Bounded Rationality and Industrial Organization

Bounded Rationality and Industrial Organization

Bounded Rationality and Industrial Organization

Bounded Rationality and Industrial Organization


Conventional economic theory assumes that consumers are fully rational, that they have well-defined preferences and easily understand the market environment. Yet, in fact, consumers may have inconsistent, context-dependent preferences, or simply not enough brain-power to evaluate and comparecomplicated products. Thus the standard model of consumer behavior - which depends on an ideal market in which consumers are boundlessly rational - is called into question. While behavioral economists have for some time confirmed and characterized these inconsistencies, the logical next step is toexamine the implications they have in markets. Grounded in key observations in consumer psychology, Bounded Rationality and Industrial Organization develops non-standard models of "boundedly rational" consumer behavior and embeds them into familiar models of markets. It then rigorously analyses each model in the tradition of microeconomictheory, leading to a richer, more realistic picture of consumer behavior. Ran Spiegler analyses phenomena such as exploitative price plans in the credit market, complexity of financial products and other obfuscation practices, consumer antagonism to unexpected price increases, and the role ofdefault options in consumer decision making. Spiegler unifies the relevant literature into three main strands: limited ability to anticipate and control future choices, limited ability to understand complex market environments, and sensitivity to reference points. Although the challenge of enriching the psychology of decision makers in economic models has been at the frontier of theoretical research in the last decade, there has been no graduate-level, theory-oriented textbook to cover developments in the last 10-15 years. Thus, Bounded Rationality and Industrial Organization offers a welcome and crucial new understanding of market behavior - it challenges conventional wisdom in ways that are interesting and economically significant, and which in the end effect the well-being of all market participants.


This book summarizes and synthesizes recent developments in the theory of Industrial Organization that incorporate departures from the standard model of consumer behavior in the direction of a “richer psychology.” It cannot be denied that the challenge of enriching the psychology of decision makers in economic models has been at the very frontier of theoretical research in the last decade, given an enormous boost by the behavioral economics movement.

However, while the subject has given rise to a large and varied literature that includes numerous research articles as well as a number of surveys and anthologies, one can think of very few proper textbooks that could serve a graduate-level course in economic theory. Indeed, the most recent theory-oriented textbook of any relevance that I am aware of is Ariel Rubinstein’s 1998 Modeling Bounded Rationality, which preceded many of the developments that caused such a stir in our profession. This book aims to narrow this gap, albeit in the very specific domain of industrial organization.

The book is meant to serve as a textbook for graduate courses in microeconomic theory, as well as theory-oriented courses in industrial organization or behavioral economics. It is partly based on lecture notes from courses given at Tel Aviv University, University College London and the Helsinki Center of Economic Research.In the course of writing this book,Ihave greatly benefitted from financial support by the European Research Council and the esrc (UK). Parts of the research it is based on were supported by bsf and isf grants.

I wish to thank several colleagues who gave comments on earlier drafts of book chapters: Eddie Dekel, Kfir Eliaz, Susana Esteban, Ignacio Esponda, Erik Eyster, Yves Guéron, Michael Grubb, Paul Heidhues, Philippe Jehiel, Barton Lipman, Marco Mariotti, Erik Mohlin, Michele Piccione, Jidong Zhou, and especially Ayala Arad for her consistently superb feedback. I am hugely indebted to Ariel Rubinstein, who not only contributed concrete suggestions that helped me improve the exposition and proofs of several results, but also provided valuable encouragement throughout this project. Ariel got me “hooked” on the subject of bounded rationality fifteen years ago, and I have continued to benefit from his work and his thoughts ever since. Ayala Arad and Yves Guéron have provided truly spectacular research assistance. in particular, Yves helped typesetting the manuscript and wrote the solution manual. I am forever grateful to both. My coauthors, Kfir Eliaz and Michele Piccione, deserve some of the credit for the material in the book, as our joint work has formed the basis of several chapters. the Oxford University Press editors, Terry Vaughn and Joe Jackson, provided warm and reliable support. Finally, I wish to thank the composer Steve Reich, whose music provided an indispensable soundtrack for the writing process. If the book feels monotonous or repetitive at times, blame it on him.

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