DRAFT

BEHAVIORAL ECONOMICS AND DYNAMIC COMPETITION

Maurice E. Stucke*

INTRODUCTION 

Antitrust’s concept of competition assumes rational market

participants with willpower who pursue their self-interest.  This Article first

examines how our conception of competition alters when this assumption is

relaxed to reflect bounded rational market participants with imperfect

willpower and bounded self-interest.  Part II examines two implications of

this dynamic theory of competition on antitrust’s monopolization law,

namely herding and behavioral learning as entry barriers and second a

monopolist’s exploitation of biases to illegally maintain its monopoly.

I. THEORY OF COMPETITION WITH BOUNDED RATIONAL FIRMS AND

CONSUMERS

Before addressing the implications of behavioral economics on

antitrust’s monopolization standard, it is helpful to quickly sketch how

behavioral economics can inform our conception of competition. The

prevailing assumption underlying today’s antitrust policy is that firms,

consumers, and the government are rational. As I discuss elsewhere,1 our

theory of competition changes when one relaxes the assumption of rational

firms, consumers, and government. My aim here is summarize Scenario IV

competition, whereby both firms and consumers are bounded rational.2 * Associate Professor, University of Tennessee College of Law; Senior

Fellow, American Antitrust Institute. I wish to thank for their helpful comments <insert>. I also thank the University of Tennessee College of Law for the summer research grant.

1 Maurice E. Stucke, Reconsidering Competition, Mississippi L.J. (forthcoming 2012), available at http://ssrn.com/abstract=1646151.

2 Id. (discussing competition under scenarios I (firms, consumers, government rational); II (firms relatively more rational than consumers);

2 Behavioral Economics and Dynamic Competition [23-MAY-11Under Scenario IV competition, biases and heuristics are systemic. At

closer inspection, competition under Scenario IV is better viewed as a

discovery process than a stable equilibrium.  Bounded rational firms have

imperfect knowledge about current and future consumer preferences, a

blurred and changing understanding of their goals and preferences, and a

limited repertoire of actions to cope with whatever problems they face.3

Bounded rational consumers have changing and, at times, inconsistent

preferences.4

Thus, under a behavioral lens, competition is more fully understood as

an “evolutionary trial and error process, in which the firms try out different

problem solutions and can learn from the feedback of the market, which of

their specific products and technological solutions are the superior ones.”5

Rather than an end-state capable of being perfected, competition is a

continuous process “in which previously unknown knowledge is

generated,” and “the multiplicity and diversity of the (parallel trials of the)

firms might be crucial for the effectiveness of competition as a discovery

procedure.”6 Firms and consumers make mistakes, readjust, and undertake

new strategies. The competitive process “is inherently a process of trial and

III (consumers relatively more rational than firms; and IV (firms, consumers, and government bounded rational).

3 Giovanni Dosi & Luigi Marengo, On the Evolutionary and Behavioral Theories of Organizations: A Tentative Roadmap, 18 ORG. SCI. 491, 492, 494 (2007).

4 See, e.g., Steven C. Michael & Tracy Pun Palandjian, Organizational Learning and New Product Introductions, 21 J. PRODUCT INNOVATION MGMT. 268, 270 (2004) (discussing shampoo industry dynamism where consumers with changing tastes buyers seek variety); Richard Layard, Happiness & Public Policy: A Challenge to the Profession, 116 THE ECON. J. C24, C24 (2006) (noting from happiness economic literature how “tastes are not given – the happiness we get from what we have is largely culturally determined”).

5 Kerber, supra note **, at 2; see also Moreau, supra note **, at 851 (discussing how “evolutionary theory refutes the neoclassical economic theory’s focus on a steady state of the economic system”).

6 Kerber, supra note **, at 2.

23-May-11]Behavioral Economics and Dynamic Competition 3error with no stable end-state considered by the participants in the

process.”7

Scenario IV involves several important competitive dimensions beyond

price. One facet of competition is the extent to which bounded rational

firms debias themselves to provide a competitive advantage.8 The corporate

literature describes firms being overconfident about a merger’s likely

efficiencies,9 overvaluing the purchased assets,10 being overly confident or

pessimistic about their chances of entering particular markets,11 and

consistent with the sunk cost fallacy throwing good money after bad in

corporate projects.12 Even though firms are bounded rational, it does not 7 Moreau, supra note **, at 851.8 See, e.g., Andrew Healy, Do Firms Have Short Memories?: Evidence

from Major League Baseball, 9 J. SPORTS ECON. 407, 415-18 (2009) (discussing how some professional baseball teams overweigh, relative to more successful teams, athletes’ recent performance in determining salary).

9 See, e.g., Matthew T. Billett & Yiming Qian, Are Overconfident CEOs Born or Made? Evidence of Self Attribution Bias from Frequent Acquirers, 54 MGMT. SCI. 1037 (2008) (finding from sample of public acquisitions between 1985 and 2002 that CEOs who previously engaged in a successful acquisition appear to overly attribute their role in successful deals, leading to more deals even though these subsequent deals are value destructive); ROBERT F. BRUNER, DEALS FROM HELL: M&A LESSONS THAT RISE ABOVE THE ASHES (2005) (summarizing major failed mergers).

10 Mathew L.A. Hayward & Donald C. Hambrick, Explaining the Premiums Paid for Large Acquisitions: Evidence of CEO Hubris, 42 ADMIN. SCI. Q. 103 (1997) (finding from empirical study of mergers over $100 million involving publicly traded firms over four year period that CEO hubris plays a substantial role in acquisition process and acquisitions tend to reduce shareholder wealth); see also Mauricio R. Delgado et al., Understanding Overbidding Using the Neural Circuitry of Reward to Design Economic Auctions, SCIENCE, Sept. 26, 2008, at 1849; RICHARD H. THALER, WINNER’S CURSE: PARADOXES AND ANOMALIES OF ECONOMIC LIFE 50–62 (1992) (discussing experimental and field evidence); Mackintosh, supra note **, at 15 (discussing a 2010 auction of a $20 bill for $61).

11 Amanda P. Reeves & Maurice E. Stucke, Behavioral Antitrust, 86 INDIANA L.J. (forthcoming 2011) (discussing increasing interest in behavioral economics and its applications to competition law), available at http://ssrn.com/abstract=1582720; Maurice E. Stucke, Behavioral Economists at the Gate: Antitrust in the Twenty-First Century, 38 LOY. U. CHI. L.J. 513 (2007).

12 Malcolm Baker et al., Behavioral Corporate Finance: A Survey 49 (Sept. 29, 2005), http://ssrn.com/abstract=602902; Hal R. Arkes & Catherine Blumer, The Psychology of Sunk Cost, 35 ORGANIZATIONAL BEHAVIOR & HUMAN DECISION PROCESSES 124-140 (1985).

4 Behavioral Economics and Dynamic Competition [23-MAY-11follow that their heuristics and biases are of the same nature and to the same

degree.13 Accordingly, firms can implement mechanisms to debias their

outlooks and decision-making. Firms with significant free cash flow can

seek advice from outside advisors to evaluate prospective mergers to ensure

the senior managers are not overconfident or optimistic on the potential

efficiencies.14 As the management consulting firm McKinsey & Company

summarized,

First, managers can become more aware of how biases can affect their own decision making and then endeavor to counter those biases. Second, companies can better avoid distortions and deceptions by reviewing the way they make decisions and embedding safeguards into their formal decision-making processes and corporate culture.15

One effective mechanism for firms to identify biases and take

preventive measures is through “frequent, rapid, and unambiguous

feedback.”16 Accordingly, an important competitive dimension is providing

firms (like consumers) the incentive to improve feedback mechanisms and

ultimately their decision-making and willpower.17

13 John A. List, Neoclassical Theory Versus Prospect Theory: Evidence from the Marketplace, 72 ECONOMETRICA 615, 615 (2004); John A. List, Does Market Experience Eliminate Market Anomalies?, 118 Q. J. ECON. 41 (2003). For example, frequent and more experienced sports cards traders display less of an endowment effect for sports cards (such as baseball trading cards) than for other items such as chocolates and mugs.

14 Ulrike Malmendier, A “New” Paradigm in Corporate Finance: The Role of Managers and Managerial Biases, 4 NBER REPORTER 13, 15-16 (2010) (discussing correlation between overconfidence and acquisitions by cash-rich firms not dependent on external financing).

15 Dan P. Lovallo & Olivier Sibony, Distortions and Deceptions in Strategic Decisions, McKinsey Quarterly, Feb. 2006, available at http://www.mckinseyquarterly.com/Distortions_and_deceptions_in_strategic_decisions_1716.

16 Lovallo & Sibony, supra note **; Camerer & Malmendier, supra note **, at 269 (noting some of the literature, such as investment firms combating loss aversion by having traders switch positions with one another).

17 See Linda Argote & Henrich R. Greve, A Behavioral Theory of the Firm – 40 Years and Counting: Introduction and Impact, 18 ORG. SCI. 337 (2007) (surveying impact of Behavioral Theory of the Firm’s impact on organizational science research, including institutional theory and population ecology); Dosi & Marengo, supra note **, at 491.

23-May-11]Behavioral Economics and Dynamic Competition 5With bounded rational firms with imperfect information, a second

important dimension of competition is the ways in which companies learn,

accomplish tasks, and deal with the uncertainty, which again can vary

across firms.18 Rather than incur costs to continually process information

anew, bounded rational firms (like consumers) can use rules-of-thumb

(heuristics). Firms with better routines/rules-of-thumb can lower their

information processing and decision-making costs to gain a competitive

advantage.

While providing at times a competitive advantage, corporate routines

can also disadvantage firms competitively. Bounded rational firms face the

risk of competency traps, whereby they become wedded to existing

routines, which as industry conditions change, place the firms at a

competitive disadvantage.19 One CEO recently observed the paradox: “in a

creative company, you want to give as much variability as possible, and yet

in a manufacturing process you want as little variability as possible.”20

Under Scenario IV, “[i]n some sense knowledge depreciates in value over

time.”21 So another important dimension of competition is adaptive

efficiency,22 whereby bounded rational firms update routines to reflect

18 Dan Lovallo & Olivier Sibony, The Case for Behavioral Strategy, MCKINSEY Q. 3 (March 2010) (noting recent survey of 2,207 executives where only 28 percent said the quality of their companies’ strategic decisions was generally good, 60 percent thought that bad decisions were about as frequent as good ones, and 12 percent thought good decisions were altogether infrequent).

19 Eyal Biyalogorsky et al., Stuck in the Past: Why Managers Persist with New Product Failures, 70 J. MARKETING 108 (2006) (discussing the “extensive attention in the literature” to firms’ escalation of commitment, which is the tendency of managers to stay committed to a course of action despite strong negative feedback with respect to the advisability of this action); Michael & Palandjian, supra note 4, at 270 (discussing literature on competency traps).

20 Hal Weitzman, The Man who Turns Post-it Notes Into Bank Notes, Fin. Times, Feb. 28, 2011, at 12 (quoting 3M CEO George Buckley).

21 NORTH, UNDERSTANDING, supra note **, at 23 (discussing uncertainty in a non-ergodic world (e.g., Scenario IV)).

22 Id. at 70.

6 Behavioral Economics and Dynamic Competition [23-MAY-11consumers’ changing preferences.23 Rational choice theory often views

suspiciously a strong incumbent firm that seeks to acquire a maverick firm

with a new technology or business model.24 But in the business literature, a

firm may acquire a maverick with a disruptive business model or

technology to better adapt and compete.25

A third important dimension of Scenario IV competition is the

importance of scale, openness, randomness, and connectivity. Innovation,

as Steven Johnson recently wrote, occurs mostly in the adjacent possible,

namely iterative advances leading from one innovation to an improvement

in the adjoining space: “Environments that block or limit those new

combinations–by punishing experimentation, by obscuring certain branches

of possibility, by making the current state so satisfying that no one bothers

to explore the edges—will, on average, generate and circulate fewer

innovations than environments that encourage exploration.”26 Networks,

and as discussed below network effects, are playing a greater role across

industries. Firms can learn and adapt more quickly through the Internet’s

social network technologies. Firms are also developing internal networks to

better interact with employees and disperse information and ideas. Some

firms are fully networked, combining both external and internal networks.

One recent survey of 3,249 executives found significant correlations

between market share gains and companies that are fully networked.27

Indeed with the proliferation of data on consumer preferences and

purchasing behavior, networks will increase in competitive significance.

23 Michael & Palandjian, supra note 4, at 275.24 2010 Horizontal Merger Guidelines § 2.1.5.25 Clayton M. Christensen et al., The New M&A Playbook, Harv. Bus.

Rev., March 2011, at 49, 50, 54-55.26 STEVEN JOHNSON, WHERE GOOD IDEAS COME FROM: THE NATURAL HISTORY

OF INNOVATION 36, 41 (2010).27 Jacques Bughin & Michael Chui, How Web 2.0 Pays Off: The

Growth Dividend Enjoyed by Networked Enterprises, 2 McKinsey Quarterly 17, (2011)

23-May-11]Behavioral Economics and Dynamic Competition 7By increasing the collaboration among consumers, suppliers and firm

employees, the firms can quickly gain insights of the adjacent possible

(modifications to an existing technology or collection of technologies) and

better tailor products and services to accommodate changing consumer

preferences.

A fourth dimension of Scenario IV competition is the value of

individuality, creativity, and ethics. Under antitrust’s rational choice

theory, firms and consumers are undifferentiated in motivation. They seek,

whenever the opportunity, to promote their economic self-interest.

But profit-maximization, as a direct goal, is arguably self-defeating for

firms and consumers. “The most profitable businesses” observed John Kay

“are not the most profit oriented.”28 Companies with excellent reputations

deliver more than profits for their shareholders; they deliver value to

society.29 Moreover, firms, even monopolists, at times do not behave as

their rational self-interested counterparts in exploiting consumers.30 One key 28 JOHN KAY, OBLIQUITY: WHY OUR GOALS ARE BEST ACHIEVED INDIRECTLY

12, 24-34 (2011).29 2011 Harris Annual RQ Poll, supra note **, at 9 (companies with

high reputation quotients can be characterized as “’support[ing] the infrastructure of the lives of the American public, both personally and professionally”); Michael Porter, Shared Value, Harvard Bus. Rev. **

30 Concurring Statement of Comm’r J. Thomas Rosch, FTC v. Ovation Pharms., Inc. (Dec. 16, 2008), available at http://www.ftc.gov/os/caselist/0810156/081216ovationroschstmt.pdf (hereinafter “Rosch Concurrence”); Concurring Statement of Comm’r Jon Leibowitz, FTC v. Ovation Pharms., Inc. (Dec. 16, 2008), available at http://www.ftc.gov/os/caselist/0810156/081216ovationleibowitzstmt.pdf (“Leibowitz Concurrence”). Ovation Pharmaceuticals, Inc. acquired two drugs to treat patent ductus arteriosus (“PDA”), a serious congenital heart defect in newborns. First, Ovation acquired from Merck the drug Indocin. Several months later, Ovation acquired from Abbott Laboratories the U.S. rights to the drug NeoProfen. After acquiring NeoProfen, Ovation raised the price it charged hospitals for Indocin by nearly 1,300 percent. In December 2008, the FTC challenged under Section 7 of the Clayton Act Ovation’s acquisition of NeoProfen as a merger to monopoly in a market for drugs used to treat PDA. Although Commissioner Rosch voted in favor of the Section 7 challenge, he argued in his concurrence that Ovation’s earlier acquisition of Indocin was also subject to challenge under Section 7. Here the actual evidence is hard to reconcile with the Chicago School’s neoclassical economic theories. Specifically Indocin for many years was the only FDA-approved pharmaceutical treatment for PDA. Given Indocin’s market position, Merck (its

8 Behavioral Economics and Dynamic Competition [23-MAY-11driver of corporate reputation is whether consumers perceive that company

having high ethical standards.31

Labor, under rational choice theory, is a commodity, an instrument for

providing goods and services, which can be downsized, outsourced, or

automated.32 There is no inherent dignity in work or greater social calling

to use one’s skills to society’s betterment. But as a matter of common

experience, the greater value we see our work as having, the more meaning

we can attribute to our labor, the more engaged and motivated we are in our

work.33 Scenario IV’s theory of competition helps explain why firms

devote significant resources in identifying and attracting talented workers.

It re-introduces moral beliefs of why we work.34 Scenario IV competition

original owner) could have charged a monopoly price for its drug. Indeed under the Court’s dicta in Trinko, Merck’s charging a monopoly price would serve “an important element of the free market system,” in that monopoly pricing serves as an inducement to “attract[] ‘business acumen’ in the first place” and engage in “risk taking that produces innovation and economic growth.” Trinko, 540 U.S. at 407. In a world of rational profit-maximizers, consumers would applaud, not condemn, Merck. Charging parents whose babies were born with this potentially life-threatening congenital heart defect the monopoly price would signal others to invest in such innovative drugs. Instead, reality suggests that consumers and rational choice theorists differ at times in their perception of what is fair.

31 Harris Interactive, The 2011 Harris Interactive Annual RQ Summary Report 7 (Apr. 2011) (interviewing 30,104 people on the reputations of 60 highly visible companies). Not surprisingly among the 60 companies with the poorer reputations was cable company Comcast, two domestic airlines (American and Delta), five financial institutions (JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs, and AIG), two domestic automobile and two oil companies responsible for monumental oil spills (BP, ExxonMobil)

32 In contrast the Clayton Act provides that the “labor of a human being is not a commodity or article of commerce.” 15 U.S.C. § 17 (2006).

33 DAN ARIELY, THE UPSIDE OF RATIONALITY: THE UNEXPECTED BENEFITS OF DEFYING LOGIC AT WORK AND HOME 66-82 (2010); Jason Krieger, Creating a Culture of Innovation, GALLUP MGMT. J., Oct. 5, 2010, http://gmj.gallup.com/content/143282/creating-culture-innovation.aspx (finding that higher levels of employee engagement “correlate to more idea sharing, better idea generation, more creativity in role, and improved business outcomes (on key items, including customer metrics, productivity, and profitability)”).

34 R.H. TAWNEY, THE ACQUISITIVE SOCIETY 33 (2004) (“For what gives meaning to economic activity, as to any other activity is [] the purpose to which it is directed.”)

23-May-11]Behavioral Economics and Dynamic Competition 9enriches our definition of labor, namely the opportunity to use one’s unique

gifts to improve the welfare of others, and thereby express and deepen

individual dignity. In addition, by inculcating a unique identity, firms can

promote (or hinder) social, ethical and moral values that affect employee

behavior;35 these values in turn can lower the firm’s monitoring costs and

increase its competitiveness.36

Scenario IV competition, while offering several additional competitive

dimensions, also presents two additional risks. One risk is that with

bounded rational firms and consumers, some forms of market failure (such

as cartels and monopolies) are likelier than rational choice theory predicts.37

The stronger the presumption of rationality, the more likely the market will

be efficient, the less the governmental concern over the sustained exercise

of market power in markets characterized with low to moderate entry

barriers. Rational consumers often can defeat the exercise of market power

by switching to lower-cost substitutes offered by rational fringe firms or

entrants. But as discussed below, bounded rational consumers do not

switch as predictably as rational choice theory predicts.38 Bounded rational

35 Paul C. Nystrom, Differences in Moral Values between Corporations, 9 J. BUS. ETHICS 971, 974 (1990) (survey of how closely-matched corporations within industrial sectors differed significantly in perceived importance of management’s moral values).

36 GEORGE A. AKERLOF & RACHEL E. KRANTON, IDENTITY ECONOMICS: HOW OUR IDENTITIES SHAPE OUR WORK, WAGES, AND WELLBEING 39–59 (2010) (exploring how workers can abide to shared corporate norms, and lose utility when they put in low effort, and how job-holders, if they have only monetary rewards and only economic goals, “will game the system insofar as they can get away with it”).

37 Stucke, Behavioral Economists, supra note 11, at 546-75. At times, market failure is less likely than rational actors faced with the prisoner dilemma. Some people are more trusting than others, and willing to incur a cost to punish unfair behavior. With a sufficient number of these conditional cooperators in the group, one study of 49 forest group users, the tragedy of the commons can be averted. Devesh Rustagi et al., Conditional Cooperation and Costly Monitoring Explain Success in Forest Commons Management, Science, Nov. 12, 2010, at 961.

38 See infra ; see also U.K. Independent Commission on Banking, Interim Report Consultation on Reform Options 33-38 (Apr. 2011)

10 Behavioral Economics and Dynamic Competition [23-MAY-11firms will not always enter.39 Cartels can be more durable when price-

fixers, like the subjects in other behavioral experiments, are more trustful

and cooperative than rational choice theory predicts.40

A second risk of Scenario IV competition is new forms of market

failure. In competitive markets, firms identify and discover ways to solve

consumers’ problems.41 But the financial crisis, Professor Stiglitz wrote,

showed how the financial innovations involving the subprime mortgage

industry worsened, rather than solved, borrowers’ problems.42 Their

mortgages increased costs and risks for consumers while providing the

mortgage brokers and lenders greater fees. These products increased risk to

the institutions that acquired the ensuing credit default swaps and

collateralized debt obligations.43 Among the losers in the financial crisis

were other supposedly sophisticated investors who failed to appreciate these

assets’ risks.44 Moreover, these financial innovations made speculation

easer.45 Thus market forces under Scenario IV do not necessarily yield the

desired outcome.

II. IMPLICATIONS OF DYNAMIC THEORY OF COMPETITION ON

MONOPOLIZATION LAW

Once the assumption of rationality is relaxed, a more dynamic

conception of competition emerges. This conception of competition has

many potential implications for monopolization claims. This Article

(noting how consumers do not switch banks as often as economic theory predicts).

39 Reeves & Stucke, Behavioral Antitrust, supra note 11.40 Stucke, Behavioral Economists, supra note 11; Stucke, Am I a

Price-Fixer, supra note **.41 Kerber, supra note **, at 4.42 STIGLITZ, supra note **, at 5, 80.43 MICHAEL LEWIS, THE BIG SHORT: INSIDE THE DOOMSDAY MACHINE (2010).44 JOHNSON & KWAK, supra note **, at 199; CASSIDY, supra note **, at

272.45 CASSIDY, supra note **, at 239, 243-50; GILLIAN TETT, FOOL’S GOLD: HOW

THE BOLD DREAM OF A SMALL TRIBE AT J.P. MORGAN WAS CORRUPTED BY WALL STREET GREED AND UNLEASHED A CATASTROPHE (2009).

23-May-11]Behavioral Economics and Dynamic Competition 11focuses on two implications: entry barriers and behavioral exploitation.

A. Herding and Behavioral Learning as Entry Barriers

For Robert Bork and others, monopolies (other than those protected by

the government) are short-term phenomena46: the innovator’s supra-

competitive profits serve as bait for imitators, who “first reduce and then

annihilate [the monopolist’s] profit,” which reverts to the competitive

mean.47 Innovation attracts imitation, which leads to commoditization.

While not necessarily adopting Bork’s view of entry barriers, U.S.

courts in considering whether a firm can attempt to monopolize, or

monopolize, a market examine the likelihood of entry.48 Entry analysis

plays a key role in any section 2 case. Courts will dismiss a monopolization

or attempted monopolization claim if the plaintiff cannot prove that entry

barriers in the relevant market are “significant” and “substantial” enough to

confer monopoly power.49 Notwithstanding the firm’s intent to monopolize

a market and its anticompetitive conduct, the court could find that rational

profit-maximizing entrants will materialize and rescue the consumer.

Given the importance of entry analysis in monopolization cases, it

follows that the types of entry barriers that the courts recognize are of great

importance. Traditional entry analysis focused on manufacturing,

46 ROBERT H. BORK, THE ANTITRUST PARADOX: A POLICY AT WAR WITH ITSELF 195-96 (1978).

47 JOSEPH A. SCHUMPETER, THE THEORY OF ECONOMIC DEVELOPMENT 89 (1934).48 See, e.g., AD/SAT v. AP, 181 F.3d 216, 229 (2d Cir. 1999) (affirming summary

judgment for defendant on attempted monopolization claim and noting that the presence of “low barriers to market entry” suggested that the defendant would “face significant competition from new entrants”); Bailey v. Allgas, Inc., 284 F.3d 1237 (11th Cir. 2002) (affirming summary judgment for defendant in Robinson Patman Act case where plaintiff failed to show the presence of entry barriers and noting that “the ease or difficulty of entry” is “[t]he most significant structural factor bearing on the ability to recoup predatory losses through inflated prices” because “[w]here a market has low barriers to entry, sellers charging supracompetitive prices will soon attract new competitors, sellers charging supracompetitive prices will soon attract new competitors”).

49 United States v. Microsoft Corp., 253 F.3d 34, 81, 82 (D.C. Cir. 2001) (“firm cannot possess monopoly power in a market unless that market is also protected by significant barriers to entry”).

12 Behavioral Economics and Dynamic Competition [23-MAY-11distribution and regulatory barriers, such as “planning, design, and

management; permitting, licensing, or other approvals; construction,

debugging, and operation of production facilities; and promotion (including

necessary introductory discounts), marketing, distribution, and satisfaction

of customer testing and qualification requirements.”50 The agencies’ and

courts’ analyses of entry barriers have evolved. One important entry

consideration for branded differentiated consumer goods is the time,

expense, and likelihood of an entrant in gaining consumers’ confidence and

trust (especially for products with powerful chemicals that may pose

significant health risks, like hair relaxers).51

Another important development in entry analysis is network effects.52

In Microsoft, the antitrust plaintiff had to prove that (1) “network effects

were a necessary or even probable, rather than merely possible,

consequence of high market share in the browser market and (2) that a

barrier to entry resulting from network effects would be ‘significant’

enough to confer monopoly power.”53 Network effects can be direct or

indirect.54 Direct network effects arise when a consumer’s utility from a

product (e.g., telephone) increases when others use the product.55 Indirect

network effects arise when “the greater the number of users of a given

software platform, the more there will be invested in developing products 50 2010 Horizontal Merger Guidelines § 9.51 U.S. Dep’t of Justice & Fed. Trade Comm’n, Commentary on the

Horizontal Merger Guidelines 39 (Mar. 2006). 52 See, e.g., Skydive Arizona, Inc. v. Quattrocchi, 2009 WL 2515616,

at *2 (D. Ariz. Aug. 13, 2009) (finding under Daubert that general economic principles on networks and network effects was reliable foundation); Bristol Technology, Inc. v. Microsoft Corp., 42 F. Supp. 2d 153, 169 (D. Conn. 1998); U.S. v. Microsoft Corp., 1998 WL 614485, at *4 (D.D.C. Sept. 14, 1998).

53 United States v. Microsoft Corp., 253 F.3d 34, 83 (D.C. Cir. 2001). 54 Marina Lao, Networks, Access, and “Essential Facilities”: From Terminal Railroad

to Microsoft, 62 SMU L. REV. 557, 560-61 (2009).55 Microsoft, 253 F.3d at 49; In re Ebay Seller Antitrust Litig., 2010 WL 760433, at

*10 (N.D. Cal. Mar. 4, 2010) (eBay not contesting significant entry barriers to the online auctions market because of network effects).

23-May-11]Behavioral Economics and Dynamic Competition 13compatible with that platform, which, in turn reinforces the popularity of

that platform with users.”56 Firms compete to dominate markets

characterized with network effects, and “once dominance is achieved,

threats come largely from outside the dominated market, because the degree

of dominance of such a market tends to become so extreme.”57

A behavioral economics perspective raises two additional entry

barriers: herding and behavioral learning. Consumers, at times, are

confronted with competing, incompatible technologies. In choosing, the

consumer wants the technology platform that others will likely choose, as

the more popular platform (e.g., Blu-ray v. HD DVD, Google’s Android

versus Apple58) will attract more supporting complements developed for

that platform.59 Each consumer may prefer the superior technology, but

forego it for the perceived popular one.60 In believing that others will opt

for the subpar technology, the consumer will choose the subpar technology

and contribute to the suboptimal outcome. Herding leads to irrational

exuberance (or pessimism) over stocks, real estate, and tulips.61 Fads

emerge where a consumer’s utility from an item (such as a designer bag)

depends on who else owns the item (either the perceived trend-setters62 or

masses63). Thus, a firm may seek to secure (or maintain) its monopoly

56 CFI Microsoft ¶ 1061.57 Novell, Inc. v. Microsoft Corp., 505 F.3d 302, 308 (4th Cir. 2007).58 Dylan Byers, Google and Apple Battle for Developers' Hearts and

Minds, at Google I/O Conference, Fight between Android, iPhone Rages On, Adweek, May 12, 2011, http://www.adweek.com/news/technology/google-and-apple-battle-developers-hearts-and-minds-131550.

59 See United States v. Microsoft Corp., 84 F. Supp. 2d 9, 20 (D.D.C. 1999); Case T-201/04, Microsoft Corp. v. Comm’n, 2007 E.C.R. II-3601 (Ct. First Instance).

60 CASSIDY, supra note **, at 130-31.61 JOHN KENNETH GALBRAITH, A SHORT HISTORY OF FINANCIAL EUPHORIA

(1993).62 See, e.g., THORSTEIN VEBLEN, THE THEORY OF THE LEISURE CLASS 25, 33

(Penguin 1994) (discussing primary motive to accumulate wealth is pecuniary emulation).

63 Peter Sheridan Dodds & Duncan J. Watts, Influentials, Networks,

14 Behavioral Economics and Dynamic Competition [23-MAY-11through herding, by using deceptive statements64 and vaporware.65

A second entry barrier is behavioral learning, whereby a firm to

effectively compete must attain a sufficient scale of trial-and-error

feedback. As Part I discusses, bounded rational firms compete by

improving their products and services through a trial-and-error process.

Through trial-and-error firms can increase internal productive efficiencies.

Semiconductor firms, as F.M. Scherer discusses, make mistakes in the early

stages of production, adjust their processes, and thereby lower their

manufacturing costs for their next batch.66 Consequently, aside from the

direct and indirect network effects,67 Intel benefited from another network

effect, namely continually learning from its mistakes during its early

production period, which enabled it to lower costs as it increased output.

Aside from internal behavioral learning, firms can also learn through

their networks with suppliers and customers. Here scale is also critical

when consumer preferences are not stable and predictable. To keep abreast

with changing customer preferences, bounded rational firms rely on trial-

and-error feedback loops. Firms experiment with an option, monitor

and Public Opinion Formation, 34 J. CONSUMER RES. 441-458 (2007).64 FTC Intel Compl. ¶ 10 (alleging how Intel engaged in deceptive

acts and practices to mislead consumers and the public, including pressuring independent software vendors to label their products as compatible with Intel and not to similarly label with competitor’s products’ names or logos, even though these competitor microprocessor products were compatible).

65 Maurice E. Stucke, How Do (and Should) Competition Authorities Treat a Dominant Firm’s Deception?, 63 SMU L. REV. 1069 (2010).

66 Scherer, High Tech, supra note **, at 49-50.67 Complaint, In re: Intel Corporation, FTC Docket No. 9288, ¶ 10

(discussing the need simultaneously to secure a large number of users in order to make the product attractive to software developers and to secure the efforts of software developers in order to make the product attractive to users, and Intel’s success “in obtaining commitments from many computer manufacturers and software vendors to build computers and write software for Intel's new 64-bit Merced microprocessor, even though the product will not be available for nearly two years”).

23-May-11]Behavioral Economics and Dynamic Competition 15customer reaction to their (and their competitors’) offerings, readjust, and

monitor. The more feedback firms receive from a larger percentage of

targeted consumers, the more the firms can refine their technologies, the

better able they can match their technology to customers’ preferences, the

greater their competitive advantage. Thus, competitors in some industries

may require a minimum scale of feedback from bounded rational customers,

without which they cannot effectively compete. One example is search

engines.

To navigate the Internet, Google, Yahoo and other search engines rely

on algorithms to identify web pages that match the consumers’ search

terms. In this two-sided market, the better the search engine is in

identifying the right matches, the more popular the search engine is for

consumers, the more attractive the search engine is to advertisers seeking to

target those consumers, the greater the advertising revenue the search

engine garners compared to competitors, and the likelier the search engine

company can monopolize this two-sided market.68

Under rational choice theory, an antitrust plaintiff would have a

difficult time proving that (1) network effects were probable and (2) if even

if probable, they would create entry barriers significant enough to confer

monopoly power. With Mozilla’s Firefox Internet browser for example,

one can easily run a search among the different search engines and compare

results. To the extent one search engine is lagging, it can hire a

competitor’s search engine engineers to develop better algorithms.

Accordingly, one would expect a competitive equilibrium among search

engines, whereby a consumer could obtain roughly similar results for the

same search terms. Absent another point of differentiation (such as better

68 See Competitive Impact Statement, United States v. Google, (D.D.C. Apr. 8, 2011); Author’s Guild v. Google, No. 05 Civ. 8136 (DC), 2011 WL 986049, at *12 (S.D.N.Y. Mar. 22, 2011) (recognizing “Google’s market power in the online search market”).

16 Behavioral Economics and Dynamic Competition [23-MAY-11graphics or quicker results) or a tipping point (similar to daily newspapers

whereby advertisers would support only one competitor), one search engine

should not dominate the market.

But with bounded rational consumers, a new form of network effects

emerges. When a consumer types “orange” and “apple” in Google, for

example, the search engine quickly generates results that seek to best match

the consumer’s interest. Google has the benefit of observing which, if any,

links the consumer actually chooses. If many consumers choose a link that

was originally offered down the list (say on the fourth page of results),

Google can move that result up the list, and demote suggested links that are

infrequently tapped down the list. Thus the greater the number of

consumers who use the search engine and the greater the number of

searches, the more trials the search engine company has in predicting

consumer preferences, the more feedback the search engine receives of any

errors, and the quicker the search engine can respond with recalibrating its

offerings. Increased traffic volumes make more experiments possible,

thereby improving search results.69 With a greater churn of trial and error,

the search engine can quickly adapt to changing preferences, improve its

product, and thereby attract additional consumers to that search engine

compared to competitor sites. If consumers lack time or inclination to run

their search on multiple sites, then entry becomes more difficult. The new

entrant can hire Google’s tech talent, but it still lacks the scale of this trial-

and-error experimentation. With fewer trials, search results will likely be

inferior going forward in identifying sites that consumers prefer, decreasing

the popularity of that search engine for consumers and advertisers. Indeed,

with more trial-and-error experimentation, the search engine can innovate

69 Teresa Vecchi et al., The Microsoft/Yahoo! Search Business Case, European Commission Competition Policy Newsletter Issue 2, at 46 (2010).

23-May-11]Behavioral Economics and Dynamic Competition 17with predictive search technology (such as suggesting search phrases that

refine the consumer’s search or her need to complete typing the search

term).

To the extent that preferences diverge across demographics, a search

engine that loses important segment of the population can become a niche

player. As Microsoft observed,

there's this kind of inverse power loss, where 39 percent of the users

account for 66 percent of all the searches. I think of them as the heavy

searchers. Ourselves and Yahoo! and others have been losing heavy

searchers for the last number of years. Since the Bing launch, we've

actually inverted that, we're actually growing heavy searchers. And

when you look at the demographics, we are over-indexed on 18 to 24

year olds now as a result of those heavy users. Before that, we were

over-indexed on 65-year plus in terms of demographics, which is our

MSN base.70

A justification of the Microsoft-Yahoo partnership was to achieve this

scale of behavioral learning through trial-and-error. In December 2009,

Microsoft partnered with Yahoo! to provide the exclusive algorithmic and

paid search platform for Yahoo! Web sites. Microsoft believed this

agreement would allow it over time to improve the effectiveness and

increase the value of its “search offering through greater scale in search

queries and an expanded and more competitive search and advertising

marketplace.”71 Before the partnership, fewer people used Microsoft’s and

Yahoo’s search engines.72 The European Commission found that Yahoo

and Microsoft were below 10 percent in both search and search advertising 70 Credit Suisse Annual Technology Conference, December 1, 2009, Yusuf Mehdi,

senior vice president, Online Audience Business.71 Microsoft 2010 Annual Report.72 Teresa Vecchi et al., The Microsoft/Yahoo! Search Business Case,

European Commission Competition Policy Newsletter Issue 2, at 46 (2010).

18 Behavioral Economics and Dynamic Competition [23-MAY-11in the European Economic Area.73 Google’s share of the search and

advertising markets was over 90 percent.74 The search business, the

European Commission found, required “substantial and continuous

investment in the quality of the search and related R&D.”75 The

Commission’s market investigation found that the “quality and relevance of

the algorithmic search engine” as “the most important factor in attracting

users to a particular search engine.”76 As Microsoft’s CEO Steve Ballmer

said,

it turns out there's a feedback loop in the search business, where the most searches you serve, or paid ad searches you serve, the more you learn about what people click on, what's relevant, and it turns out that scale drives knowledge which then can turn around and redrive innovation and relevance. So, actually even our ability to understand our customers and innovate around that is enhanced by putting the two assets together. It's not just putting them together, but putting them together in this business, which is unlike other businesses, there is a return to scale from seeing that much more Internet activity than either Yahoo! or Microsoft sees independently.77

One year later, Microsoft’s Bing has seen an increase in consumer usage;

whether the search engine will attain the necessary scale to threaten

Google’s monopoly is less clear.78

Consequently, aside from conventional network effects, courts going

forward must consider other entry barriers when consumer preferences are

unstable and hard to predict. To effectively compete, an entrant in some 73 Vecchi et al., supra note **, at 46.74 Vecchi et al., supra note **, at 46.75 Vecchi et al., supra note **, at 46.76 Vecchi et al., supra note **, at 46.77 http://www.microsoft.com/presspass/exec/steve/2009/07-

29search.mspx.78 Matt Rosoff, Microsoft Should Have Let Google Have Search To

Itself, Business Insider, Apr. 20, 2011, http://www.businessinsider.com/microsoft-should-have-let-google-have-search-to-itself-2011-4#ixzz1Lyx0ikow.

23-May-11]Behavioral Economics and Dynamic Competition 19industries must attract enough consumers (or those heavy consumers whose

preferences most closely resemble the target audience) to engage in this

trial-and-error feedback loop. This behavioral entry barrier will be of

greater significance going forward as companies seek to match offerings

with consumer tastes. To the extent pairing specific products with consumer

preference is an important facet of competition, companies with more

subscribers (like Netflix, Amazon, or Apple’s iTunes) have more

opportunities to predict what movies, books, or music the subscribers would

enjoy, monitor actual selections, and revise their predictions, thereby

adapting to evolving consumer preferences and products. With this scale

from behavioral learning, the company will secure a significant competitive

advantage over smaller rivals and decrease the likelihood that an entrant can

threaten its monopoly.

B. Behavioral Exploitation

Although firms and consumer, while bounded rational, are not

necessarily bounded rational in the same way and to the same degree.

Firms, for example, may be more susceptible than consumers to one bias in

one factual context (e.g., overconfidence over a merger’s efficiencies).

Moreover being bounded rational with bounded willpower does not

necessarily mean ignorance. One may recognize one’s shortcomings

(eating snacks before the television rather than exercising), but lack the

necessary commitment device.

Thus firms can compete in ways to help consumers address or mitigate

their biases and bounded willpower and provide consumers a better mix of

solutions.79 As subpart A discusses, bounded rational firms through their

(or monitoring their competitors’) trial-and-error experiments can update

79 Kerber, supra note **, at 4; MISES, supra note **, at 24 (“competition among the various entrepreneurs is essentially a competition among the various possibilities open to individuals to remove as far as possible their state of uneasiness by the acquisition of consumers’ goods”).

20 Behavioral Economics and Dynamic Competition [23-MAY-11product offerings to accommodate consumers’ changing preferences. Their

ability depends in part on the feedback loop’s efficacy and the competitive

behavior’s transparency.80

Alternatively firms can compete in devising better ways to exploit

consumers’ bounded rationality to the consumers’ detriment. Firms also

can seek to lessen competition by reducing price transparency and

differentiating their products or services through branding and technological

innovation.81

So too monopolists can use the biases and heuristics discussed in the

behavioral economics literature (such as status quo bias, framing effects) to

attain or maintain their monopoly. Through the lens of neoclassical

economic theory, such behavior, rather than exploitive, would appear

benign. One example is the European Commission’s prosecution of

Microsoft for abusive tying. Although similar behavior was at issue in the

U.S. prosecution, the Commission’s case provides a richer narrative: how

Microsoft premised its defense on rational choice theory; the Commission

and Court of First Instance’s response, which was in accord with behavioral

economics findings of actual consumer behavior; the shortcomings of the

Commission’s remedy (which indeed was predictable under behavioral

economics); the Commission’s reappraisal of its behavioral remedy in the

Internet browser settlement, and the remedy’s advantages and shortcomings.

The Commission accused Microsoft inter alia of tying its media player

to its operating system, where it enjoyed a dominant position. Media

players, which are now ubiquitous, enable consumers to store and play

80 Kerber, supra note **, at 5.81 State of Ill., ex rel. Burris v. Panhandle Eastern Pipe Line Co., 935

F.2d 1469, 1481 (7th Cir. 1991) (“Virtually all business behavior is designed to enable firms to raise their prices above the level that would exist in a perfectly competitive market.”); see also Desai & Waller, supra note **; Steiner, supra note **, at 84-85 (discussing price premium for strong reputation brands).

23-May-11]Behavioral Economics and Dynamic Competition 21music and videos on their computers (and now on handheld devices).

Originally RealNetworks licensed Microsoft its media player, RealPlayer.82

In 1997, senior Microsoft executives “noted the dangers of Apple’s and

RealNetworks’ multimedia playback technologies, which ran on several

platforms (including the Mac OS and Windows) and similarly exposed

APIs to content developers. Microsoft feared all of these technologies

because they facilitated the development of user-oriented software that

would be indifferent to the identity of the underlying operating system.”83

In 1998, Microsoft released its Windows Media Player, which at that time

supported different formats, including Apple’s QuickTime and

RealNetworks’s RealAudio and RealVideo. But that changed by 1999,

when Microsoft released its Windows 98 Second Edition.

The European Commission found Microsoft liable for abusive tying of

its personal computer operating system and its streaming media player. Of

the offense’s four elements, the focus was on the second element (the tied

and tying products are two separate goods).84 The first and third elements

of abusive tying were not at issue. Microsoft’s dominant position in the

operating system market (the tying product) was not seriously disputed.

Nor was the third element, namely that Microsoft did not give customers a

choice to obtain the tying product without the tied product, seriously

contested. In both the U.S. and EU, one evil of tying is the monopolist

82 CFI Microsoft ¶ 837 (noting how Microsoft included RealPlayer in its Internet Explorer 4.0).

83 U.S. v. Microsoft Corp., 84 F. Supp. 2d 9, 30 (D.D.C. 1999), affirmed in part, reversed in part, 253 F.3d 34 (D.C. Cir. 2001).

84 Microsoft argued that liability would punish dominant undertakings from improving their products by integrating new features in them. A dominant firm, argued Microsoft, would be obligated to remove its innovations whenever a third party marketed a standalone product that provided the same or similar functionalities. CFI Microsoft ¶ 888. The United States Court of Appeals for the D.C. Circuit was sympathetic to Microsoft’s claims. The Court held that the per se illegality standard should not apply to Microsoft’s tying its Internet web browser, Explorer, to its operating system. The Court remanded for a more lenient rule of reason standard, and the United States and Microsoft settled.

22 Behavioral Economics and Dynamic Competition [23-MAY-11“affords consumers no choice but to purchase” (not so much to use85) the

tied product.86 Microsoft’s Windows Media Player came with the operating

system. Neither computer manufacturers (OEMs) nor consumers could

remove the Windows Media Player.87

What is interesting for our purposes is the offense’s fourth element,

namely that Microsoft’s tying practice foreclosed competition. The

European Commission, like the district court in the U.S. case, observed how

the industry was characterized with network effects. One complaint was

that with its operating systems monopoly (enforced by network effects),

Microsoft could ward off potential threats by tying its imitation product.

Once Microsoft added its version, the Commission found, programmers will

develop solutions for the Microsoft platform because it will reach

automatically 90% of client PC users, and thus save the content providers

the costs of supporting different technology platforms. Under this positive

feed-back loop, more users of a given software platform lead to a greater

incentive to develop products compatible with that platform, which

reinforces that platform’s popularity with end-users (and the software

company’s market power). Thus Microsoft chilled the incentives for

potential innovators to challenge the entrenched monopolist. As the

Commission argued and Court of First Instance found, such bundling

“discourages investment in all the technologies in which Microsoft could

conceivably take an interest in the future.”88

85 CFI Microsoft Decision ¶ 970 (“neither Article 82(d) EC nor the case-law on bundling requires that consumers must be forced to use the tied product or prevented from using the same product supplied by a competitor of the dominant undertaking in order for the condition that the conclusion of contracts is made subject to acceptance of supplementary obligations to be capable of being regarded as satisfied”).

86 Cite Microsoft, Kodak, Jefferson Parish. The evil is in coercing the consumer to purchase the tied good. CFI Microsoft ¶ 865 (noting how coercion was mainly applied first of all to OEMs, who then pass it on to the end user).

87 CFI Microsoft ¶¶ 832, 837.88 Microsoft, 2007 E.C.R. II-3601.

23-May-11]Behavioral Economics and Dynamic Competition 23But from a rational choice perspective, it is difficult to see the coercion

or foreclosure one typically finds in tying claims. It was uncontested that

consumers, after unpacking the computer and starting it up, could search the

Internet for the media player they want, download the software to their

computer, and use that media player for listening to music or watching

videos.89 Consequently, the issue was to what extent did the monopolist

foreclose competition when consumers could download (often for free)

alternative media players on the Internet.90

Nor were consumers or the OEMs disadvantaged if they opted for an

alternative media player.91 After the U.S. antitrust consent decree,

Microsoft could not design its operating system to hamper rival media

players, as it earlier did with its Internet browser. Nor could Microsoft

contractually require software developers, content providers or anyone else

to distribute or promote exclusively or mainly its Windows Media Player.92

It was undisputed that Microsoft’s operating system could run one or more

media players without affecting the media players’ performance.93 Nor

were consumers forced to use Microsoft’s Windows Media Player.

Consumers could set another media player as the default option.94 As the

Commission and Court of First Instance observed, a “not insignificant 89 CFI Microsoft ¶ 829. Moreover media players may be sold in retail outlets or

distributed with other software products. CFI Microsoft ¶ 830. 90 The Commission questioned the extent the media players were free: “Third-party

media players offering all the functionality of WMP are often not given away for free. Microsoft’s argument that ‘media player vendors have business models in which they give away most copies of their products’ therefore has to be taken with a degree of caution. It would indeed appear that users feel still less inclined to buy a second media player - even though it offers more functionality than a basic free version of the same brand - where they have already obtained a comparable full-fledged media player pre-installed on their PC.” EC Decision ¶ 847 (footnotes omitted). Consumers today can download a free copy of RealPlayer (http://www.real.com/realplayer), QuickTime (http://www.apple.com/quicktime/download/), and other media players (http://download.cnet.com/windows/media-players/).

91 CFI Microsoft ¶ 995.92 CFI Microsoft ¶ 995 (no exclusivity provisions).93 CFI Microsoft ¶ 993.94 CFI Microsoft ¶ 952.

24 Behavioral Economics and Dynamic Competition [23-MAY-11number of customers continue to acquire media players from Microsoft’s

competitors, separately from their client PC operating system, which shows

that they regard the two products as separate.”95 At the time of litigation,

consumers used on average 1.7 media players each month, and that number

was increasing.96

One could strain under rational choice theory to find some coercion.

First, rational consumers must devote some time and effort to download a

media player,97 which could take longer for users without broadband

Internet service. Second, OEMs and consumers could not delete Windows

Media Player from Microsoft’s Windows operating system. Any media

player would be in addition to Microsoft’s product.98 Thus, consumers were

unable to devote this computer memory, used by Microsoft’s media player,

for other purposes. Third, Microsoft devised its software so that its

Windows Media Player could override the consumer’s default setting and

reappear when the consumer used Microsoft’s Internet Explorer to access

media files streamed over the Internet.99

While annoying, these factors hardly justify a finding of coercion or

foreclosure. If other media players offered superior performance for free

(or at an attractive price), then rational consumers would incur these minor

costs to install and use a competing media player. Put simply, the benefits

of using a competing media player outweigh the costs to download it (and

use up some additional computer memory). Accordingly, rational

consumers would switch if alternative media players indeed were

objectively of “better quality.”100 Since rational consumers would switch to

95 CFI Microsoft ¶ 932.96 CFI Microsoft ¶ 953.97 EC decision ¶ 866-67. The scarcity of broadband Internet, slower download times,

and failed downloads also may have contributed to consumers’ sticking with the default. 98 CFI Microsoft ¶ 946.99 CFI Microsoft ¶ 974.100 CFI Microsoft ¶ 971.

23-May-11]Behavioral Economics and Dynamic Competition 25superior media players, then logically software programmers and music

companies would continue to support the superior players’ formats;

Microsoft’s attempt to thwart the competitive threat of middleware (or

leverage its monopoly to the media player market) would fail.

Many consumers, however, did not (i) purchase Windows N (the

version of Microsoft’s operating system without its Windows Media

Player), and (ii) download RealNetworks’s and Apple’s competing media

players when they readily could have. But this too is explainable under

rational choice theory: these facts are consistent with competition on the

merits. Rational consumers could and would easily switch to superior

media players. If actual consumers are rational and if many did not

download other media players, one can deduce that Microsoft’s Windows

Media Player was as good as, if not superior to, competing media players.

Herein lies the problem. Windows Media Player’s growth, as Microsoft

itself recognized, was not attributable to its superior quality to rival

products or that the rival products, in particular RealPlayer, had defects.101

“In fact, Microsoft’s own October 2003 submission illustrates that the

reviews presented (1999-2003) rate the best product to be

RealNetworks’player more often than WMP.”102 Consequently, rational

choice theory cannot explain actual consumer behavior.

For a rational choice theorist, the default option (assuming low

transactions costs) should not matter. Whatever the default option,

consumers would readily opt for their preferred option, which here would

be the superior media player. If many consumers preferred Windows Media

Player, but OEMs installed RealNetworks’s player, then consumers would

switch to Windows Media Player.

But as the behavioral economics literature shows, the setting of the

101 CFI Microsoft ¶ 1057.102 EC Microsoft ¶ 948.

26 Behavioral Economics and Dynamic Competition [23-MAY-11default can often determine the outcome (even when transaction costs are

nominal).103 Default options have played an important role in participation

and investments in retirement savings, contractual choices in health-clubs,

organ donations, and car insurance plans.104 With different views (until

perhaps recently) of the benefits of class actions, the EU and the U.S. have

different preferences of class members opting out versus opting into the

class.105 The district court in the Google book search action recently

observed that many concerns over the proposed settlement would be

“ameliorated” if the settlement were converted from an “opt-out” to an

“opt-in” settlement.106 Not surprisingly, firms and consumers can have

different preferences over the default option. In the Federal Reserve’s

testing, for example, the majority of surveyed participants preferred setting

the default as consumers having to opt into the bank’s overdraft program

rather than having to opt out (which many banks preferred).107

In Microsoft, the monopolist preferred having its inferior media player

as the default option requiring consumers to opt into an alternative media

103 RICHARD H. THALER & CASS R. SUNSTEIN, NUDGE: IMPROVING DECISIONS ABOUT HEALTH, WEALTH, AND HAPPINESS 78 (2008); Camerer et al., supra note **, at 1211.

104 SUNSTEIN & THALER, NUDGE, supra note 103, at 129-30; Stefano DellaVigna, Psychology and Economics: Evidence from the Field, 47 J. ECON. LIT. 315, 322 n.11 (2009); Eric J. Johnson et al., Defaults, Framing and Privacy: Why Opting In-Opting Out, 13 MARKETING LETTERS 5-15 (2003) (consent to receive e-mail marketing); C. Whan Park et al., Choosing What I Want Versus Rejecting What I Do Not Want: An Application of Decision Framing to Product Option Choice Decisions, 37 J. MARKETING RES. 187-202 (2000) (car option purchases).

105 European Consumer Consultative Group, Opinion on Private Damages Actions 4 (2010) (noting Europe’s recent experience that the rate of participation in opt-in procedure for consumer claims was less than one percent, whereas under opt-out regimes, rates are typically very high (97% in the Netherlands and almost 100% in Portugal)), http://ec.europa.eu/consumers/empowerment/docs/ECCG_opinion_on_actions_for_damages_18112010.pdf.

106 Authors Guild v. Google Inc., Civ. Act. No. 05 Civ. 8136, slip op. at 46 (S.D.N.Y. Mar. 22, 2011).

107 Board of Governors of the Federal Reserve System, Final rule; official staff commentary, 12 C.F.R. Part 205, http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20091112a1.pdf.

23-May-11]Behavioral Economics and Dynamic Competition 27player. As Microsoft recognized, some consumers would reject the default

option and download a rival media player. But many simply would stick

with the default option. Consequently, the Court of First Instance

recognized that consumers “who find Windows Media Player pre-installed

on their client PCs are generally less inclined to use another media

player.”108 The EC was blunt: “A supply-side aspect to consider is that,

while downloading is in itself a technically inexpensive way of distributing

media players, vendors must expend resources to overcome end-users’

inertia and persuade them to ignore the pre-installation of WMP.”109 Not

only is inertia (status quo bias) at work. Some non-computer savvy

consumers may believe that default option represents the deliberate choice

by the OEM to include the superior media player.110 Status quo bias

explains why many consumers remain with the default option, even though

rational choice theory predicts that they would download the superior rival

media browser.

Although the facts did not support its rational choice theory, Microsoft

argued that the facts contradicted the Commission’s behavioral explanation.

Downloading was a viable mechanism to distribute a media player,

Microsoft argued, as “more than 100 million copies of WMP 9 were

downloaded in the ten months the software was available to the general

public.”111 The EC noted that these “copies were downloaded by people

who already had a version of Windows Media Player installed on their

PCs.”112 If bounded rational consumers remain with the default option, then

logically consumers would stick not only with the default media player, but

108 CFI Microsoft ¶ 980.109 EC Microsoft ¶ 870, quoted in CFI Microsoft ¶ 1052.110 CFI Microsoft ¶ 1050.111 EC decision ¶ 864, http://ec.europa.eu/competition/elojade/isef/case_details.cfm?

proc_code=1_37792112 EC decision ¶ 864, http://ec.europa.eu/competition/elojade/isef/case_details.cfm?

proc_code=1_37792

28 Behavioral Economics and Dynamic Competition [23-MAY-11also with that version of the media player. If Microsoft users overcame

status quo bias to upgrade their default media player, arguably they could

upgrade to any media player. But here Microsoft did not rely on consumers

to search for and download software updates. Instead Microsoft nudged its

consumers. Microsoft implemented a mechanism in its Windows Media

Player by which the player independently and regularly looked for upgrades

on Microsoft’s Web site, and prompted the user to download it.113

Moreover, since consumers procrastinate, Microsoft “repeatedly” prompted

the consumer to download the upgraded WMP 9 if consumers chose not to

do so at the first prompt.114

Thus as the European Commission recognized, the default option

matters. Regulators and the industry will continue to battle over whether

consumers need to opt-out or opt-in. For if Microsoft seriously considered

downloading as “an equivalent alternative to pre-installation,” observed the

European Commission, then Microsoft’s “insistence on maintaining its

current privilege of automatic pre-installation appears inconsistent.”115

Besides status quo bias, there is also the sunk cost fallacy. Consumers,

under rational choice theory, “ignore sunk costs (costs that cannot be

recovered, such as the cost of nonrefundable tickets).”116 Consumers should

instead consider the costs and benefits going forward. To illustrate:

Assume that you have spent $100 on a ticket for a weekend ski trip to Michigan. Several weeks later you buy a $50 ticket for a weekend ski trip to Wisconsin. You think you will enjoy the Wisconsin ski trip more than the Michigan ski trip. As you are putting your just-purchased Wisconsin ski trip ticket in your wallet, you notice that the Michigan ski trip and the Wisconsin ski trip are for the same weekend! It’s too late to sell either ticket, and you cannot return either one. You must use one ticket and not the

113 EC decision ¶ 864. 114 EC decision ¶ 864.115 EC Decision ¶ 871.116 Jolls et al. supra note, at 1482.

23-May-11]Behavioral Economics and Dynamic Competition 29other. Which ski trip will you go on?117

Under rational choice theory, the $50 and $100 costs are effectively

sunk. Consumers instead would consider the costs/benefits going forward

and opt for the more enjoyable Wisconsin ski trip. But more people, in

response to this question, chose the Michigan trip.118 Bounded rational

firms, governments, and consumers “throw good time and money after bad

even when the logical decision is to cut bait.”119

Monopolists also can use the sunk cost fallacy to maintain their

monopoly. Consumers, for example, can invest significant costs in

downloading songs and movies, creating play lists, and organizing their

music and videos in their media players. These costs are effectively sunk if

consumers cannot transfer their media library to a rival player. Originally

Microsoft’s media player was compatible with rivals. But Windows Media

Player no longer supported the formats of its rivals’ media players. For

rational consumers, the sunk costs invested in Windows Media Player are

irrelevant. Knowing they will continue to download music and movies,

consumers would consider the benefits and costs going forward with the

different media players. But bounded rational consumers, under sunk cost

fallacy, would not want to waste their prior time, expense and effort; so they

continue using Windows Media Player until a new disruptive innovation

(like the iPod, iPhone, and iPad) comes along.120 117 Hal R. Arkes & Catherine Blumer, The Psychology of Sunk Cost, 35 ORG. BEHAV.

& HUM. DECISION PROCESSES 124, 126 (1985).118 Arkes & Blumer, supra note **, at 126 (33 opted for Michigan v. 28 for

Wisconsin).119 Malcolm Baker et al., Behavioral Corporate Finance: A Survey 49 (Sept. 29,

2005), http://ssrn.com/abstract=602902 ; Janky v. Batistatos, 2008 WL 4411504, at *1 (N.D. Ind. Sept. 25, 2008) (noting how “from the acorn of a relatively minor copyright dispute a mighty oak tree of litigation has resulted-two federal cases, three federal appeals, a state case, and several rounds of sanctions”).

120 Interestingly, Apple is currently being sued for encoding its digital music files with its proprietary digital rights management software that only allowed digital music files purchased from Apple’s iTunes Store to be played directly on iPods; the files could not be

30 Behavioral Economics and Dynamic Competition [23-MAY-11To lock-in consumers, monopolists can proactively remind bounded

rational consumers of the sunk costs (e.g., how many installments they

already paid for their appliances, furniture, or home, to induce them to

continue paying installments), even though the consumer going forward

would be better off opting out (e.g., item’s value is less than the remainder

of payments). Thus the sunk cost fallacy magnifies the switching costs,

thereby increasing the “locked-in” effect and the level of price increases (or

reduced quality or services) bounded rational consumers tolerate before

switching brands.121

One issue with status quo bias is determining an appropriate remedy. In

the Commission’s Microsoft case, the remedy was criticized as

ineffectual.122 The Commission, as Microsoft argued, would not have found

an abusive tie if Microsoft offered at the same price two versions of its

operating system: one with Windows Media Player and one without.123 As

its principal remedy, the Commission required Microsoft to allow

consumers to obtain a version of its operating system without its media

player, “a measure which does not mean any change in Microsoft’s current

played directly on competitors’ digital music players. Apple allegedly prevented digital music files sold at other companies' online music stores from being played on iPods. Plaintiffs in the private antitrust claim allege that Apple sought to foreclose RealNetworks, which in 2004, announced that its digital music files could be played on iPods. When Apple's updates to the software were released in October 2004, plaintiffs allege that “users were forced to update their iTunes applications and iPods, the digital music files from RealNetworks's online store were no longer interoperable with Apple's iPods.” Apple iPod iTunes Antitrust Litigation, Slip Copy, 2011 WL 976942, at *1 (N.D. Cal. March 21, 2011).

121 Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992). 122 Kevin J. O'Brien, As EU Debated, Microsoft Took Market Share, N.Y. Times, Sept.

16, 2007, at http://www.nytimes.com/2007/09/16/business/worldbusiness/16iht-msft17.1.7522119.html (noting that settlement perceived as a “commercial flop”); Frederic M. Scherer, Abuse of Dominance by High Technology Enterprises: A Comparison of U.S. and E.C. Approaches, 38 J. Indus. and Bus. Econ. 39, 45 (2011) (characterizing remedy as “an abject failure”).

123 CFI Microsoft ¶ 891. The EC denied making this admission in its decision. Id. at ¶ 908.

23-May-11]Behavioral Economics and Dynamic Competition 31technical practice other than the development of that version of

Windows.”124 As Microsoft accurately predicted, no one would demand the

operating system without the media player.125 This lack of demand, argued

Microsoft to the Court of First Instance, supported its contention that

“’Windows with media functionality’ is a single product.”126

One need not be a behavioral economist to predict the shortcomings of

the Commission’s remedy. But the remedy shows the importance of

prospect theory’s framing effects and the reference point. Prospect theory

predicts that consumers’ response will vary if the option is perceived as

avoiding a loss (consumers are more risk seeking) or as a sure gain

(consumers are more risk adverse). Losses closer to a reference point hurt

more than twice the joy from comparable gains. So if one could measure

joy and pain in standard units (say utils), prospect theory predicts that the

pain one feels in losing $100 is more than twice the joy one would feel in

finding $100.127

Whether the remedy is perceived as a loss or a gain depends on the

reference point.128 Microsoft effectively set the reference point as the

124 EC PRESS RELEASE No 63/07, Judgment of the Court of First Instance in Case T-201/04, Microsoft Corp. v Commission of the European Communities, 17 September 2007, http://europa.eu/rapid/pressReleasesAction.do?reference=CJE/07/63&format=HTML&aged=0&language=EN&guiLanguage=en.

125 CFI Microsoft ¶ 891. 126 CFI Microsoft ¶ 891. 127 Kahneman, supra note **, at 1456. 128 Kahneman et al., supra note **, at 257. One sees the importance

of the reference point for merchants accepting credit cards. The merchant bears different cost for accepting different credit card. The merchant has two ways to characterize the reference point: first as a lower cash price and impose a surcharge for customers using a credit card with a higher interchange fee. Alternatively, the merchant can set the credit price as the reference point, and offer consumers a discount if they paid with cash (or a credit or debit card with a lower interchange fee). Since the net price is the same, how the choice is framed should not affect the outcome. After the credit card companies' No-Discrimination Rule was abolished, Dutch merchants could impose surcharges or offer discounts, based on how the customer was going to

32 Behavioral Economics and Dynamic Competition [23-MAY-11bundled product, namely an operating system with a media player. Thus

the Commission’s remedy was a perceived loss in two aspects: getting a

“degraded” product (the Windows product without a media player)129 and

effectively paying more for it. Since losses (here the loss of one media

player) hurt more than comparable gains (adding one media player of one’s

choosing130), the European Commission’s remedy was likely to fail. The

Commission put itself in an awkward position when it chose as the

reference point the basic unbundled operating system. The Commission

argued that consumers and OEMs could choose which competitor’s media

player, if any, they wanted. Although the Commission properly insisted

that the operating system and media player were two separate products, they

were nonetheless complementary products. The Commission implicitly told

consumers to settle for less (simply an operating system). Alternatively, the

Commission could have required consumers to pay more for the Windows

operating system with Windows Media Player, but this remedy increases

the Commission’s regulatory role for a product that is freely available on

the Internet.131 Neither option is desirable.

Instead, using prospect theory, the European Commission should have

pay. Over seventy percent of the merchants surveyed were unaware of the rule's abolition, and eighty-nine percent of the merchants did not surcharge customers. Nine percent of the merchants offered discounts to customers who paid by different means. Of the consumers surveyed, seventy-four percent thought it (very) bad if a merchant asked for a surcharge for using a credit card. But when asked about a merchant offering a discount, only forty-nine percent thought it (very) bad, with twenty-two percent neutral and twenty-one percent saying it is a (very) good thing. ITM Research, The Abolition of the No-Discrimination Rule at 7-8 (March 2000), http:// ec.europa.eu/comm/competition/antitrust/cases/29373/studies/netherlands/report.pdf.

129 CFI Microsoft ¶ 1171130 The EC believed that OEMs would respond to consumer

expectations by pre-installing another media player on the version without Windows Media Player. CFI Microsoft ¶ 1204.

131 CFI Microsoft ¶ 968.

23-May-11]Behavioral Economics and Dynamic Competition 33moved the reference point in the opposite direction such that consumers

would have perceived Microsoft’s reference point as a loss. The

Commission never asserted that operating systems and media players were

unrelated. Rather, the Commission asserted that it was not necessary for

Microsoft’s media player to be bundled with its operating system. Thus, the

Commission could have established as the reference point an operating

system that came with several choices of media players, from which users

could chose. With this reference point, a Windows operating system that

comes only with Windows Media Player is a perceived loss (and the loss of

two options hurts more than the pleasure gained from one option); moreover

consumer prefer having some choices rather than having no choice.

The Commission learned from its mistake, and experimented with this

other reference point when it later challenged Microsoft for tying its web

browser, Internet Explorer, to its personal computer operating system,

Windows.132 Before the settlement, consumers who used Windows had

Microsoft’s Internet Explorer as their default web browser. Although

consumers could download other Internet browsers, many did not, a

function not attributable necessarily to the superiority of Microsoft’s

browser but status quo bias.133 Rather than using its earlier reference point

(namely an operating system without a browser), the Commission

effectively shifted to the superior reference point: “’The commission had

suggested to Microsoft that consumers be provided with a choice of web

browsers,’ the EC wrote regarding the standalone software proposal.

132 Press Release, European Commission, Antitrust: Commission Welcomes Microsoft's Roll-Out of Web Browser Choice, IP/10/216 (Mar. 2, 2010), http://europa.eu/rapid/pressReleasesAction.do?reference=IP/10/216&format=HTML&aged=0&language=EN.

133 Shane Frederick, Automated Choice Heuristics, in HEURISTICS AND BIASES: THE PSYCHOLOGY OF INTUITIVE JUDGMENT 555 (Thomas Gilovich et al. eds. 2002) (summarizing experimental evidence of peopling preferring current options over other options to a degree that is difficult to justify).

34 Behavioral Economics and Dynamic Competition [23-MAY-11‘Rather than more choice, Microsoft seems to have chosen to provide

less.’”134

As part of its settlement, Microsoft for five years must provide

consumers within the European Economic Area a Browser Choice Screen.

Rather than having one Internet browser as the default, computer users must

choose whether they want a browser, and if so, which browser they want to

install from the competing web browsers listed on the screen.135 Identified

are five Internet browsers, with a short description of each, along with links

for further information.136

The European Commission’s browser remedy is superior under prospect

theory to its earlier media player remedy. But it remains unclear how

successful the settlement has been to date. On the one hand, Microsoft’s

share of the European browser market declined after the settlement--from

44.9 percent in January 2010 to 39.8 percent in October 2010.137 Thus

Microsoft has a lower market share in the European Union, where

consumers are given a choice, than elsewhere in the world where consumers

with the Windows operating system must continue downloading an

alternative browser.138 Moreover, according to one report, downloads of

134 Ryan Singel, EU Criticizes Microsoft’s IE Unbundling, but Does It Matter Anymore?, Wired, June 12, 2009, http://www.wired.com/epicenter/2009/06/eu-criticizes-microsofts-ie-un-bundling-but-does-it-matter-anymore/

135 Summary of Commission Decision of 16 December 2009 relating to a proceeding under Article 102 of the Treaty on the Functioning of the European Union and Article 54 of the EEA Agreement (Case COMP/39.530 — Microsoft (Tying)) (2010/C 36/06).

136 http://www.browserchoice.eu/BrowserChoice/browserchoice_en.htm.

137 In 2009, Microsoft’s share declined by 5.5 percentage points; in 2008 by 8 points. Kevin J. O'Brien, European Antitrust Deal With Microsoft Barely Affects Browser Market, N.Y. TIMES, Oct. 10, 2010, http://www.nytimes.com/2010/10/11/technology/11eubrowser.html?ref=business.

138 As of April 2011, Microsoft’s Internet Explorer accounted for 55.11 percent of the global usage of browsers, Mozilla's Firefox had 21.63 percent, Google's Chrome had 11.94 percent, and Apple's Safari held 7.15 percent. http://marketshare.hitslink.com/browser-market-

23-May-11]Behavioral Economics and Dynamic Competition 35Opera Software’s desktop browser “increased in number significantly after

Microsoft started offering Windows users in Europe a choice in browser

with a so-called ballot screen” with “on average, more than half of the

European downloads of Opera’s latest browser com[ing] directly from that

Choice Screen.”139 The remedy, by enabling consumers to easily choose

which browser they desire, increases the likelihood that the market share

reflects more the consumers’ informed choice, rather than the

monopolist’s.140

On the other hand, even before the settlement, Microsoft’s browser

market share was declining.141 So Microsoft’s share could have declined

absent the remedy. Moreover, while providing consumers some choice is

better than no choice, the choice remedy has at least two limitations. First,

offering too many choices can be self-defeating. For example, having

consumers choose among 16 web browsers may lead to a worse outcome

than choosing among five. Consumers may demand more choices than

they actually prefer.142 Again under loss aversion, consumers hate giving up

options and restricting their choice set. But when faced with many choices,

share.aspx?qprid=0&qptimeframe=M 139 http://techcrunch.com/2010/03/18/microsofts-european-browser-

choice-screen-causes-spike-in-opera-downloads/.140 Emanuele Ciriolo, Behavioural Economics in the European Commission: Past,

Present and Future, OXERA AGENDA, Jan. 2011, at 3 (noting how 25% of the consumers who viewed the Choice Screen chose an alternative browser), http://www.oxera.com/main.aspx?id=9324.

141 Id. 142 In one computer experiment, participants tried to keep options open even when

counter-productive. ARIELY, supra note **, at 142-48. In the Door Game, each MIT student could click on three doors on the computer screen to find the room with the biggest payoff (between 1 and 10 cents). Each student was given 100 clicks, and could click one door as many times possible without a penalty. Each time the student sampled another door, that switch cost the student one additional click. Experiment 2, the Disappearing Door Game, was the same as the Door Game except each time a door was left unvisited for 12 clicks, it disappeared forever. To keep options open, participants in Experiment 2 ended up making substantially less money (about fifteen percent less) than participants in Experiment 1. Participants would have made more money by sticking to one door. Id. at 147. A similar result occurred when participants were told the exact monetary outcome they could expect from each room.

36 Behavioral Economics and Dynamic Competition [23-MAY-11some bounded rational consumers avoid choosing any option, even when

the choice of opting out has negative consequences for future well-being.143

Other consumers choose an option, but have lower confidence in their

choice and greater dissatisfaction in choosing. Thus too many choices may

lead to suboptimal results for consumers and firms.144

A second shortcoming with the Commission’s choice model is the lack

of any feedback loop, whereby consumers can test the products and

compare their performance. For search engines, the consumer can see the

number and quality of results for a search term. But benchmarking web

browsers and media players may be harder. To the extent the choice screen

provides consumers a way to compare the products’ performance on

popular metrics, the more likely the consumer’s choice will be informed.

One may question the extent to which defaults matter going forward for

technological innovation. Consumers arguably are more comfortable with

computer technology. Indeed Apple’s Steve Jobs discusses the post-

Personal Computer world of handheld devices,145 where Microsoft is

lagging.146 Many consumers today search and download apps for their

143 Simona Botti & Sheena S. Iyengar, The Dark Side of Choice: When Choice Impairs Social Welfare, 25 J. PUBLIC POL’Y & MARKETING 24, 26 (2006) (discussing information overload, where an increase in options raises the cognitive costs in comparing and evaluating the options and leads to suboptimal decision strategies).

144 The bounded rational firms, as a result, lose sales opportunities of their products. Iyengar and Lepper, in their famous experiment, set up a tasting booth in an upscale grocery store. The booth displayed either six or twenty-four different flavors of jam. A greater percentage of the shoppers stopped to sample one of the displayed jams when the booth had twenty-four jam flavors (60 percent versus 40 percent when booth displayed six jam flavors). But a lower percentage actually purchased a jar of jam (3 percent versus 30 percent of customers when booth had only six flavors). Sheena S. Iyengar & Mark R. Lepper, When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?, 79 J. PERSONALITY & SOC. PSYCHOL. 995–1006 (2000).

145 Brier Dudley, Feisty Steve Jobs Talks Up Apple's 'post-PC' iPad 2, Seattle Times, March 2, 2011, http://o.seattletimes.nwsource.com/html/businesstechnology/2014381153_brier03.html.

146 In a recent Nielsen survey of U.S. mobile consumers for January 2011 to March 2011, 31 percent of consumers who plan to get a new smartphone indicated that Android was now their preferred operating

23-May-11]Behavioral Economics and Dynamic Competition 37mobile telephones, iPods, and iPads; “the average number of apps

downloaded to every iPhone/iPod touch and iPad is more than 60.”147

Downloading itself may become dated with cloud computing. It is fitting

that the same week that the United States antitrust consent decree with

Microsoft expired, two other things happened. First, Google announced its

Chromebook, whereby the user accesses its data and applications through

the Internet. The computer has no operating system (which would require

downloads, updates, etc.). As advertised none of the consumer’s data is

lost, if the computer falls in a lake. Second, Microsoft announced its

purchase of Skype. Microsoft hopes Skype will provide greater inroads in

social networks, which like Facebook, the most popular visited site, do not

require downloads, but can be accessed anywhere.148

Nonetheless defaults will continue to be an issue. Competitors in South

Korea, for example, have complained to the Korean FTC of Google offering

its Android system for free with smartphones.149 Android smartphones use

Google as the default search engine.150 Although it its technically possible

to switch to competing search applications, the competitors argue, as did

Microsoft’s competitors in the earlier antitrust cases, that it is not easy. 151

They complain that their applications cannot be preloaded on the

smartphone.152

system, 30 percent preferred Apple’s iOS, 11 percent identified RIM/Blackberry, and 6 percent identified Windows Phone devices (nearly 20 percent were unsure what to choose next). http://techcrunch.com/2011/04/26/nielsen-consumer-desire-for-android-grows-unlike-ios-and-blackberry/

147 BRYAN M. WOLFE, The Number Of Apps Downloaded Each Day Reaches 30 Million, Jan. 20, 2011,

148 Richard Waters et al., Micosoft Pays $8.5bn for Skype in Push for Consumer Internet Control, Fin. Times, May 11, 2011, at 1.

149 McDonald, supra note **, at B3.150 McDonald, supra note **, at B3.151 McDonald, supra note **, at B3.152 McDonald, supra note **, at B3.

38 Behavioral Economics and Dynamic Competition [23-MAY-11CONCLUSION

Dynamic competition with bounded rational market participants is inherently complex and difficult to predict. We can only comprehend the competitive process imperfectly. But by updating competition policy with the developments of behavioral economics we can see the importance of feedback loops and adaptation to the competitive process as well as a potential entry barrier. Antitrust analysis accordingly must move beyond rational choice theory to

assess the behavior observed in the marketplace. Besides the recognized arsenal of practices to illegally maintain their monopolies, monopolists can exploit consumer biases and heuristics, such as status quo bias and the sunk cost fallacy, to attain or

maintain their monopoly.

Ultimately the issue involves incentives. Bounded rational firms, as this

Article discusses, have an incentive to improve their rationality and

willpower when debiasing provides a competitive advantage. But the

government often lacks this incentive. At times competition agencies

compete for prestige, resources, and cases (such as the FTC and DOJ over

mergers). But inter-agency competition does not necessarily increase

political accountability and reduce the government’s biases and

heuristics.153 Although the competition agencies may attract dynamic

leaders with a desire to critically test the prevailing economic theory’s

assumptions, there are no built-in institutional mechanisms that will

regularly the incentives for government officials to recognize their bounded

rationality, to continually test their theories’ assumptions, to retrospectively

153 When test subjects were expected to defend their judgments to their peers, subjects chose more complex and time-consuming decision-making strategies. Ziva Kunda, The Case for Motivated Reasoning, 108 PSYCHOLOGICAL BULL. 480, 481(1990).

23-May-11]Behavioral Economics and Dynamic Competition 39examine the efficacy of their actions, and to use these findings to update

their policies.154

Consequently, while competition can supply firms the incentive to

debias, competition agencies must now design institutional mechanisms to

engage in the same trial-and-error feedback loop. While some may argue

boring, antitrust enforcement requires patient gardeners, who experiment,

monitor, and update the economic theories of competition, entry barriers,

and monopolization.

154 NORTH, UNDERSTANDING, supra note 39, at 68.