernst Fehr & Klaus Schmidt, A Theory of Fairness, Competition, and Cooperation, Q. J. ECON. 114, 817-868, §IIIA (1999) for a review of this literature.
85. The proposer might offer a significant proportion of the prize to the responder because he is purely self-interested and is afraid of lower offers being rejected by spiteful responders, or because he cares directly for fair allocations and is willing to sacrifice some of the prize to achieve a more equitable outcome. A variant of the ultimatum game-the dictator game-can discriminate between these two hypotheses. The dictator game does not allow the responder to reject the offer. Experimental comparisons of the two games reveal that offers are considerably less generous (and often zero) in the dictator game than in the ultimatum game, suggesting that generosity on the part of many proposers is purely strategic. For more details, see Robert Forsythe, Joel Horowitz, N. E. Slavin, & Martin Sefton, Fairness in Simple Bargaining Experiments, GAMES AND ECON. BEHAVIOR 6, 347-369 (1994).
86. Steffen Huck,Wieland Muller, & Hans-Theo Normann, Stackelberg Beats Cournot: On Collusion and Efficiency in Experimental Markets, ECON. J. 111, 749-765 (2001).
87. Supra note 60.
88. Steffen Huck,Wieland Muller, & Hans-Theo Normann, Strategic Delegation in Experimental Markets, INT'L J. INDUS. ORG. 22, 561-574 (2004).
89. Supra note 62.
90. See Doruk Iris & Luis Santos-Pinto, Tacit Collusion Under Fairness and Reciprocity, mimeo, (2009), for a model along these lines. However, we are aware of no experimental test of this hypothesis.
91. For instance, if the ultimatum game is modified so that the proposer has first to run around a running track, or if the proposer is chosen by his performance in a general knowledge quiz, then the responder may feel that the proposer "owns" the initial stake, and so be more willing to accept a lower share of the prize.
92. See §§ IIIB and IIIC of Fehr & Schmidt (supra note 65) for further details and references.
93. See Levenstein & Suslow, supra note 17, and, especially, Christopher Leslie, Trust, Distrust and Antitrust, TEXAS L. REV. 82, 515-680 (2004), for further discussion of these points and illustrations of the role of trust and distrust in cartel stability.
94. William Page, The Gary Dinners and the Meaning of Concerted Action, SMU L. REV. 62, 597-619, at 608, (2009).
95. Joel Podolny & Fiona Scott Morton, Social Status, Entry and Predation: The Case of British Shipping Cartels 1879-1929, J. INDUS. ECON. 47, 41-67 (1999).
96. For instance, Gordon writes: The fear of bankruptcy and the even more widespread fear of temporary financial embarrassment are probably more powerful drives than the desire for the absolute maximum in profits. [-] Given the fog of uncertainty within which [the businessman] must operate, the limited number of variables his mind can juggle at one time, and his desire to play safe, it would not be at all surprising if he adopted a set of yardsticks that promised reasonably satisfactory profits, R. A. Gordon, Short-Period Price Determination in Theory and Practice, AMER. ECON. REV. 3, 265-280 at 271 (1948)
97. See also K.W. Rothschild, Price Theory and Oligopoly, ECON. J. 57, 299-320 1947) and Herbert Simon,A Behavioral Model of Rational Choice, Q. J. ECON. 69, 69, 118, 1955.
98. Simon makes a joke about those economists who believe that departures from the predictions of rational behavior do not matter if the predictions of the standard models are good enough: "economists who are zealous in insisting that economic agents maximize turn around and become satisficers when the evaluation of their own theories is concerned." Herbert Simon, Rational Decision Making in Business Organizations, AMER. ECON. REV. 69, 493-513, at 495, (1979).
99. Richard Cyert & James March, Organizational Factors in the Theory of Oligopoly, Q. J. ECON. 70, 44-64 (1956).
100. Steffen Huck, Kai Konrad,Wieland Muller, & Hans-Theo Normann, The Merger Paradox and Why Aspiration Levels Let it Fail in the Laboratory, ECON. J. 117, 1073-1095 (2007).
101. Stephen Salant, Sheldon Switzer, & Robert Reynolds, Losses from Horizontal Merger: The Effects of an Exogenous Change in Market Structure on Cournot-Nash Equilibrium, Q. J. ECON. 98, 185-199 (1983).
102. The prediction is typically reversed when firms have differentiated products and compete in prices. See Raymond Deneckere & Carl Davidson, Incentives to Form Coalitions with Bertrand Competition, RAND 16, 474-486 (1985).
103. Levin presents a related theoretical analysis of mergers in Cournot markets, in which he allows that a merged firm changes its behavior from a Cournot-Nash player to a Stackelberg player (among other possible behavioral changes), in which case a merger becomes profitable. Daniel Levin, Horizontal Mergers: The 50-Percent Benchmark, AMER. ECON. REV. 80, 1238-1245 (1990).
104. Huw Dixon, Keeping Up with the Jones's: Competition and the Evolution of Collusion, J. ECON. BEHAVIOR AND ORG. 43, 223-238 (2000),
105. and Jorg Oechssler, Cooperation as a Result of Learning with Aspiration Levels, J. ECON. BEHAVIOR AND ORG. 49, 405-409 (2002).
106. An alternative adjustment mechanism which does not require any information about rival actions or profits, or indeed about the demand and cost functions, but which may nevertheless lead again to collusive outcomes, is discussed by Huck, Normann, & Oechssler. They consider the rule of thumb: "If your last increase in output [or price] increased your profit, increase your output [or price] again; if your last increase in output [or price] decreased your profit, now decrease your output [or price]." They show that if firms are constrained to change their strategy at a fixed rate over time, then the market moves towards the collusive outcome. Steffen Huck, Hans-Theo Normann, & Jorg Oechssler, Through Trial & Error to Collusion, INT'L ECON. REV. 45, 205-224 (2004).
107. See Ellison (supra note 1 at 170-171). Note that if there are n firms instead of just two, the monopoly outcome can be implemented as an ε-equilibrium provided that ε > (n - 1)2/(16n2), and so with more firms it does become harder to sustain the monopoly outcome with satisficing behavior. Relatedly, approximately optimal behavior by firms can sustain tacit collusion when they interact only finitely often, at least for the early periods of the interaction. (In simple models, fully rational firms cannot sustain any collusion when they meet a known, finite number of times.) For further details, see Roy Radnor, Collusive Behavior in Non-Cooperative Epsilon-Equilibria of Oligopolies with Long but Finite Lives, J. ECON. THEORY 22, 136-154 (1980).
108. Baye & Norman, supra note 25.
109. For further details of this form of approximately optimal behaviour, see Richard McKelvey & Thomas Palfrey, Quantal Response Equilibria for Normal Form Games, GAMES AND ECON. BEHAVIOR 10, 6-38 (1995).
110. Renou & Schlag propose an alternative model for the Bertrand market, which is that firms are unsure about the rationality of their opponents, and a firm aims to minimize the maximum "regret" it experiences when competing with rivals. (A firm feels regret if it sets a price far below the minimum price of its rivals, since it could have made more profit with a higher price, and it feels regret if it sets a price above the minimum of its rivals' prices.) Using this model, they predict that firms set random prices, and expected profits are positive but decreasing with the number of competitors. They argue that the data reported in Baye & Morgan, supra note 25, conform well with their predictions. See, Ludovic Renou & Karl Schlag, Minimax Regret and Strategic Uncertainty, J. ECON. THEORY 145, 264-286 (2010).
111. For example, Svenson finds that 93 percent of respondents report that they are above the median in terms of driving ability. Ola Svenson, Are We All Less risky and More Skilful Than our Fellow Drivers?, ACTA PSYCHOLOGICA 47, 143-148 (1981).
112. For a persuasive account of how Adam Smith anticipated many of the central ideas of behavioral economics, see Nava Ashraf, Colin Camerer & George Loewenstein, Adam Smith, Behavioral Economist, J. ECON. PERSP. 19, 131-145 (2005).
113. See De Meza & Southey for empirical evidence and a model which predicts that entrepreneurs are more optimistic than the general population, David De Meza & Clive Southey, The Borrower's Curse: Optimism, Finance and Entrepreneurship, ECON. J. 106, 375-386 (1996).
114. Camerer & Lovallo document in an experimental study that excessive entry can be driven by over-confidence in own ability, Colin Camerer & Dan Lovallo, Overconfidence and Excess Entry: An Experimental Approach, AMER. ECON. REV. 89, 306-318 (1999).
115. See Tor for an extended discussion of behavioral economics and entry decisions, and the implications for competition policy, Avishalom Tor, The Fable of Entry: Bounded Rationality, Market Discipline, and Legal Policy, MICH. L. REV.101, 482-568 (2002).
116. Edward Lazear & Sherwin Rosen, Rank-Order Tournaments as Optimal Labor Contracts, J. POL. ECON. 89, 841-864 (1981).
117. For a model along these lines, see Anand Goel & Anjan Thakor, Rationality, Overconfidence and Leadership, mimeo, (2000).
118. Aviad Heifetz, Chris Shannon, & Yossi Spiegel, The Dynamic Evolution of Preferences, ECON. THEORY 32, 251-286 (2007).
119. Vickers, supra note 60.
120. See Florian Englmaier, A Strategic Rationale of Having Overoptimistic Managers, mimeo, (2007) for such a model. In a Cournot market, hiring a manager who is overoptimistic (say, about the scale of market demand) again confers strategic advantage to the firm, but if all firms do this they will all be worse off relative to the situation with unbiased managers.
121. Richard Roll, The Hubris Hypothesis of Corporate Takeovers, J. BUS. 59, 197-216 (1986).
122. Ulrike Malmendier & Geoffrey Tate, CEO Overconfidence and Corporate Investment, J. FIN. 60, 2661- 2700 (2005) and
123. Ulrike Malmendier & Geoffrey Tate, Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction, J. FIN. ECON. 89, 20-43 (2008).
124. This correlation between holding onto stock options and corporate behavior could also be due to the CEO's inside information. However, Malmendier & Tate argue that this is unlikely to be the explanation since the CEOs who hold onto their stock options do not gain money from doing so, Id.
125. For further discuss of this point, see Maurice Stucke, Am I a Price-Fixer? A Behavioral Economics Analysis of Cartels, mimeo, University of Tennessee College of Law (2010).
126. For more details, see Bradford De Long, Andrei Shleifer, Laurence Summers, & Robert Waldmann, The Survival of Noise Traders in Financial Markets, J. POL. ECON. 64, 703-738 (1991).
127. See Luo Hirshleifer & Guo Ying Luo, On the Survival of Overconfident Traders in a Competitive Securities Market, J. FIN. MARKETS 4, 73-84 (2001).
128. Albert Kyle & Albert Wang, Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test?, J. FIN. 52, 2073-2090 (1997).
129. Robert Hall & Charles Hitch, Price Theory and Business Behavior,
130. Nabil Al-Najjar, Sandeep Baliga, & David Besanko, Market Forces Meet Behavioral Biases: Cost Misallocation and Irrational Pricing, RAND 39, 214-237 (2008).
131. Theo Offerman & Jan Potters, Does Auctioning of Entry Licences Induce Collusion? An Experimental Study, R. ECON. STUDIES 73, 769-792 (2006).
132. 2 = 1/11, and costs are artificially boosted so as to raise equilibrium prices. In this example, prices rise by approximately 10 percent relative to the situation in which managers base their prices on the true marginal costs.
133. Al-Najjar et al., supra note 106, suppose that the oligopolists reach equilibrium prices via a myopic adjustment process, and this means that rivals do not need to observe the "bias" of the manager. In addition, they assume that each firm observes only its own profits and not the profits of its rivals, and are more likely to choose cost methodologies that are performed well for it in the past.
134. Jonathan Eaton & Gene Grossman, Optimal Trade and Industrial Policy Under Oligopoly, Q. J. ECON. 101, 383-406 (1986).
135. See Giacomo Bonanno & John Vickers, Vertical Separation, J. INDUS. ECON. 36, 257-265 (1988) for this model.
136. See David Kreps, Paul Milgrom, John Roberts, & Robert Wilson, Rational Cooperation in the Finitely Repeated Prisoners' Dilemma, J. ECON. THEORY 27, 245-252 (1982).
137. However, if the potential irrationality took a different form then collusion might not be sustained. For instance, if the irrational player has a strategy of always colluding, then a rational player's best response to this is always to defect (just as if she were playing against a rational agent).
138. See David Kreps & Robert Wilson, Reputation and Imperfect Information, J. ECON THEORY 27, 253-279 (1982).
139. Yun Joo Jung, John Kagel, & Dan Levin, On the Existence of Predatory pricing: An Experimental Study of Reputation and Entry Deterrence in the Chain-Store Game, RAND 25, 72-93 (1994).
140. Kenneth Rogoff, The Optimal Degree of Commitment to an Intermediate Monetary Target, Q. J. ECON. 100, 1169-1189 (1985).
141. THOMAS SCHELLING, THE STRATEGY OF CONFLICT, 142 (1960).
142. For more analysis of this and related points, see Christopher Leslie, Rationality Analysis in Antitrust, U. PA. L. REV. 158, 262-353 (2010).
143. However, as discussed in section III, the effect may be limited if rivals react punitively when one firm puts in place an aggressive manager or an incentive scheme which induces aggressive behavior by its manager.
144. John List, Does Market Experience Eliminate Market Anomalies? Q. J. ECON. 118, 41-71 (2003)
145. and John List, Neoclassical Theory Versus Prospect Theory: Evidence From the Marketplace, ECONOMETRICA 72, 615-625 (2004).
146. Huck et al., supra note 80.
147. HERBERT HOVENKAMP, THE ANTITRUST ENTERPRISE: PRINCIPLE AND EXECUTION, 134 (2005).
148. Leslie, supra note 118 at 269.
149. See also Leslie, supra note 118 at § III.F.
150. For instance, Armstrong & Vickers show how it can be optimal for a competition authority to permit only those mergers which do not harm consumers, even if society places equal weight on profit and consumer surplus. The reason is that a "consumer standard" affects the merger opportunities considered by firms, in a way which enhances total welfare. Mark Armstrong & John Vickers, A Model of Delegated Project Choice, ECONOMETRICA 78, 213-244 (2010).