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Essays in Behavioral Industrial Organization


This dissertation consists of three chapters on behavioral industrial organization.

The first chapter, titled "Deception under Competitive Intermediation," investigates the incentives of intermediaries - such as mortgage brokers, financial advisors, or insurance salespeople - to educate consumers who misperceive the value of products. Two types of firms sell products through competing common-agent intermediaries and pay commissions for sales. One sells a transparent product, while the other sells a deceptive product that has a hidden fee, quality, or risk. Each intermediary chooses which product to offer and whether or not to educate consumers about the hidden attribute. Each consumer visits a fixed number of intermediaries and buys at most one item. When consumers correctly anticipate the hidden attribute, intermediaries reveal it and commissions are competed away. When consumers misperceive the hidden attribute, however, intermediaries employ deception if and only if the degree of misperception is large. If deception occurs, intermediaries earn high commissions despite competition. Furthermore, because consumers ultimately bear the cost of such commissions, consumer welfare is lower when intermediaries can educate consumers than when they cannot. Deception is less likely to occur when consumers visit more intermediaries before making their purchase decisions. Conditional on deception, however, visiting more intermediaries further raises the level of commissions because deceptive firms need to give each intermediary a higher commission to maintain the deception. Regulating commissions - analogous to recent policies in the US mortgage industry as well as in the Australian and UK mutual-fund industries - can lead intermediaries to reveal all hidden attributes.

The second chapter, titled "Inferior Products and Profitable Deception" and co-authored with Paul Heidhues and Botond Kőszegi, analyzes conditions facilitating profitable deception in a simple model of a competitive retail market. Firms selling homogenous products set up-front prices that consumers understand and additional prices that naive consumers ignore unless revealed to them by a firm, where - to model especially financial products such as credit cards and mutual funds - we assume that there is a binding floor on the up-front prices. Our main results establish that "bad" products (those with lower social surplus than an alternative) tend to be more reliably profitable than "good" products. Specifically, (1) in a market with a single socially valuable product and sufficiently many firms, a deceptive equilibrium - in which firms hide additional prices - does not exist and firms make zero profits. But perversely, (2) if the product is socially wasteful, then a firm cannot profitably sell a transparent product, so there is no incentive to reveal the additional prices and hence a profitable deceptive equilibrium always exists. Furthermore, (3) in a market with multiple products, since a superior product both diverts sophisticated consumers and renders an inferior product socially wasteful in comparison, it guarantees that firms can profitably sell the inferior product by deceiving consumers.

The third chapter, titled "Exploitative Innovation" and co-authored with Paul Heidhues and Botond Kőszegi, studies innovation incentives in a simple model of a competitive retail market with naive consumers. Firms selling perfect substitutes play a game consisting of an innovation stage and a pricing stage. At the pricing stage, firms simultaneously set a transparent "up-front price" and an "additional price," and decide whether to shroud the additional price from naive consumers. To capture especially financial products such as banking services, credit cards, and mutual funds, we allow for a floor on the product's up-front price. At the preceding innovation stage, a firm can invest either in increasing the product's value (value-increasing innovation) or in increasing the maximum additional price (exploitative innovation). We show that if the price floor is not binding, the incentive for either kind of innovation equal the "appropriable part" of the innovation, implying similar incentives for exploitative and value-increasing innovations. If the price floor is binding, however, innovation incentives are often stronger for exploitative than for value-increasing innovations. Because learning ways to charge higher additional prices increases the profits from shrouding and thereby lowers the motive to unshroud, a firm may have strong incentives to make appropriable exploitative innovations, and even stronger incentives to make non-appropriable exploitative innovations. In contrast, the incentive to make non-appropriable value-increasing innovations is zero or negative, and even the incentive to make appropriable value-increasing innovations is strong only if the product is socially wasteful. These results help explain why firms in the financial industry have been willing to make innovations others could easily copy, and why these innovations often seem to have included exploitative features.

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