Abstract:

Behavioral models propose that bounded rationality can lead decision makers to have mis-specified mental models of competitor behavior, with implications for strategic decisions, but field evidence is scarce. We study a firm with 20,000+ gas stations, where station managers have substantial discretion over strategic choices including oil prices. Survey measures eliciting manager ``narratives'' about the causes of high profits show that cognitive skills matter for what managers think is the optimal strategic pricing behavior, with low-skill managers believing that price cuts are beneficial. We show that cognitive skills also matter for ability to model strategic behavior of other gas station managers, in a lab-in-the-field beauty-contest type game implemented in a survey with the managers. This difference in ability to model competitors at least partly mediates the link between cognitive skills and having the high price narrative. Turning to actual pricing, lower cognitive skills, and worse ability at modeling competitor behavior, lead to charging lower average prices and engaging in more price wars. We provide evidence that the more aggressive price cuts of low ability managers cause lower profits. Our findings show how bounded rationality matters for consumer surplus, market efficiency, and measured market power, and challenge traditional mode that assume full rationality in calibrating model parameters and formulating competition policies.

For further information, please contact sara.picciallo@unibocconi.it