“Exploitative Innovation” Heidhues, Koszegi & Murooka (2012)

This blog has already covered the companion to this paper, which looks at equilibria in markets for deceptive goods. This paper extends that static model to the case where firms can invest in exploitative innovations. Firms can make either value-increasing or deceptive innovations. As in the previous paper, deceptive equilibria are more likely to occur in socially wasteful industries, since no firm can profit from educating consumers.

The first counterintuitive result is that incentives to create socially beneficial innovations are low if innovations can be copied. These innovations only increase consumer surplus, so there is no increased payoff to the innovating firm. Exploitative innovations are very different. These innovations are profitable if they cannot be copied, but are even more profitable if exploitative innovations can be copied. Spreading exploitation amongst competitors weakens the incentives these competitors have to educate consumers.

These theoretical results are interesting, but do the necessary modelling assumptions reflect real financial markets? The authors mention credit cards and mutual funds as two potentially relevant markets, and discuss these markets at greater length in their companion paper. These are interesting markets, but consumer exploitation in at least the mutual fund industry may be driven mainly by historical accident – how consumers weight fees against past returns. Mutual funds have not changed that much in the past few years (beyond increased choice and ETFs, etc). The gambling sector has seen much more innovation – being the first sector to properly monetize the internet. Furthermore, since gambling is purely zero-sum, gambling is more likely to meet the authors conditions for a socially wasteful industry. If consumers are not too naïve, then mutual funds do have a good potential to increase consumer welfare through easier access to diversification.

My last point is that any empirical study of exploitative innovation should be grounded by a psychological theory of decision-making. Any exploitative innovation is likely to reverse engineer some previously established bias.