Abstract: To survive fierce competition,firms can invest in product innovation and cater their designs to match the preferences of certain consumer segments,thus cultivating brand loyalty.However,it is well-documented in the marketing literature that firms sometimes would rather direct their efforts in making consumers believe (or misbelieve) that the products are more differentiated than they actually are,so that a loyalty premium can be commanded even when true product values are very similar.In particular,firms often obfuscate product information through complex offerings,confusing pricing,excessive features,and limited disclosure,making it difficult for consumers to make informed decisions.This phenomenon appears to contradict the conventional,neoclassical framework,which posits that consumers make optimal decisions based on perfect rationality and that firms compete on quality and price rather than by engendering confusion.
How can we explain the pervasiveness and persistence of obfuscation in real market competition? The emerging literature on behavioral industrial organization adopts a novel perspective premised upon consumers’ bounded rationality and cognitive biases.In this article,we focus specifically on one such bias—correlation neglect,which refers to the tendency to underestimate or even completely neglect the correlations between various information sources,and which has attracted significant research interest recently.In this paper,we provide a theoretical framework to explore how this type of consumer naivete impacts firms’ competition strategies and overall social welfare.
To illustrate the key idea of our paper,consider two fund management companies offering investment products based on very similar underlying assets.Although aware that their products’ returns are highly correlated,the companies may prefer not to convey this fact to consumers,because doing so would intensify fee competition.Instead,the companies may engage in obfuscation,with the aim of generating the perception that their offerings differ significantly.For instance,they could use distinctive industry jargon to describe their investment portfolios,cherry-pick performance benchmarks for comparison,or highlight either the impressive credentials or dazzling prior performance of their fund managers.Were consumers rational enough and able to discern the underlying homogeneity of the two products,such informational obfuscation would prove ineffective.However,if consumers evaluate each piece of information that they receive in isolation without properly accounting for the prior correlation,the companies’ obfuscation tactics could succeed in creating an illusion of differentiation.In this way,correlation neglect grants the companies exaggerated market power to charge higher fees than competition would otherwise necessitate.
The key premise in the example above is that even if aware of the potential correlation between competing products,consumers may fail to assess it accurately,let alone fully incorporate it into their decisions.Formally,correlation neglect refers to the cognitive bias where individuals underestimate or even completely ignore the correlation between different information sources when updating beliefs on which choices are based.To study the implications of such biases for market competition,this paper develops a duopoly model with correlation-neglecting consumers.We demonstrate that equilibrium outcomes differ substantially across settings.With perfect knowledge and accurate accounting of correlation,firms have no incentive to obfuscate because competition eliminates any potential gains.However,when consumers underestimate or neglect correlation,firms can often obfuscate to soften competition and earn extra profits at the expense of consumers.Our results offer a rationale for firms using misleading marketing messages,while shedding light on how policy interventions such as consumer education or mandatory basic goods may help or backfire.In sum,the core contribution of our analysis is to show how correlation neglect enables obfuscated marketing to emerge and persist,which could have implications for future research on other biases or market structures as well.
In the paper,we present a two-stage duopoly competition model in which two firms compete on marketing and price for customers.The valuations may vary between products,but can be arbitrarily correlated.Here,the true degree of correlation between product values can be interpreted as a measure of product differentiation.Consumers cannot directly observe the true valuations,but instead receive a signal from each firm,which is composed of the true valuation of the product offered by that firm and an unbiased noise with variance being chosen strategically by the firm.The noise that one particular firm adds to the signal may change consumers’ valuation for its product,but does not affect consumers’ willingness to pay for the competing product.In the first stage,two firms simultaneously choose their obfuscation strategy.Upon receiving signals from both firms,consumers update their beliefs about product values.In the second stage,the firms post price and engage in the conventional Bertrand competition.Essentially,we assume that firms can manipulate perceived correlation and valuations by providing noisy signals about product values,thereby impeding product comparison.
We first establish a benchmark result: if consumers are rational enough to properly assess and accounting for the true correlation, firms would opt for maximal transparency of product information. Then we turn to our main discussion of the impact of correlation neglect.Here,consumers understand the information provided by each firm in isolation, but they hold incorrect beliefs about the correlation between the true product values and, as a consequence, misjudge the interdependence of the signals that they received. We show that when products become sufficiently homogeneous, firms would adopt a moderate level of obfuscation for their marketing strategies. The equilibrium results and subsequent comparative statics and welfare analysis show that as the gap between the true and perceived degrees of correlation increases (i.e., as consumer naivete increases),firms’ profits rise while consumer/social surplus decreases due to a higher probability of mismatch in purchase.
Lastly, we explore two extensions of our main analysis.First,we characterize the conditions under which asymmetric equilibria can also emerge in our setting. Comparing the symmetric and asymmetric equilibria suggests that the asymmetric equilibrium yields higher profits for firms but a lower surplus for consumers.Second,we extend the discussion to general value distributions, demonstrating the robustness of our core insights.