“Inferior Products and Profitable Deception” Heidhues, Koszegi & Murooka (2014)
This paper builds on earlier theoretical analyses of competitively exploitative industries (e.g. Gabaix and Laibson, 2006), and lists conditions under which competitive industries converge on equilibria where naïve consumers are exploited. In this model firms compete to provide goods with variable social surplus by charging an up-front fee and then deciding to “shroud” an add-on fee, or “unshroud” and reveal the full fee of their product to naïve consumers. Sophisticated consumers exist in the market and know the magnitude of the full fee even if prices are shrouded.
There always exists an equilibrium where firms unshroud prices and naïve consumers are not exploited, but the authors argue that shrouded equilibria are more plausible when theoretically possible. A shrouded equilibrium can only remain if all firms decide to shroud their prices, so a key determinant is the good’s social surplus. If the product is socially valuable, then a single firm may find it profitable to unshroud its prices and turn all consumers sophisticated. But if the product is socially wasteful, then sophisticated consumers will not buy it, and unshrouding is unprofitable. For socially wasteful goods firms always maximize profits by shrouding prices and exploiting naïve consumers. The results continue to hold in multi-product markets, where sophisticated consumers buy the superior product, while naïve consumers buy a shrouded inferior product.
The authors suggest that real-world markets that are competitive but remain profitable are likely to involve exploitative price shrouding, and use mutual fund and credit card markets as two examples. The mutual fund market seems perfectly described as a shrouded multi-product market, where sophisticated consumers buy low-cost index mutual funds and naïve consumers buy high-cost actively managed funds.
Later on I hope to show how the results apply to the UK gambling market.