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November 05, 2004

Do Markets Cure Consumer Mistakes? Schwartz paper

Yesterday Alan Schwartz of Yale Law was here to give a talk.
His subject was a good one. People make dumb mistakes. They
are not always "rational" in the economic sense. Some of
these mistakes can be viewed as having poor information--
for example, buying astrology predictions even though they
won't come true. Other mistakes are in processing
information-- putting good money after bad into a business
that won't succeed, for example, because of the fallacy of
sunk cost. We have always known people make mistake, but
recent research, "behavioral economics", has focussed more
on the precise kinds of mistakes that get made.

But does the tendency to make this kind of mistake actually
result in bad decisions? The market has some tendency to
cure mistakes. If I put my antique chair up for auction, for
example, then even if my information as to its value is
poor, I will still get a price for it that reflects the good
information of other people. If I am buying things, then
sellers will endeavor to make sure I understand that the
apparently good offers of their competitors are actually bad
for me.

Schwartz's paper modelled this, in one particular way. He
used a search model, where some people shop and others just
look at one seller's offers, and where one product is best
for sophisticated people and another for mistake-prone
people. It is a tricky problem to get a handle on, though.

Another way to model the situation is with an advertising
model. Suppose no consumer searches, but sellers send them
advertisements, and that some consumers are sophisticated
but others are mistake-prone. Sellers will send three kinds
of messages. First, there will be offers aimed at the
sophisticated buyers. Second, there will be offers aimed to
fool the mistake-prone buyer. Third, there will be offers
aimed to tell the mistake-prone buyer about the deceptive
offers. I'm afraid this model would get rather
complicated, since each seller would want his offer to be
just slightly better than what the buyer is likely to get
from some other seller. Also, someone may well have worked
out this idea years ago. But it has some realism to it, I
think.

Posted by erasmuse at November 5, 2004 02:36 PM

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