EARIE 2008

Toulouse, September 4-6, 2008

Spurious complexity and common

standards in markets for consumer
goods
Alexia Gaudeul
and
Robert Sugden
Outline of the presentation
Spurious complexity and libertarian paternalism
Some examples for illustration.
A model of consumer choice.
Individuated standard and common standard.
Dynamics: towards a common standard.
Conclusion.
Spurious complexity
In industrial organisation: investigation of whether firms
can exploit consumers’ cognitive limitations by adding
spurious complexity to tariff structures (e.g. Ellison and
Ellison, 2004; Ellison, 2005; Gabaix and Laibson, 2006;
Spiegler, 2006).
Typical conclusion: firms do have incentives to do this;
results make markets less competitive.
In some markets (e.g. domestic supply of electricity and gas
in UK), competing suppliers sell exactly the same product,
competing only on price.
Yet tariffs are quite complex and consumers often fail to
choose the lowest-cost supplier [Chris Wilson and Catherine
Waddams, ‘Do consumers switch to the best suppliers?’,
CCP, 2006].
Libertarian paternalism
Libertarian paternalism (Sunstein and Thaler, 2003);
‘regulation for conservatives’ (Camerer, Issacharoff,
Loewenstein, O’Donaghue and Rabin, 2003):
Claim that people find it difficult to process complex choice
problems.
Result: consumers may fail to choose in their own best
interests due to ‘uninformed preferences’.
Recommendation: paternalistic regulation to simplify
consumers’ choice problems, possibly by reducing the number
of choices given to consumers.
The common standard effect
These literatures neglect a countervailing force: the ‘common
standard effect’.
Consumers’ choices are made less complex if competing firms
follow common conventions about tariff structures, package sizes,
labelling, etc.
Such conventions facilitate competition.
But therefore: common standards signal that goods which meet
them are likely to give good value for money.
So, consumers can learn by experience to favour products which
meet common standards.
And this gives firms an incentive to follow common standards.
There are therefore mechanisms at work in markets that favour the
emergence and persistence of conventions which reduce choice
complexity for consumers.
Examples
You want to drive from Dover to London. Three filling stations:
A charges £0.96 per litre,
B charges £0.97 per litre,
C charges £4.56 per gallon.
Which one do you choose?
You consume 530 kWh/month in electricity. You have a choice
between three tariffs:
A: fixed charge of £10/month and unit charge of £0.14/kWh
B: fixed charge of £10/month and unit charge of £0.15/kWh
C: fixed charge of £20/month and unit charge of £0.13/kWh.
Which one do you choose?
A model
n identical firms selling a homogeneous good, competing on
price.
Free entry.
N identical consumers. Each wants either to buy a fixed
quantity (1 unit) or not to buy at all.
Firms choose their prices pi and their standard si.
Consumer h receive signal rhi of the value of firm i’s offering:
rhi=α+βvhi-pi+ehi
vhi is the idiosyncratic value of the firm’s product for h.
ehi is an error term due to the difficulty in evaluating firm i’s
offering.
If two firms i and j share a standard (si=sj), then the consumer
knows which one obtains the highest utility (the sign of [βvhi-pi]-
[βvhj-pj]).
 Equilibrium with common
standards
If all firms use the same standard and β=0
£/quantity If all firms use the
Common same standard, then
standard consumers can
AC equilibrium compare their value in
an accurate way.
If β=0, then they
always choose the
firm with the lowest
price = AR price
 perfect
pC
competition,
price=min(AC)=MC
 few firms, low
N/n quantity
prices.
 Equilibrium with individuated
standards
If all firms use different standards (Perloff and Salop,
1985).:
£/quantity If all firms use
individuated different standards,
standards then consumers have
AC equilibrium to choose between
firms based on their
signal
price =  model of
pIS idiosyncratic
differentiation, except
the differentiation is
MR AR spurious
 price s.t. MR=MC
 higher prices.
N/n quantity
Dynamics
Suppose
β=0 (no idiosyncratic differentiation)
Consumers are either naïve (don’t care about standards) or
savvy (choose only among common standards).
There are two sectors, one with firms that share a common
standard (CS) and one with firms that share no standard (IS).
In taking their decisions about price, firms take the
distribution of savvy and naïve consumers, and of CS and IS
firms as given.
Firms can change sector from period to period.
Consumers can change their decision rule from period to
period.
 Dynamics
1
In zone A, many naïve
B consumers  IS firms
πCS> πIS make positive profit and
USavvy>UNaïve price higher than CS
Proportion of CS firms

firms who make zero

profit.
In zone B, too few naïve
consumers  high
C average costs  IS
losses.
πCS> πIS
In zone C, very low
A USavvy<UNaïve
demand for IS firms 
πCS< πIS low MC  possibility that
USavvy>UNaïve pIS>MC and yet
pIS<min(AC)=pCS.
0 1
Proportion of savvy consumers
Conclusion
Common Standard rule is transferrable from sector to
sector across the economy and is evolutionarily stable.
Adherence to common standard is an ‘honest’ signal of
low prices, i.e. a firm cannot ‘fake’ adherence and set high
prices.
Need only for ‘light touch’ regulation to favour the
emergence of a common standard in one industry.
Then consumers who know to favour common standard
from other industries will be sufficiently numerous to make the
common standard sustainable.
No need to enforce the standard or to intervene in its
design.