Credit cards carry hidden fees, cell phone plans have two year contracts, hotels rip you off if you get a Kit Kat from the minibar etc etc.
It is possible to explain these features in the “rational firm, dumb consumer” paradigm if there is one rational firm, i.e. a monopolist. Things get trickier if there is competition. If one firm is offering a deliberately confusing pricing scheme to extract surplus from boundedly rational consumers, why doesn’t another offer something transparent and steal customers? Then the usual logic of Bertrand competition should eliminate intransparent pricing and lead to a zero profit equilibrium. There are two theories (I know of) for why this might not happen.
The first is the adverse selection story of Ausubel. If one credit card company cuts prices, instead of attracting confused, profitable consumers, it attracts unprofitable, risky customers who might default. The deviation is not worthwhile and this undercuts the usual Bertrand logic.
The second is the add-on story of Ellison and Gabaix and Laibson. Let’s say hotels are pricing hotel rooms below cost and making profits on the add-ons (minibars, pay per view, phones etc.). One hotel deviates and prices the room just above costs and gets rid of the rip off pricing on the add-ons. Confused consumers learn they have been confused and go to the hotel which prices rooms below cost and remember to take their cell phone and laptop (to watch streaming movies) and pack a few energy bars. The hotel that prices just above costs does not get new customers and the deviation was not worthwhile.
You can’t purchase the subsidized cell phone from ATT without signing on to the rip off two year plan – so the add-on story is hard to apply. There might be some adverse selection towards TMobile because you can pay for the cellphone in installments so you can default. But this effect does not seem large and could go the other way – stay with ATT, get an even more subsidized cell phone and default on the two year plan.
So, does that mean the upstart maverick player TMobile has triggered competition and cheap plans await us?
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April 12, 2013 at 12:46 am
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April 12, 2013 at 8:57 am
BKnowles
Its interesting to consider why the European market has a different equilibrium where everyone unshrouds. How do shrouding equilibrium arise? And why do they only arise in certain markets? Does it depend on the share of myopic and sophisticated consumers?
April 16, 2013 at 12:31 pm
Sandeep Baliga
Hi Beyonce: Thanks for coming to our blog and say hi to Jay Z.
Great question. My claim was that shrouding story does not fit the situation anyway so you should expect competition to arise both here and in Europe at least w.r.t. this theory. Also, maybe there are some regulations in Europe that might make market more competitive?
Rani Speigler at UCL has some other theories that might apply but have yet to get through those – I’m teaching.
Sandeep
April 12, 2013 at 10:48 pm
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May 4, 2013 at 5:24 am
Celia
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