Price and format competition with consumer confusion (a new paper with Alexia Gaudeul)

Imagine there are three firms in an industry. They sell a homogeneous product (say, internet access): the product of firm 1 is a perfect substitute of the products of firms 2 and 3. Imagine firms can compete only on price. How will the market share depend on the price the firms decide to set?

Now, you know the solution already. This is called a Bertrand triopoly, and it is as simple as it gets: the firms pricing lower gets the whole market. The firms equally divide the market between themselves only if they adopt the same price. Competition, absent collusion, should lead firms to undercut each other in a nasty price war, until all (extra)profit is lost and price are at marginal cost.

In the real world, we seldom observe price wars and prices falling to marginal cost. This might be due to outright collusion: the three firms have simply gotten into an agreement to sell at price X, period.  This happens all the time, but it is illegal in many a country, and it is not the only way firms have to avoid price wars.

One lever firms might use is to try to differentiate their product. When two products are different, other consideration than price might enter the picture. When differentiation fails – after all, internet access is not so different across firms – spurious differentiation steps in. Firms might convince consumers that the products are different, when indeed they are not. Think brands, advertisement, anything that might create consumer loyalty – i.e., the attachment of a consumer to a product. If consumers are loyal, to, say, Apple, inc., then price cuts by competitors hurt much less in terms of market share. Moreover, firms might confuse consumers. Introducing difficult-to-evaluate offers, muti-parts complex tariffs, etc… might create such confusion in the consumers that they tend to stick to one firm and be done with it.

Suppose loyalty can be measured in price units. That is, I am happy to buy from Apple even if it is more expensive than Samsung, but only up to a point. Let’s call this point ε. Then, price wars might still exist, but at a higher cost: firms have to undercut the competitor by more than ε to steal market share. The equilibrium in this case is more complicated, and it includes a cycle: firms undercut each other to get the whole market; but then, when they reach low prices, they can gain by pricing higher again and restricting the market to their own loyal customers. Then a new descending price war ensues.

But in such a market, firms face two choices and not just one. They can choose their price; but they can also choose whether to confuse consumers – creating a confusopoly – or make their product comparable with the competition. Imagine there is a share of consumers – we call them savvy – that is able to exploit comparability. They are, like all other consumer, confounded by the firms and subject to loyalty. At the same time, in case a firm chooses to make its product comparable with the competitors, they drop their loyalty altogether and compare the two products freely. They might even go one step further: they might realize that the very same choice of making one’s product comparable indicates willingness to compete directly on price, and this is a signal that lower prices are likely. The sub-market among firms that share the same standard and make their offers comparable (in the picture, the small circle of the chrome-like icon) is a simple Bertrand oligopoly, and prices there are therefore low: savvy consumers know this, and tend to shop among these firms, disregarding the incomparable products. The implications of the presence of such consumers on a confusopoly can be great. Strategies for firms are more complex – should I make my product comparable and undercut, or should I confuse and overprice?

In a recent paper with Alexia Gaudeul (find it here, here, or here) we investigate by means of a laboratory experiment what happens when firms must choose their price and whether to make their product comparable with the competitors or not, in markets with varying share of savvy consumers. We also vary what firms know about the action of competitors: in a full information setting, they know prices, profits, market shares; in a no information setting they just know their own price, shares and profits.

Results are in line with intuition – and reveal interesting insights for policy.

In the full information setting, firms are able to collude into choosing high prices and confusion. Avoiding to present comparable offers is used as a signal of the willingness to collude; moreover, punishment for broken collusion could be both visible and highly effective. This effect is less strong in no information treatments.

The presence of savvy consumers has positive effects for consumer welfare only in the no information treatments. When more consumers are savvy, firms competed more, to the benefit of both the savvy and the naive consumers. On the other hand, in full information treatments, the presence of savvy consumers leads, paradoxically, to worse outcomes for consumers. The punishment for deviation from collusion being higher, and monitoring easier, firms avoid competition much more as consumers become savvyer.

In a nutshell, clever consumers are not enough to avoid collusion and high prices. Consumer protection may therefore require some encouragement for firms to present prices and products in a common format. For example, firms may have to be required to provide some standard information to help consumers in comparing products, for example an index of energy efficiency for fridges and other appliances. Unit price information is already generally available or even mandated in supermarkets. Some standardization is also
present at the national level for presenting lending rates in terms of annual percentage rate of charge. There is however a lot of progress to be made for example in the automobile market, where fuel economy information is
often misleading and wrongly conveyed. Agreeing on common formats for measuring the performance and prices of different type of relatively undifferentiated products could therefore be a valuable extension to the efforts that have led to the progressive spread of the metric system for physical measurements

You can find the paper in SSRN here, or on IDEAS here and here. Comments welcome!

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