17-May-11] Behavioral Economics and Dynamic Competition 37
Draft
Behavioral Economics and Dynamic Competition
Maurice E. Stucke[*]
Introduction
Antitrust’s concept of competition assumes rational market participants with willpower who pursue their self-interest. This Article first examines how our conception of competition alters when this assumption is relaxed to reflect bounded rational market participants with imperfect willpower and bounded self-interest. Part II examines two implications of this dynamic theory of competition on antitrust’s monopolization law, namely herding and behavioral learning as entry barriers and second a monopolist’s exploitation of biases to illegally maintain its monopoly.
I. Theory of Competition with Bounded Rational Firms and Consumers
Before addressing the implications of behavioral economics on antitrust’s monopolization standard, it is helpful to quickly sketch how behavioral economics can inform our conception of competition. The prevailing assumption underlying today’s antitrust policy is that firms, consumers, and the government are rational. As I discuss elsewhere,[1] our theory of competition changes when one relaxes the assumption of rational firms, consumers, and government. My aim here is summarize Scenario IV competition, whereby both firms and consumers are bounded rational.[2]
Under Scenario IV competition, biases and heuristics are systemic. At closer inspection, competition under Scenario IV is better viewed as a discovery process than a stable equilibrium. Bounded rational firms have imperfect knowledge about current and future consumer preferences, a blurred and changing understanding of their goals and preferences, and a limited repertoire of actions to cope with whatever problems they face.[3] Bounded rational consumers have changing and, at times, inconsistent preferences.[4]
Thus, under a behavioral lens, competition is more fully understood as an “evolutionary trial and error process, in which the firms try out different problem solutions and can learn from the feedback of the market, which of their specific products and technological solutions are the superior ones.”[5] Rather than an end-state capable of being perfected, competition is a continuous process “in which previously unknown knowledge is generated,” and “the multiplicity and diversity of the (parallel trials of the) firms might be crucial for the effectiveness of competition as a discovery procedure.”[6] Firms and consumers make mistakes, readjust, and undertake new strategies. The competitive process “is inherently a process of trial and error with no stable end-state considered by the participants in the process.”[7]
Scenario IV involves several important competitive dimensions beyond price. One facet of competition is the extent to which bounded rational firms debias themselves to provide a competitive advantage.[8] The corporate literature describes firms being overconfident about a merger’s likely efficiencies,[9] overvaluing the purchased assets,[10] being overly confident or pessimistic about their chances of entering particular markets,[11] and consistent with the sunk cost fallacy throwing good money after bad in corporate projects.[12] Even though firms are bounded rational, it does not follow that their heuristics and biases are of the same nature and to the same degree.[13] Accordingly, firms can implement mechanisms to debias their outlooks and decision-making. Firms with significant free cash flow can seek advice from outside advisors to evaluate prospective mergers to ensure the senior managers are not overconfident or optimistic on the potential efficiencies.[14] As the management consulting firm McKinsey & Company summarized,
First, managers can become more aware of how biases can affect their own decision making and then endeavor to counter those biases. Second, companies can better avoid distortions and deceptions by reviewing the way they make decisions and embedding safeguards into their formal decision-making processes and corporate culture.[15]
One effective mechanism for firms to identify biases and take preventive measures is through “frequent, rapid, and unambiguous feedback.”[16] Accordingly, an important competitive dimension is providing firms (like consumers) the incentive to improve feedback mechanisms and ultimately their decision-making and willpower.[17]
With bounded rational firms with imperfect information, a second important dimension of competition is the ways in which companies learn, accomplish tasks, and deal with the uncertainty, which again can vary across firms.[18] Rather than incur costs to continually process information anew, bounded rational firms (like consumers) can use rules-of-thumb (heuristics). Firms with better routines/rules-of-thumb can lower their information processing and decision-making costs to gain a competitive advantage.
While providing at times a competitive advantage, corporate routines can also disadvantage firms competitively. Bounded rational firms face the risk of competency traps, whereby they become wedded to existing routines, which as industry conditions change, place the firms at a competitive disadvantage.[19] One CEO recently observed the paradox: “in a creative company, you want to give as much variability as possible, and yet in a manufacturing process you want as little variability as possible.”[20] Under Scenario IV, “[i]n some sense knowledge depreciates in value over time.”[21] So another important dimension of competition is adaptive efficiency,[22] whereby bounded rational firms update routines to reflect consumers’ changing preferences.[23] Rational choice theory often views suspiciously a strong incumbent firm that seeks to acquire a maverick firm with a new technology or business model.[24] But in the business literature, a firm may acquire a maverick with a disruptive business model or technology to better adapt and compete.[25]
A third important dimension of Scenario IV competition is the importance of scale, openness, randomness, and connectivity. Innovation, as Steven Johnson recently wrote, occurs mostly in the adjacent possible, namely iterative advances leading from one innovation to an improvement in the adjoining space: “Environments that block or limit those new combinations–by punishing experimentation, by obscuring certain branches of possibility, by making the current state so satisfying that no one bothers to explore the edges—will, on average, generate and circulate fewer innovations than environments that encourage exploration.”[26] Networks, and as discussed below network effects, are playing a greater role across industries. Firms can learn and adapt more quickly through the Internet’s social network technologies. Firms are also developing internal networks to better interact with employees and disperse information and ideas. Some firms are fully networked, combining both external and internal networks. One recent survey of 3,249 executives found significant correlations between market share gains and companies that are fully networked.[27] Indeed with the proliferation of data on consumer preferences and purchasing behavior, networks will increase in competitive significance. By increasing the collaboration among consumers, suppliers and firm employees, the firms can quickly gain insights of the adjacent possible (modifications to an existing technology or collection of technologies) and better tailor products and services to accommodate changing consumer preferences.
A fourth dimension of Scenario IV competition is the value of individuality, creativity, and ethics. Under antitrust’s rational choice theory, firms and consumers are undifferentiated in motivation. They seek, whenever the opportunity, to promote their economic self-interest.
But profit-maximization, as a direct goal, is arguably self-defeating for firms and consumers. “The most profitable businesses” observed John Kay “are not the most profit oriented.”[28] Companies with excellent reputations deliver more than profits for their shareholders; they deliver value to society.[29] Moreover, firms, even monopolists, at times do not behave as their rational self-interested counterparts in exploiting consumers.[30] One key driver of corporate reputation is whether consumers perceive that company having high ethical standards.[31]
Labor, under rational choice theory, is a commodity, an instrument for providing goods and services, which can be downsized, outsourced, or automated.[32] There is no inherent dignity in work or greater social calling to use one’s skills to society’s betterment. But as a matter of common experience, the greater value we see our work as having, the more meaning we can attribute to our labor, the more engaged and motivated we are in our work.[33] Scenario IV’s theory of competition helps explain why firms devote significant resources in identifying and attracting talented workers. It re-introduces moral beliefs of why we work.[34] Scenario IV competition enriches our definition of labor, namely the opportunity to use one’s unique gifts to improve the welfare of others, and thereby express and deepen individual dignity. In addition, by inculcating a unique identity, firms can promote (or hinder) social, ethical and moral values that affect employee behavior;[35] these values in turn can lower the firm’s monitoring costs and increase its competitiveness.[36]
Scenario IV competition, while offering several additional competitive dimensions, also presents two additional risks. One risk is that with bounded rational firms and consumers, some forms of market failure (such as cartels and monopolies) are likelier than rational choice theory predicts.[37] The stronger the presumption of rationality, the more likely the market will be efficient, the less the governmental concern over the sustained exercise of market power in markets characterized with low to moderate entry barriers. Rational consumers often can defeat the exercise of market power by switching to lower-cost substitutes offered by rational fringe firms or entrants. But as discussed below, bounded rational consumers do not switch as predictably as rational choice theory predicts.[38] Bounded rational firms will not always enter.[39] Cartels can be more durable when price-fixers, like the subjects in other behavioral experiments, are more trustful and cooperative than rational choice theory predicts.[40]
A second risk of Scenario IV competition is new forms of market failure. In competitive markets, firms identify and discover ways to solve consumers’ problems.[41] But the financial crisis, Professor Stiglitz wrote, showed how the financial innovations involving the subprime mortgage industry worsened, rather than solved, borrowers’ problems.[42] Their mortgages increased costs and risks for consumers while providing the mortgage brokers and lenders greater fees. These products increased risk to the institutions that acquired the ensuing credit default swaps and collateralized debt obligations.[43] Among the losers in the financial crisis were other supposedly sophisticated investors who failed to appreciate these assets’ risks.[44] Moreover, these financial innovations made speculation easer.[45] Thus market forces under Scenario IV do not necessarily yield the desired outcome.
II. Implications of Dynamic Theory of Competition on Monopolization Law
Once the assumption of rationality is relaxed, a more dynamic conception of competition emerges. This conception of competition has many potential implications for monopolization claims. This Article focuses on two implications: entry barriers and behavioral exploitation.
A. Herding and Behavioral Learning as Entry Barriers
For Robert Bork and others, monopolies (other than those protected by the government) are short-term phenomena[46]: the innovator’s supra-competitive profits serve as bait for imitators, who “first reduce and then annihilate [the monopolist’s] profit,” which reverts to the competitive mean.[47] Innovation attracts imitation, which leads to commoditization.
While not necessarily adopting Bork’s view of entry barriers, U.S. courts in considering whether a firm can attempt to monopolize, or monopolize, a market examine the likelihood of entry.[48] Entry analysis plays a key role in any section 2 case. Courts will dismiss a monopolization or attempted monopolization claim if the plaintiff cannot prove that entry barriers in the relevant market are “significant” and “substantial” enough to confer monopoly power.[49] Notwithstanding the firm’s intent to monopolize a market and its anticompetitive conduct, the court could find that rational profit-maximizing entrants will materialize and rescue the consumer.
Given the importance of entry analysis in monopolization cases, it follows that the types of entry barriers that the courts recognize are of great importance. Traditional entry analysis focused on manufacturing, distribution and regulatory barriers, such as “planning, design, and management; permitting, licensing, or other approvals; construction, debugging, and operation of production facilities; and promotion (including necessary introductory discounts), marketing, distribution, and satisfaction of customer testing and qualification requirements.”[50] The agencies’ and courts’ analyses of entry barriers have evolved. One important entry consideration for branded differentiated consumer goods is the time, expense, and likelihood of an entrant in gaining consumers’ confidence and trust (especially for products with powerful chemicals that may pose significant health risks, like hair relaxers).[51]
Another important development in entry analysis is network effects.[52] In Microsoft, the antitrust plaintiff had to prove that (1) “network effects were a necessary or even probable, rather than merely possible, consequence of high market share in the browser market and (2) that a barrier to entry resulting from network effects would be ‘significant’ enough to confer monopoly power.”[53] Network effects can be direct or indirect.[54] Direct network effects arise when a consumer’s utility from a product (e.g., telephone) increases when others use the product.[55] Indirect network effects arise when “the greater the number of users of a given software platform, the more there will be invested in developing products compatible with that platform, which, in turn reinforces the popularity of that platform with users.”[56] Firms compete to dominate markets characterized with network effects, and “once dominance is achieved, threats come largely from outside the dominated market, because the degree of dominance of such a market tends to become so extreme.”[57]
A behavioral economics perspective raises two additional entry barriers: herding and behavioral learning. Consumers, at times, are confronted with competing, incompatible technologies. In choosing, the consumer wants the technology platform that others will likely choose, as the more popular platform (e.g., Blu-ray v. HD DVD, Google’s Android versus Apple[58]) will attract more supporting complements developed for that platform.[59] Each consumer may prefer the superior technology, but forego it for the perceived popular one.[60] In believing that others will opt for the subpar technology, the consumer will choose the subpar technology and contribute to the suboptimal outcome. Herding leads to irrational exuberance (or pessimism) over stocks, real estate, and tulips.[61] Fads emerge where a consumer’s utility from an item (such as a designer bag) depends on who else owns the item (either the perceived trend-setters[62] or masses[63]). Thus, a firm may seek to secure (or maintain) its monopoly through herding, by using deceptive statements[64] and vaporware.[65]
A second entry barrier is behavioral learning, whereby a firm to effectively compete must attain a sufficient scale of trial-and-error feedback. As Part I discusses, bounded rational firms compete by improving their products and services through a trial-and-error process. Through trial-and-error firms can increase internal productive efficiencies. Semiconductor firms, as F.M. Scherer discusses, make mistakes in the early stages of production, adjust their processes, and thereby lower their manufacturing costs for their next batch.[66] Consequently, aside from the direct and indirect network effects,[67] Intel benefited from another network effect, namely continually learning from its mistakes during its early production period, which enabled it to lower costs as it increased output.